The criminal findings against former directors of the Independent Insurance Company were of particular interest to me: a large slice of my firm’s primary layer of professional indemnity insurance was carried by the Independent at the time of its collapse in mid-2001 and had to be replaced in a hurry. Secondly, a small team from my forensic department assisted the SFO during the pre-trial investigation, although I was not privy to their findings, which were covered by the Official Secrets Act.

Insurers and brokers would often express puzzlement at the astonishing growth of the Independent

Throughout the 1990s I was Chairman of the Institute’s PI Committee. Insurers and brokers would often express puzzlement at the astonishing growth of the Independent at a time when the indemnity market was so soft that margins were miniscule and other underwriters were turning elsewhere to apply their capacity. Yet the Independent floated on the Stock Exchange in 1993 and its market share grew until it become the UK’s ninth largest insurance company by the end of the decade with a market capitalization of £900 million.

The truth about its magic formula only came out, of course, after its collapse in June 2001, an event that sent shock waves through the world’s insurance markets, the professions, the stock exchange, the financial services regulators and the City at large.  The FS Compensation Scheme paid out £366 million to holders of Independent’s policies.

The prosecution’s evidence showed that a major factor contributing to the company’s demise was the consistent and deliberate withholding of claims data from external consulting actuaries Watson Wyatt.

 Claims reserves – what should happen

Bona fide claims invariably require reserves to be made. One obvious component of these is an estimate of the amount needed to settle claims notified before the end of the year.  Another relates to claims “incurred but not reported” (IBNR); and there is a further component labelled IBNER: “incurred but not enough reported”. The IBNR category includes an estimate of claims anticipated in addition to those already notified, relating to business actually written prior to the year-end.

All these analyses and sub-analyses are routinely entered in the central computing system, on which external auditors and actuaries rely when extracting information about claims. At the Independent, however, large claims were deliberately left in IBNER (effectively “pending”) long after they had been quantified for reserving purposes.

Upward adjustments to existing claims reserves, needed in the light of current developments, were also deliberately kept off the computer system.  Finally, claims-handling agencies submitted regular “bordereaux” to the Independent showing the sums they believed were warranted in respect of each claim, yet a significant volume of these remained unrecorded. Calculations made by the prosecution’s actuarial experts estimated that by December 2000 the understatement in required reserves lay between £110 and £250 million.  No wonder the company appeared to be profitable!

Estimation hazards

Whenever estimation plays a key role in determining financial performance it is essential that actuaries, auditors and regulators should remain circumspect. They must resist the temptation to accept seemingly plausible explanations from the browbeating  top man and pursue their own objectives diligently.

Traditional reliance on analytical year-on-year comparisons would, in Independent’s case, have rung alarm bells only if a few large claims somehow got onto the system – so consistently were they suppressed!  And what is the use of an industry regulator if it lacks the power to investigate an insurer whose premium rates are the lowest on offer; whose claims reserves are the lowest in the sector; yet whose profits break all records?

Manipulation of claims reserves by simply suppressing the liabilities is a virtual licence to print money – until the currency is so debased that the real cash dries up. Regulators who impose a disciplinary framework for an entire industry but are impotent to pursue its rogue elements just make life difficult for its compliant members.

For years many suspected that the emperor had no clothes, yet nothing was done about it.  Will the glaring lessons of the Independent now be taken seriously?