Old Skeletons…

While the financial fortunes of North American property and casualty insurers are looking decidedly better for 2004 compared with the last two lean years, there remain many unresolved issues that could undermine the industry’s long-term financial stability. Among these “old skeletons” still knocking around are market fragmentation, reserve adequacy and the lack of new investment capital available to the industry. And, rating agencies also point to a newer “set of bones” in terms of questionable reinsurance recoverables which seem to have been secreted away in the industry’s dark closet.

Most Canadian and U.S. insurer CEOs concur that their respective marketplaces are highly fragmented compared with that of the other financial services sectors. This is hardly a new problem, and lies at the heart of the industry’s wild “hard” to “soft” market swings of the past. “Inevitably there will have to be consolidation [of the industry] through mergers and acquisitions if we [insurers] are to achieve the returns [sought by investors],” comments Jay Fishman, CEO of The St. Paul Cos. (Fishman partook in a CEO panel discussion at the recently held Joint Industry Forum (JIF) – see article on page 34 of this issue of CU for further details). A survey conducted by the Insurance Information Institute of attendees at the JIF event indicates that over 70% of senior management in the U.S. insurance industry also expect to see consolidation within their ranks this year.

However, while all agree that industry consolidation is a necessary step as part of the “road to recovery”, there is not much enthusiasm that this will be achieved through M&As. Basically, insurers recognize there is currently little value in “buying up business”, which doing so also opens the door to potentially nasty surprises such as reserve shortfalls, bad books of business and technology compatibility hassles. As Ronald Pressman, CEO of GE Employers Reinsurance Corp., observes, “the list of successful industry M&As is a very short list”. The rating agencies have also adopted a jaundiced view toward companies engaged in either mergers or acquisitions. As such, M&A activity will likely remain slow for the foreseeable future, predicts Henry Witmer, a senior financial analyst at A.M. Best (see article on page 32 of the December 2003 issue of CU for further details). So, if M&As are not likely to play a significant role in industry consolidation, how will this be achieved? And, as such, why will this “cycle” be any different to years past?

Then there is the problem of reserve shortfalls. The last two years have witnessed most of the global insurance players at the primary and reinsurance levels bringing in multi-billion dollar reserve adjustments not just for “big ticket” loss covers like asbestos, but also for what rating agency Standard & Poor’s (S&P) describes as “bread and butter” business. The rating agency has been highly critical of insurers’ actuaries for their poor judgements in this regard.

But, the more alarming concern as the industry moves ahead is the “quality” of the reserves made by insurers. S&P notes that a significant portion of the reserving adjustments depend on reinsurance recoverables. In the rating agency’s opinion, these charges are doubtful in terms of whether some reinsurers will have the ability to pay up while the very large numbers at stake will see increased legal disputes with primary companies. Notably, S&P points to a “ground up review” conducted by Liberty Mutual Insurance Co. toward the end of last year after which the insurer boosted its gross reserves relating to asbestos claims by US$405 million. Included in this adjustment is a bad-debt provision of US$158 million which the insurer believes may not be recoverable from its reinsurers (this is equal to about 55% of Liberty’s asbestos reinsurance receivables in this area). So, while insurers’ reserves are gradually becoming stronger as the industry’s profitability rises, there remains grave concern regarding the true financial soundness of many companies (which therefore dulls the potential for M&As and a proactive means of consolidation).

Against the market difficulties described above, insurers will face a formidable challenge in enticing new investment capital into the industry. Even with Canadian and U.S. insurers achieving substantial gains during 2003 in lowering combined ratios to around 100%, most companies are still only delivering ROEs of 10% or less. This is almost 50% less than expected by stock market investors, the III’s chief economist Robert Hartwig notes. Low returns and high risk do not make an appetizing meal. In order to grow and bring about the necessary consolidation of numbers within the industry’s ranks, insurers will have to find a way to convince shareholders to open their purse-strings. But, is it the egg before the chicken, or the chicken before the egg?