The Future of U.S. Property and Casualty Insurance Industry: Six Feet Under?

U.S. property and casualty insurers made reserve “top ups” of about US$20 billion for 2003 as a result of adverse reserve developments on prior accident years, observes Vincent Dowling, an analyst at Dowling & Partners. Dowling partook in a panel discussion under the theme of “What keeps analysts awake at night?” which formed part of the recently held National Insurance Leadership Symposium hosted by investment bankers Russell Miller, The Council of Insurance Agents & Brokers (CIAB), the Reinsurance Association of America (RAA) and the American Insurance Association (AIA).

Dowling’s comment on the staggeringly large reserving adjustments made by insurers last year highlighted the prime concern of the analyst, company CEO, broker and risk management speakers – that being the financial security of the U.S. p&c insurance industry moving forward. On a particularly grave note, the speakers were wary of the ability of insurers to realize “reinsurance collectibles” as global reinsurers continue to face financial pressure – which could see some companies being unable to meet their underwriting obligations while others may adopt a “hard line” in payment of claims. Notably, reinsurance collectibles accounted for a significant portion of the reserve adjustments made last year by insurers, the analysts point out.

As a result, the broker and risk management speakers say increased attention is been given to the financial security and the financial ratings of insurers in the placement of business. This could well see a flight of premium from the traditional insurance marketplace as well as a shift in business to a handful of top-rated companies.

In turn, insurer CEOs concede that capital availability relative to poor shareholder investment returns is the biggest challenge facing the industry. They are also alarmed by the dramatic increase in company financial downgrades over 2002, and whether there will be any “A-rated” insurers left by the end of this year. With the outlook on the investment markets – both equities and bonds – remaining bleak, the insurer commentators do not expect 2003 will produce any significant gain in either industry profitability or return on equity (ROE) – despite the ongoing hard market.

ANALYSTS AWAKE

“My biggest concern [regarding the financial stability of primary insurers] is ‘unproductive reinsurance’,” says Steve Dreyer, insurance practice leader at Standard & Poor’s Rating Services (S&P). He points to the large reserve adjustments made by several insurers toward the end of last year, and the significant portion allocated to reinsurance collectibles. Notably, the announcement by the ACE group of a reserve “top up” of about US$2.2 billion included reinsurance of US$1.9 billion. “I’m concerned when companies [primary insurers] say ‘don’t worry, reinsurance is covering most of it [reserve costs]’. Who are these reinsurers?”

Dowling notes that U.S. insurers collectively made reserve adjustments last year of about US$20 billion. His greatest concern is that the primary insurers that account for this amount are among the most conservatively managed operations. “How many companies are there out there that have not yet taken their ‘hits’, or even realize their exposures?” Dowling also shares doubt over the ability of primary companies to collect against reinsurance. He notes that reinsurance contracts often hold special exclusions, for instance “rating clauses”, that enable them to avoid liability if an insurer slips back in its rating. “There are all sorts of things going on behind the scenes,” he comments which could present a more dire picture of the true state of the primary insurance sector. And, he adds, there are a growing number of legal disputes between insurers and their reinsurers in the courts. “It was only in 1989 that the first case of an insurer against a reinsurer went to court.”

Even if insurers are able to collect the bulk of the reinsurance covers that they claim to have in support of their reserves, another negative factor is the pace at which these payments are being made, observes Chris Winans, senior research analyst at Williams Capital Group. “There is [presently] a lot of ‘slow pay’ by reinsurers,” he adds, which has to have an impact on the balance-sheet of insurers.

“The loss reserve adjustments [made by insurers] over the past year have been enormous,” confirms Matt Mosher, group vice president for property-casualty at A.M. Best. He predicts further large reserve adjusting by companies in the year ahead, “as companies will have to fill in the [loss] hole”. As such, Mosher expects to see additional company financial downgrades in 2003. However, the number of downgrades this year will likely be less than 2002, as the industry begins to deal with its reserving restrictions and pricing benefits of the hard market begin to strengthen the balance-sheet.

But, Dreyer is less optimistic of the recovering financial strength of insurers in the current year, and therefore expects that there will be more company downgrades than upgrades coming through. “The environment has definitely changed. Who would have thought that Kemper wouldn’t be around a year ago,” he notes with respect to the announcement earlier this year that the Kemper group had decided to exit the p&c marketplace with its operations placed in run-off.

