The complexity of pricing for long-tail liability

How long is a piece of string? For insurers, long-tail liability claims are an unpleasant unknown: extending way past policy expiry dates, and eroding value.

Naturally, an industry that deals in assessing and pricing risk would like to understand and quantify long-tail liability, but how?

Long-tail liability claims can arise across many different insurance lines, including construction, events, directors and officers (D&O) liability, and legal and medical malpractice.

Actuarial perspective

Taylor Fry director Danielle Ling views long-tail liability from an actuarial perspective.

‘If we look back in history, one of the reasons behind rising premiums is that claim costs have been rising and insurers can't make enough profit,' she says.

'The only choice they have is to either withdraw cover, which reduces availability, or increase the premiums, which reduces affordability, or both.’

She points to the construction industry and the issues with building cladding as an example.

‘Claims costs have been so much higher over the past five, six years compared with what we saw 20 years ago,’ she says. ‘There was a little bit of under-pricing too, in some of these classes, so you have two forces working jointly to push up the premiums.’

Hard and soft cycles

‘How do you price something when you don't know, potentially 10 years later, what the legislation is going to look like and what the cost of the claim will be?’

That's a question of interest to Cameron Hill, senior underwriter, casualty, at Liberty Specialty Markets.

He says inflationary pressure, judicial flavour, social employment inflation, increased medical and legal costs, and psychological elements are all currently driving up the costs of long-tail liability claims.

These factors are typical in the cycle of hard and soft markets that characterise long-tail liability.

Ling says if we look back over the last 20 years, we can see the patterns emerging.

‘In the early 2000s, there were very high public liability premiums,’ she explains. ‘Regulators and the government stepped in with tort law reform to limit the maximum benefits payable and to tighten the eligibility criteria. Essentially, legislation reform was introduced to keep premiums affordable.

‘But when you introduce legislation reforms, there's always going to be pushback from stakeholders such as the unions. Right after the introduction of the law reforms, premiums dropped very sharply for the next two, three years.

'But, over time, the effect of the legislation reform deteriorated through further laws relaxing some of the limitations, lawyers finding loopholes, and landmark court cases opening up whole new avenues for more benefits.

‘When premiums once again become unaffordable, new legislation is passed — and so the cycle continues,’ she says.

On the books for a long time

In some instances, it can take the courts many years to come to a decision on an interpretation of the law as it relates to a claim.

Hill says this was the case in a dangerous recreational activity claim concerning a fall from a horse, which was decided in the High Court recently.

‘The NSW Civil Liability Act was introduced in 2002, in part, to limit claims from obvious risk when engaging in dangerous recreational activities,’ says Hill.

‘In this case, an accident took place in 2011 and the final court decision was made in 2022 — 20 years since the revision of the law and more than 10 years since the accident occurred. Reserves were set based on understandings of how the law was designed and had been applied since 2002.’

Ling adds that claims such as these can remain on the book for a long time.

‘We might be talking medical costs that are available for life: financial compensation for a young worker that will last 30 years, until retirement age,’ she says. ‘The liability for those future 20 or 30 years of claims is very sensitive to factors like changing economic assumptions and social inflation.

‘When insurers calculate the premium, they look at the present value or the present estimate of all those future payments. That's what makes long-tail liability so much more challenging compared with, say, short-term home insurance.’

Adding COVID-19 to the mix

The pandemic also impacted the long-tail liability landscape.

Says Ling: ‘In workers comp, there was a very sharp decline in our return-to-work outcomes during COVID. Workers stayed on benefit for longer, either because the position they wanted to return to no longer existed or because of the lack of treatment options, due to hospitals getting inundated with COVID patients.

‘There were also insurance classes that were directly impacted by COVID-19, such as business interruption cover and professional indemnity covering doctors.

'Telehealth, for example, gained a lot of popularity during COVID but the lack of face-to-face assessment — especially for initial consultations — meant the rate of correct diagnoses of serious conditions like cancer dropped.

'We’ve seen a lot of claims coming in from doctors and also lawyers during COVID, in the professional indemnity classes.’

Hill agrees. ‘There was also a slowing of settlements. As you can imagine, settlements are more efficient when people get together in a room, rather than on Teams or Zoom. Because of this, claims weren't getting settled as quickly, but that’s correcting itself now.’

Realities and strategies

Hill says data shows that some segments have long-tail liability loss ratios sitting in the 60s or higher. ‘When you add in everything else — expenses and reinsurance costs — you're not meeting the company's return on capital,’ he says.

‘Whether you're an underwriter, a frontline claims manager or a broker, you can understand why prices have increased the way they have in recent years and why, in certain segments, the prices will continue to increase as we deal with the inflationary pressures we’re experiencing at the moment.’

That said, Ling says there are some potential strategies to address the affordability crisis in long-tail liability — and she’s looking forward to discussing them with insurers at the upcoming Australian Liability Conference in early November.

‘Hopefully they’ll find some inspiration among the different options, and find a strategy that will work for them in the short term, medium term and long term.’

Find out more about the ANZIIF Australia Liability Conference