Jim Armitage: Disaster warning for insurance market has a familiar ring about it

Outlook Who could ever imagine a repeat of the conditions behind the banking crisis? Surely we will never forget them: a wall of money seeking a home, low interest rates driving investors to ever more complicated assets in search of returns, a resulting downward pressure on prices as investors compete to buy without properly assessing the risk. And finally, disaster: losses on an unforseen scale.

But this week, one man in the City did imagine such a Groundhog Day.

John Nelson is not a banker now, but he was for most of his life. So we should heed him when in his current position, as chairman of the Lloyd's of London insurance market, he warns of parallels.

He warned the insurance world that a flood of cash from hedge funds, pension funds and other investors into the Lloyd's insurance market could tempt underwriters – those gatekeepers of risk – to lose sight of the correct price to charge for insurance. Lloyd's, of course, specialises in the most complex types of insurance – kidnap, oil rigs, shipping, the legal liabilites of everyone from mom 'n pop stores to local government and hospitals.

Now, as if that wasn't complex enough, those behind the clever money have created financial instruments such as catastrophe bonds, which mimic the underlying risk being covered by the insurer.

They're sold to investors by insurers to offset the risk they are taking on their own balance sheets. But now there are rising concerns that they will not cover the true exposure of the insurer when the big claims happen. As the capital markets have charged into the insurance world, so have these derivatives become more complex, boasting names like "sidecars", "Cat-E-Puts", "Cat risk swaps" – the kind of names more familiar to bank securitisation experts than insurance companies.

Fans say such innovations have benefited customers by bringing down premiums. They said the same thing about sub-prime mortgage bonds.

But Mr Nelson was clear in his message to insurers. Amid all the financial wizardry of the derivative inventors, don't lose sight of the key question: can you really afford to pay your customers' claims?