Articles

A specialist commercial law firm in the city of London

The Perfect P & I Club

As the anniversary of the P & I clubs passes on 20th February, we offer some reflections concerning what is now for shipowners their biggest insurance cost.

Mutuality

P & I clubs are said to be ‘mutual’ insurers. There is no risk transfer to a third-party underwriter, according to the classical definition. The shipowners themselves share the risks covered, mutually among themselves. There is no limit to what they may have to pay in order to meet the club’s liabilities. If there is not enough in the pot to pay the liabilities due, then ‘supplementary calls’ are levied in order to balance the books. Now however the amount of risk actually retained within a mutual arrangement, so that the members share the claims, is a small percentage only. Not only do the clubs in the International Group, for example, reinsure each other in a pooling arrangement (which is a form of mutuality), but they all collectively buy a reinsurance contract, the International Group Excess Reinsurance contract, which is said to be the biggest single reinsurance contract, by scope of cover and premium volume, in the world. Then in addition each separate club buys reinsurance to protect its retention, both against the impact of each claim and usually also against the aggregate of claims exceeding a certain limit. The objective is to make the cost predictable, to minimise the likelihood of supplementary calls.

Cost/Profit

Mutual insurance differs from market underwriting in that a mutual does not make profit, but simply aims to break even. In the classical model, if the mutual takes too much in advance, there will be a return of calls to the members. However in market underwriting, the underwriter accepts risk in return for a premium, which is calculated to provide enough to pay claims and to make a profit for the underwriter. All other things being equal, therefore, a mutual should cost less than a market cover, as there is no profit element. However, to the extent that the clubs reinsure with the market, the reinsurance cost will include an element for the reinsuring underwriters’ profit. Comparison of the figure for claims paid under the reinsurance with the premium ceded by the clubs will show the amount of the profit margin. It is considerable.

Rating

All P & I underwriting is done by reference to certain common criteria, as follows. The ‘burning cost’ for a member’s fleet is predicted. This is the likely cost of his actual claim payments in the year. The prediction is done by looking at the member’s record, and assessing how likely it is that history will repeat itself. Students of Thucydides will recall how fallacious this can be. Then the club’s reinsurance cost and the cost of administration are shared out between the members, so that typically a member will bear such proportion of these ‘overheads’ as his fleet size, compared with the club as a whole, bears, modified by the proportion which his claims record bears to the average in the club. So if he has 10% of the tonnage in the club, and his record is twice as bad as the average, he will pay 20% of the overheads. Underwriting is essentially predicting the future. However, P & I underwriters do not employ statistical theory to assist in their predictions. It is taken for granted that the samples upon which predictions would be based would be too small to allow reliable statistical extrapolation. So, ideally the club cover works to protect an owner against his liabilities, on the assumption that his record will repeat itself. In case this does not turn out to be the case, the club reinsures, by itself facultatively, with the International Group Pool, and through the Group Excess Contract. Ultimately, it falls back on its ability to collect supplementary calls. But supplementary calls are seen as something to be avoided. Predictability is the goal. But again, the edifice is based upon a fallacy, that history will repeat itself. So, in the absence of any other rational basis of prediction, clubs fall back on creating ‘free reserves’ which some commentators even call ‘profits’. This brings into focus the fact that now there is a logical confusion at the heart of P & I underwriting. On the one hand, it is said to be mutual, non-profit-making sharing of risk by collective self-insurers. On the other, in practice it can only be made to work by the use of a profit mechanism.

Mathematics and Statistics

It is suggested that it might be fruitful for the clubs to commission research into the statistics of small samples, such as the likelihood of particular risks obtaining. There are a certain number of ships of each type sailing: a certain number of them have claims or accidents of particular types each year. Is it really true that ‘… in this world nothing can be said to be certain, except death and taxes. ’? If not, perhaps at last P & I could be truly mutual, but still avoid nasty surprises.

Hugh Bryant

24 February 2004

Hugh Bryant and the Bryant Hamilton & Co team have considerable expertise in all forms of marine and commercial insurance.

Contact +44 (0) 20 7702 1156, or email bryant@bryanthamilton.com