Quicksand…

With the world in general now getting back to the serious business of “business” after the yearend festivities, those in the property and casualty insurance industry are no doubt feeling a lot more optimistic than past years with regard to market conditions for 2005. With both the Canadian and U.S. p&c insurance industries having recently reported their 2004 third quarter financial returns, the overall financial picture points to a period of healthy earnings growth with underwriting results well into the black after years of much red ink. In fact, the U.S.-based Insurance Information Institute’s (III) chief economist Robert Hartwig notes that insurers are likely to end 2004 with their first underwriting profit in over a quarter of a century.

The Canadian insurance industry nearly tripled net income for the first nine months of last year compared with its net return for the same period in 2003. Insurers also generated an underwriting profit of $2.2 billion for the first three quarters of 2004 versus a loss of $123 million for the same period in 2003. U.S. insurers increased net income for the first nine months of last year by 28% over the equivalent period in 2003, and produced an underwriting profit of US$2.8 billion compared with a loss of US$5.8 billion incurred for the first nine months of 2003 (see MarketWatch of this issue for further details). The strong growth in underwriting profit and net income over the past year has greatly benefited the surplus position of both the Canadian and U.S. industries, leading many of the rating agencies to revise their financial outlooks from negative to positive.

However, as the adverse financial outcome of the last soft market illustrates, the p&c insurance business is notorious for stepping into quicksand. Loss trends having emerged over the past decade also point to new long-term exposures (i.e., asbestos liability and the overall rise in tort-related costs) which had never been factored into the traditional underwriting model. Then are the much newer “unknown risks” such as terrorism and man-made mega cat events which represent a “black hole” of uncertainty in terms of potential risk and loss exposure. In a nutshell, the p&c insurance business has become a lot more volatile where good fortunes can easily be reversed to dire circumstances.

The current financial health of insurers, and the profits being generated by companies – which drew negative criticism in Canada and the U.S. and sparked calls for rate rollbacks – therefore has to be seen in a cautious light. Although the U.S. insurance industry bolstered its surplus by US$22 billion during the first nine months of 2004 to reach a total of US$369.4 billion – thus outpacing 1999’s high of US$339.3 billion – there remains concern that insurers still hold inadequate reserves relative to their risk exposure.

Despite the improvement made to reserves over the past year, Conning Research analyst Geri Riley says that additional reserve strengthening of the U.S. p&c insurance industry is needed. With pricing competition having re-emerged in the second half of 2004, there is concern that growth in loss costs will once again begin to overtake that of premiums, resulting in erosion of reserves, Riley adds. “When [premium] rates do not keep pace with loss growth, there is certainly reason for concern about the industry’s loss reserve position going forward.”

Hartwig shares this sentiment, noting that slower premium growth could reduce the insurance industry to negative “real growth” by mid-2005. The seemingly strong reserve position of insurers therefore needs to be carefully reviewed, he says. According to Hartwig, the industry’s capital base is now more thinly stretched than it had been in the 1990s relative to growth of the economy. “…the U.S. economy [has] expanded by 25% [since mid-1999], and the demand for insurance along with it…The combination of economic growth and greater demand for insurance along with new and emerging risks illustrates the fact that the industry’s policyholder surplus is fully committed. Increasing the size of that pool is necessary in order to finance the insurance needs of a growing U.S. economy as well as claims arising from a virtually unlimited array of new and existing risks.”

As a result, Hartwig says that criticisms surrounding the insurance industry’s growth in capacity and profitability are unfounded. “Some [critics] have inappropriately cited rising capacity and profitability to call for rate rollbacks while others will try to derail tort reform efforts…the industry’s policyholder surplus is, in effect, already fully committed to the risks being underwritten today.”

Many in the Canadian p&c insurance industry can sympathize with Hartwig’s position after last year’s highly politicized attack against insurers. And, as the industry moves forward into 2005, company management would do well in not being beguiled by last year’s financial performance and falling into the luring trap of underwriting complacency.