The International Group's reinsurance pool has to try and extract the best deal for the shipowners, while at the same time maintaining its relationship with the international reinsurance market for when it needs the higher cover levels, says Hugo Wynn-Williams, chair of the group's reinsurance sub-committee and chief executive of the UK P&I Club.

The financial year ending February 20 was, to say the least, a pretty eventful period for the UK P&I Club. As was the case for all of the 13 protection and indemnity (P&I) clubs belonging to the International Group (IG), the first six months of last year proved to be the most expensive for the UK P&I Club in terms of the cost of claims than during any other period over the past 15 years.

In contrast to the commercial insurance market, the clubs provide P&I insurance to their shipowner members on a mutual basis. In this way, the mutual P&I sector, which also includes a number of other clubs that are not members of the IG, provides insurance cover to 95% of the world's shipping community.

Indeed, the situation was a concern for the UK P&I Club midway through the financial year when it reported a combined ratio of a 113%. However, by the end of the year, the ratio was down to 102% and, with the help of a 4.5% return on invested assets, the club was able to announce a surplus or profit of around $30m for the year as well as a 7% increase in its underlying capital resources to $528m.

To top it all off, in April Standard & Poor's (S&P) upgraded the UK Club's credit and financial strength ratings from an A- rating to a full A (stable) rating. The club's capital base consists of a combination of free reserves (the mutual equivalent of shareholders' funds) and capital raised through a hybrid perpetual bond which the Club issued in 2008.

Hugo Wynn-Williams, chief executive of the UK P&I Club, says it helped that the claims experience was much more favourable for the club during the second half of last year. "First of all, claims activity calmed down considerably in the third quarter, although it did pick up again slightly in the fourth quarter. So it was a still a very expensive year for us, but it was not as bad as it could have been.

The other thing that happened was our actuaries reported a positive trend in the settlement of a number of larger claims from previous policy years and, as a result of that, we have been able to release some of our claims reserves which also helped to offset some of the impact of the losses earlier in the year."

He says the outcome of the actuarial exercise not only affects the claims being settled by the club at present, but it also affects the view the club takes of the likely outcome of claims that have not yet been settled. Wynn-Williams is also the chairman of Thomas Miller Holdings, the holding company for the Thomas Miller Group.

Reinsurance

It has been a particularly challenging time for the broader P&I sector on the claims front in recent years. So much so the issue of reinsurance costs has become increasingly urgent for the clubs. In the 2012 financial year, there were at least three major losses for the sector (the grounding, which resulted in an oil spill, and subsequent break-up of the MV Rena; the sinking of the Costa Concordia; and the fire on the MV MSC Flaminia) which went beyond the P&I Clubs' retention levels and hit the IG pool, forcing it to restructure its excess-of-loss reinsurance programme, thereby leaving clubs with increased reinsurance costs.

To mitigate the impact of the increase imposed by the market, the IG took the decision to increase the excess point on the contract from $70m to $80m, with the additional $10m retained by the group within its captive, Hydra. So within the structure of the pool, losses between $30m and $80m (previously $70m) are now reinsured by Hydra. For losses up to $9m, individual clubs make their own reinsurance arrangements. The first layer of the IG pool stretches from $9m to $45m, a second layer from $45m to $60m (within which there is a claiming club retention of 10%) and a third layer from $60m to $80m (within which there is claiming club retention of 5%).

Wynn-Williams, who chairs the reinsurance sub-committee of the IG, says the committee is always trying to balance getting the best value for the shipowners while at the same time maintaining the long-term relationship and strategic support the international reinsurance market provides to the IG.

"We know if we want the high levels of cover we have to be aware of what is going on lower down. We established the group captive Hydra so we could absorb more risk at the lower end. However, it is not as simple as saying Hydra will do this, because we have 13 P&I clubs, all of whom have a different risk appetite.

So between the clubs, we are looking at a compromise and looking at the future of the reinsurance contracts we have in place to try and extract the best deal for shipowners, while maintaining our relationship with the international reinsurance market for when we need them for those high cover levels. There are a lot of moving parts and we have to be aware of all of them."

Beyond the $80m upper pool limit reinsured by Hydra, there are a number of further layers in the IG excess-of-loss reinsurance contract to a limit of $3.1bn with Hydra retaining a 30% share up to the $580m layer.

However, according to the UK P&I Club's most recent accounts issued in May of this, during this period of "increasing cost", the club has brought relatively few claims to the IG pool, which has afforded it some protection from the increasing cost of pool claims. According to the accounts, this and other changes to the pool-sharing mechanism, has served to reduce the club's contribution significantly over recent years. In addition, the club has bought reinsurance protection, which will result in significant recoveries on the 2012 and 2013 policy years if those years develop as expected.

Claims management

Despite the dramatic improvement during the second half of the year, 2013 still turned out to be the most expensive year for the UK P&I Club since 2007. According to Wynn-Williams, the increase in claims costs for the club during the first half of 2013, was attributable to the rise in the number of individual claims that cost between $1m and $5m. These claims, he says, fall into a category situated somewhere between the really large claims and attritional claims.

