A Bridge Too Far?

A return to another cycle is inevitable, as property and casualty insurers have historically become “overly optimistic” when financial conditions have become fairer and they therefore over-react in easing underwriting guidelines and pricing, says Matt Mosher, vice president of property/casualty at rating agency A.M. Best. Mosher, along with two insurance industry investment analysts that formed a discussion panel at the recently held National Insurance Leadership Symposium (NILS), share a generally dour view of the ability of insurers to break from their bad habits of the past. Also, the analysts believe that the “sins of the past” in terms of weakened reserves will weigh heavily on the established market players, thus creating a divide between the financial returns fetched by the “old” and “new” companies having entered the marketplace.

Insurer and broker CEOs, who partook in a separate panel debate, were also cautious of current market conditions despite the dramatic recovery of the industry’s financial fortunes over the course of 2003. Notably, Jeff Post, former CEO of Fireman’s Fund Insurance Co., points out that the 9.4% return on equity (ROE) achieved by U.S. insurers for last year hardly represents a situation to gloat over. This return, he observes, was made after three years of a “hard market” in pricing – thus delivering what he describes as some of the best rates seen over his 22 years in the industry – yet the return delivered lags that of many other business sectors. More importantly, he notes, is whether the price strengthening witnessed during 2003 can be maintained moving forward. “Is this sustainable?” He referred to the Council of Insurance Agents & Brokers (CIAB) 2004 first quarter commercial rate survey which suggests that the bulk of corporate/business risks received upward pricing adjustments on coverage renewals of between 1%-10%. In some cases, rates have even declined, he adds (CIAB is the primary organizer of NILS). “With 88%-plus of commercial business not receiving premium increases, you [an insurer] need a combined ratio of 93%-94% to get a pre-tax ROE of 13%.”

Whether price strengthening can be maintained or not in moving forward, Post and the other CEO panel members point to existing financial weaknesses in the industry: the value of reinsurance recoverables, general under-reserving of companies, run-away tort costs, asbestosis exposures, uncertainty regarding the future of the U.S. government’s Terrorism Risk Insurance Act (TRIA) and the ability of the industry to attract new capital.

LOUSY BUSINESS

“This [p&c insurance] is, and will always be, a lousy business from a business [investment] point of view,” says Vincent “VJ” Dowling, an analyst and founder of Dowling & Partners Securities LLC. While the 2003 financial returns of insurers, specifically listed companies, suggests that coverage pricing in most lines of business is now adequate, he notes that there are already signs that market softening is occurring, and that company results for last year and 2004 will likely reflect the industry’s peak performance. “The market dynamic won’t change, this will still remain a single-digit ROE industry. You will just have to live with it.”

The number of rating agency financial downgrades of insurers continues to outnumber upgrades, observes Mosher. And, in going forward, there is a shift in the “matrix” by which rating agencies are evaluating companies, he says. “I expect, looking ahead, that the raters are going to look at sustainability of the financial improvement [of insurers] before issuing upgrades,” he adds.

Chris Winans, senior vice president of research at Lehman Brothers, holds a more optimistic perspective of the p&c insurance industry’s immediate future. “I think that pricing is [currently] above need [of market costs].” He believes that there is currently a “10% margin” in costing, which will likely temper rate increases/decreases this year into 2005 by about 10%. The real issue is whether further under-reserving will surface within the industry over that time period. But, he notes, insurers are in a situation where they can say “no” to unacceptable risks/pricing. “Insurers are now leaving markets/regions where they aren’t happy with their exposure…the regulators have less ‘teeth’ than four years ago.”

However, a significant market driver emerging, Winans says, is that the more financially strong companies are benefiting to a greater degree from the firm pricing cycle. “The rich are going to get richer, and the poor will get poorer,” he predicts. Dowling holds the same view: “There is going to be a lot of separation of the good companies from the bad [companies].”

RATING DILEMMA

The value of company gradings issued by the rating agencies was put on the table by Dowling. He points out that the grades made by the raters on insurers ultimately comes down to those same companies having paid for the service. In this sense, Dowling questions the content, disclosure and timing of the upgrades/downgrades made by the rating agencies in performing the role of guiding brokers and insureds in the placement of business with financially sound insurers.

In this respect, Dowling also took aim at brokers, suggesting that many in the profession simply go for the best price without full consideration of the financial strength of the carrier in question. Winans supports this sentiment, “there is no downside for brokers in going for the cheapest market and not being concerned with solvency [of the carrier].”

