FINDING RELIGION

With premium rates turning upward at long last, insurers are wondering what more can be done to improve bottom-line performance. At the recent North American Insurance Conference in Florida, insurers in both the primary and reinsurance markets heard that pushing prices up will not be enough to tackle the industry’s profit problems. Finding new markets, using surplus capital and, above all, dealing with rising expense ratios are key to finding light at the end of the tunnel, they say.

There may have been sunny skies on the sands of St. Pete’s Beach as delegates gathered for the recent North American Insurance Conference, but it was talk of persistent storm clouds hanging over the insurance industry that dominated the agenda. Lackluster underwriting results, soaring expenses and the stubbornly slow hardening of rates were among the concerns brought forward by speakers. The answers, they say, are to reduce costs and put the industry’s excess capital to work.

“The good news is 40% of Canadian [insurance] companies made an underwriting profit in 1999,” notes Serge LaPalme, president of Underwriters Adjustment Bureau (UAB). “The bad news is 60% did not.”

In fact, LaPalme says, as a whole the Canadian market has not produced an underwriting profit since 1978. The situation is only slightly less poor in terms of return on equity (ROE), which dropped from 7.3% in 1998 to 6.4% in 1999, but rebounded marginally to 7.8% for the second quarter of 2000, he explains (see Chart 1).

The trends are no more promising south of the border where the combined ratio for personal lines stands at 108% for 2000, almost 110% for commercial lines, and almost 115% for reinsurance, notes Herbert Goodfriend, senior vice president at Gill and Roeser. Critical issues facing the industry, according to Goodfriend, include e-commerce and distribution, regulations and investment performance, as well as the rise of alternative risk transfer (ART) methods. On the other hand, these same issues also present opportunities, particularly in through the potential of new risk models and the Internet.

Key factors

But how did these poor results occur in the first place? Alan Zimmermann, director of research at Fox-Pitt Kelton, says several factors led to the industry losing pricing power. Foremost is the excess of surplus in the industry. “You can’t have that disproportion.” Another key is increasing buyer sophistication. “After the hard market of the 1980s, corporations realized they didn’t need to buy as much insurance as they thought they did.” The result saw increased “self insurance” in the commercial market, and more recently the development by investment bankers of the ART market. “An informed customer expects an awful lot more…it has become a battle for client ownership,” notes LaPalme. Goodfriend points out that this trend characterizes the U.S. economy as a whole. “Taking business away from someone else seems to be the order of the day, rather than finding new business.”

The flip side of this is that insurers are increasingly feeling the pressure of the banks’ attempt to step in and take away business. In the U.S., regulatory changes allowing banks to own insurance companies may facilitate this, while in Canada banks are sidestepping the ban on selling insurance through branches by online and direct sales distribution. While the success of the banks remains to be seen, their determination to enter the business at all begs the question: if ROE on insurance business is so poor, why would anyone want to enter the fray? Goodfriend notes that ego may be at the heart of it. “They think they can manage it better…but that hasn’t held water.” And, for those insurers who have waded through the soft market, “the journey into the new millennium remains paved with danger signs, higher severity, low interest rates and inadequate premiums, not to mention the high cost of technology”, notes LaPalme.

Rates turning

There are positive signs of rate increases this year, and analysts suggest there is more to come. As Goodfriend explains, “after 14 years of poverty and self-annihilation, the [p&c insurance] industry has finally found religion.” This is true on both sides of the border, and in both the primary and reinsurance market. In fact, Goodfriend notes, reinsurance cat rates in the U.S. are up 10% to 25%, but in Europe the trend is even more startling, with rates jumping 200% to 400% in some cases.

Why are rates turning now? Zimmermann postulates that weak cash flow, poor return on surplus and lackluster stock performance, are among the factors involved. Another surprising incentive is that “corporate boards are becoming more proactive” and thus more likely to replace CEOs as a result of poor financial results. These factors are even more at work in commercial lines, he says. In the U.S. market, for example, a 40% rate inadequacy has led to 4% to 5% increases in each quarter of 1999, jumping to 12% per quarter of 2000. If insurers maintain this level of price discipline, he expects to see another 2 years of price increases.

Risky ventures

But rate increase alone will not heal insurers’ wounds, says Zimmermann. “I don’t think insurers have responded to the changing risk transfer needs of their customers,” he says. While the risks of 20 years ago were physical in nature (i.e. industrial), now the biggest share are financial risks (for example, stock prices, earnings). “The numbers are staggering in terms of what companies will pay to transfer risk…the problem is, they’re not paying it to you [insurers].”

Excess capital, which long held back rate increases, needs to be put to work, he suggests. Insurers need to “broaden their product base” and use the capital in the industry. He recommends insurers become involved in alternative risk financing methods, including such things as derivatives, futures markets, asset-backed securities.

Goodfriend also sees ART as the wave of the future for insurers. “The alternative market is a major force, rising rates may further facilitate its popularity.” The thesis was that the soft market would make ART less attractive, he notes, but this proved not to be the case. Commercial insurance has declined as a percentage of U.S. gross domestic product (GDP), he says, largely as a result of the move to ART programs.

Counting the costs

Reducing expenses has long been a theme in the insurance industry, and with the poor results being experienced by insurers the cry to cut costs is louder than ever. Despite the talk, however, expense ratios are not going down, notes LaPalme. “For the past 20 years the industry has had to depend on investment income and realized capital gains to show a bottom-line profit.”

Technology shows the promise of reducing costs, but there is mixed sentiment about whether or not this promise will be realized. “Larger players will have a key advantage in their ability to reduce costs and utilize technology,” says Goodfriend. Zimmermann agrees that technology is key to tackling expenses, particularly in reducing manpower, and laments that the industry has lagged in this area. But technology alone will not fix the industry’s financial problems, says LaPalme. “While technology might very well lower costs, it will not increase profits”, he predicts, because it will encourage further price competition.

Insurers need to “contain spiraling claims settlement,” he suggests. This means addressing the areas where more and more money is being paid out, namely in accident benefit and bodily injury claims. The industry is paying out more for “blood” than “wood and metal”, LaPalme says, alluding to the fact that, in Ontario for example, in absolute dollars more money is being paid out for injuries than collision repair in auto claims.

Analysts agree that one trend that will take shape in the future is the move to outsourcing. Cutting expenses in the claims arena will likely see the most attention, the speakers concur. “If we are to control expenses, outsourcing becomes a viable option,” says LaPalme. This is already being done by the new “virtual insurers”, he says, and can offer insurers mo re accountable claims handling.