For the UK P&I Club, attritional claims are those costing less than $500,000. These claims, Wynn-Williams says, account for around 80% of the club's total claims volume. The belief within the club is the rise and fall in attritional claim levels is a fairly accurate reflection of the state of the global economy and the state of confidence in the shipping sector.

"When Lehman Brothers collapsed, attritional claim levels came down about 25%. And they have remained down there since. World trade, in terms of the shipping industry, has not picked up as significantly as we expected, but, in the background nevertheless, the average cost of claims is going up. In fact, average claims are now 50% more expensive than they were a decade ago. Our premise is at some point the number of claims at less than $500,000 will increase and therefore we will be hit by the higher average costs experienced in more recent years."

Although 99% of all claims notified to the UK P&I Club are less than $500,000, the remaining 1% - those greater than $500,000 - represent 60% of the total cost of the policy year. "So, if you have a run of large claims, you are going to be much more affected than you are by those claims that are less than $500,000. We invest considerably in our loss prevention services.

For the lower-level claims, there is a lot you can do to keep costs down through education programmes and co-operating with members. But when it comes to the small number of larger claims, it is very much more difficult because you are not talking about an easily observable trend. The occurrence of events that lead to large claims tend to be more random and less easy to anticipate.

Occasionally, you might be able to detect a trend and be in a position to address the underlying causes. With the one-off huge claims, you can try and learn lessons from them, but they are generally more difficult to address in terms of loss prevention."

At the renewals the UK P&I Club turned down 25% of the business that was offered to it. "And that would have been for numerous reasons and not necessarily because ships were in bad condition. The ships might not have been deemed to be in the categories that we are looking for. Almost certainly that business would not have been offered to us by existing members."

New business, he says, is more often than not scrutinised by the club's ship and membership quality committee, which is largely composed of the shipowner members themselves. "It is part of their role to look at our performance as managers, to ensure we are looking for new business in the right areas.

They also deal with any question marks on ship surveys. It is also their role to decide whether it is appropriate to take measures against an existing member or to scrutinise the suitability of new members coming in. But is it is one of the curiosities of life in the P&I world there is not a direct correlation between someone who you may subjectively feel is not a good operator and the claims they may potentially bring to the club. The really bad accident can affect the great, the good and the not so good."

Capital management

An important factor that contributed to the UK P&I Club producing a $30m surplus for the last financial year, a tough and challenging period for the marine mutual insurance sector, according to Wynn-Williams, is the increased flexibility the perpetual hybrid capital bond provides to the club's investment and asset management strategies, particularly in the present low interest rate environment.

"The point about hybrid capital is it provides additional solvency capital that increases our capital base and our flexibility in terms of the investment options open to us. The way in which solvency capital works from the regulators' point of view, you always have to be aware of the investment market risks. But the stronger your capital base, the more risk you can take.

For example, with a low capital base, it is not that easy to make a meaningful investment in equities, which means in the current financial market context, you are very likely to be missing out in terms of investment income. So, last year, we were able to get a reasonable return out of our investment portfolio. About 4.5%. Had we been out of equities, our return would have been substantially less than that. So with the hybrid capital bond, we were able to enhance the capital of our shipowner members' capital. That is how we see it."

The hybrid bond, which accounts for $98m of the UK Club's total capital of $528m, was issued in 2008, during another challenging period and not only for the P&I sector. Indeed, it was so challenging, the bond did not prevent the club from having to make an additional call for funds from its members during the following year to compensate for negative investment income and an escalation in claims costs.

Wynn-Williams refrained from responding directly to the question as to whether the UK P&I Club shipowner members are among the hybrid capital bond holders. However, he says people likely to buy that kind of bond would be people who understood the credit profile a P&I club represents and, in that regard, they could potentially be P&I club members. By the same token, however, they could also be investment banks or wealth managers familiar with the P&I world .

The subject of capital management is a particularly important one for the UK P&I Club, which, between 2012 and 2013, has reorganised its structure largely in response to Solvency II. The object of the exercise, Wynn-Williams says, was to streamline the governance structure of the club, reduce compliance costs and manage the club's solvency capital requirements more efficiently.

UK Europe now constitutes the direct underwriting entity and issues insurance policies to the vast majority of UK P&I Club members.

"With UK Europe issuing the insurance policies to the members of the UK Club, that enables us to present an entity to our regulators here in the UK, the Prudential Regulatory Authority and the Financial Conduct Authority, which looks more like a normal insurance company board with executive officers, representatives of the shipowners and people, including those with auditing or accounting backgrounds, with specialist risk management backgrounds.

People with the necessary qualifications to run a regulated insurance company in the modern business environment. The restructuring has also enabled us to bring our company entirely onshore. The enables us to hold the regulatory capital necessary for the business in UK and then to hold any excess capital in Bermuda. So that is how we operate now. The business is written by UK Europe and is reinsured by UK Bermuda."

In terms of service provision to members nothing much has changed, he says. "We are still providing all the services internationally for the UK P&I Club. Effectively, we are running the business as if it were ready for Solvency II. We are also going through the pre-application process for an internal solvency model for the club, which we hope will enable us to employ our capital in the business even more efficiently. Once we have it in place, it will enable us to reduce the capital required to support the business in the UK and Europe and still continue to write the same volume of business."