Mosher concurs that the rating agencies are not in a position to disclose information not authorized by the insurers they grade. However, he believes that the current regulatory environment has enhanced the quality of public information and the reporting of insurers. He believes that application of the Sarbanes-Oxley Act, regarding heightened corporate governance and company disclosure, will influence the manner in which insurers operate. “Sarbanes-Oxley cannot be ignored as we move into a softer market.” Winans also expects that greater scrutiny and financial disclosure will influence insurers to stay on the right track. But, will this result in insurers ultimately breaking from their past cycle extremities and encourage new investment capital into the North American p&c insurance sector – the analysts were less than sure.

VEXING DOUBTS

The insurer and broker CEOs saw the industry’s ability to maintain underwriting discipline in moving ahead to be the biggest “unknown factor” that could ultimately derail the positive gains made from the hard market. However, they note that there remain several weak fundamentals in the industry’s current operating environment. At the top of their list are reserve adequacy and the exceptionally high level of reinsurance included in companies’ statutory reserves.

Post believes that the U.S. industry overall is presently about 8%-10% under-reserved. “We [the industry] currently don’t have adequate surplus. We have to keep the prior accident years clean.” He also expresses concern over the role reinsurance plays in the reserving of companies. Should a major reinsurer be unable to meet such a commitment, or is forced into proportional payment on claims, the result will have a “domino effect” on the primary marketplace, he adds.

Jerry Sullivan, chairman of the Sullivan Group, says the most alarming factor regarding the potential default of payment by a reinsurer is that the true extent of the risk of this happening is unknown. “Reinsurance as a ratio to [industry] surplus has grown dramatically over recent years. The question, just how serious is this?”

Andrew Beazley, CEO of Lloyd’s of London underwriter Beazley Group, PLC, notes that “reinsurance was a great hedge [during the soft market years]”. As a result, reinsurers took on some “big numbers” in terms of business written during the 1990s, he says, hence the current concern that some companies may not be able to respond to a mega loss. And, he adds, the issue of questionable reinsurance recoverables has two faces: “those [reinsurance companies] that won’t pay and those tha t can’t”.

However, Beazley is optimistic that the North American insurance industry will continue to show financial improvement moving forward. Tomorrow’s marketplace will be different from that of the past in that those insurers with more efficient underwriting skills will be the survivors. “It’s those [insurers] who are more adept, more efficient in underwriting skills that will get through.” Furthermore, he says insurers have to focus on “what is down the road” in terms of their risk pricing. “We have to start pricing before rather than after.”

Post notes that there are differences between “smart and dumb companies”. The industry shakeout brought on by the soft market did result in a cleansing, and in looking ahead, he believes the industry is capable of changing its future from the past.

COST FACTORS

Despite the fact that insurers brought much of the financial problems of the industry onto themselves, external factors such asbestos and the overall rise in tort costs have played critical roles in the underperformance of companies, says Post. “We’ve partly under-performed as well because of the runaway tort system in the U.S. Just look at the asbestos situation. Tort has now become a 5% ‘tax’ on every salary in the country.”

Gordon Steward, president of the Insurance Information Institute (III), and moderator of the NILS CEO panel, queries whether lack of reform to curtail asbestos liability losses could be a significant enough “external pediment” in making the industry’s bid to achieve sustainable profitability an impossible objective. Short of tort reform, the asbestos problem will get “worse and worse” predicts Robert Joyce, CEO of Westfield Group.

Asbestos is not the only tort cost issue severely impacting insurers, observes Sullivan. “The ‘trial bar’ is a growing and constant cost.” Notably, tort claims relating to medical malpractice has become an increasing concern for U.S. insurers, he adds, with a number of carriers having withdrawn from some states in response. “However, the problem is currently not big enough to attract the attention of the legislators.”

Post stresses the need for full tort reform, which he is optimistic will eventually come about. “It’s simply a matter of making enough people aware of the problem. The tort system has to change.” In this respect, Joyce notes that brokers can play a significant role in bringing about tort reform simply by “getting the word out” in their communities. “Brokers have tremendous influence with the public to get support for tort reform,” he adds.

The risk of terrorism, and the possibility that the U.S. federal government may not extend TRIA beyond 2005, is also a high priority concern for insurers, the CEOs say. Terrorism is an uninsurable event by definition, Post argues. “That’s a good reason why we can’t price it.” Beazley concurs with this sentiment in noting that insurers simply do not know how to price terrorism risk. “The government should keep the existing TRIA process in place…it’s cheaper than trying to get insurers to price it.” Over the longer-term, the government will have to be involved in some form or the other in providing terrorism coverage, agrees Joyce. “Terrorism is an uninsurable risk.”

Post says that the government has the option of either being in the terrorism reinsurance business in a thoughtful manner or being involved in a post-crisis event. “Insurers simply won’t insure [terrorism risk] if TRIA is cancelled.” And, there is a critical need for government to respond quickly regarding the future of TRIA in that covers renewed in January of next year will have to take into account the future role of reinsurance, he adds.