Responding to criticism that equity and rating agency analysts have not been accurate or timely in identifying financial troubles at companies, Winans notes, “brokers simply can’t rely on the ratings of the rating agencies, they are not always correct.” He adds that, in his own analysis, he looks at a broad range of information from various sources, as relying on single information can create a distorted perspective. “I think that brokers need to take a tougher stand with insurers. You’re [brokers] selling a product, you have to know what is in that product.”

Dowling agrees that agents/brokers, being in the “front line”, should be able to better ascertain the financial well-being of their insurer partners. “I think that agents/brokers don’t want to know that companies are in trouble. The fact is that there were signs that Kemper was in trouble a year ago,” he notes while suggesting that agents/brokers sometimes turn a “blind eye” in order to protect their relationships with companies.

Dreyer admits that the ratings issued by rating agencies are “not perfect”. He too feels that brokers on the front line are better positioned to pick up on warning signs. He points out that the ratings should be seen by brokers as a “barometer” in determining the level of risk they are willing to deal with in the placement of cover. “We can’t tell you as brokers where you want to be on the risk scale in placing business.”

TAMING THE BEAST

“The industry’s past shows it’s like a recovering alcoholic that keeps falling off the wagon,” comments Julian James, director of worldwide markets at Lloyd’s of London. As such, he says there is no doubt that the p&c insurance industry is subject to cycles. The question, he adds, is whether the industry can “tame the beast” of the cycle.

Jeff Post, CEO of Fireman’s Fund Insurance Co., concurs that the industry is subject to cycle influences. But, he notes, “the question is not whether we can tame the beast of the market, but whether the market is taming us”. Post points out, however, that the current “down cycle” the industry is experiencing is different to past occasions. He describes the current market as the “perfect storm” in that all of the factors that individually drove past hard markets have come together at present. “The stock market slump, a liability crisis of massive proportions, and a massive catastrophe in 9/11 – what’s different today is that we have all three factors that drove the last three hard markets.”

“Kemper was a perfectly good company for over 100 years, now it’s gone,” observes Judy Mann, senior vice president at Swiss Reinsurance Co. As such, she notes that cycles are inevitable, and perhaps even necessary in order for companies to “distinguish themselves” from a competitive standpoint . “Can we tame the cycle? I don’t think so, even though we know what to do, it doesn’t happen.” And, she asks, is managing the “cycle” really about “people management”? The last “soft market” had been predictable, she observes, yet the industry lacked the ability to respond in a timely manner to ward off the erosive effects. “Will it be the same the next time around? Hopefully not, but we have to control authority, accountability and training of people within the industry. There has to be a clear message to the front line that if returns aren’t there, then there has to be a reduction in the top line. We have to use this hard market to get our houses in order.”

With this point in mind, James voices the skeptical thought to whether the industry is capable of learning from its past mistakes. “Do we really believe that we’ve learnt the lessons of the past? Or, are we going to be back here three years from now pulling our hair out?” In this respect, Post believes that drawing new management and technical talent and expertise into the industry is critical, and at the same time, this is perhaps the industry’s biggest challenge. “There’s a huge gap in underwriting knowledge. Getting talent back into the industry, and retaining it, is our challenge. The issue is that no one wants to be a passenger on a boat called Titanic. When we get our business right, then we will attract good people.”

Looking ahead, Post expresses concern over the change in relationship between insurers and reinsurers. “Reinsurers have changed their appetites, and what troubles me about reinsurance is the number of companies currently engaged in litigation with their primary companies. It’s no longer a contract of ‘good faith’,” he says. Another factor directly in the industry’s headlights is how to raise new capital. “We’re [as an industry] eating up capital faster than it’s available. I wouldn’t be surprised if we end up with an insurer with a “B+ rating” as being a good rating.” Ultimately, the capital markets will determine which companies will be allowed to “play”, he adds. “The vote right now is that we [as an industry] are not responsible users of capital.”

However, Mann is more optimistic of the current ability of the industry to react to adverse conditions. She believes that the industry has become significantly more advanced in being able to price its products relative to the risk. “In terms of the pricing time lag, I think the industry is a lot more astute and sophisticated today than 10 years ago in pricing the product.”

From a buyers’ perspective, Lance Ewing, the executive director of risk management at Park Place Entertainment Corp. and president of the Risk and Insurance Management Society (RIMS), admits that pressures outside of the insurance industry heightened the extent of the last soft market. “I think that risk managers are partly to blame for what happened. As risk managers, we were like gods, when the sun came up, we told our bosses that we did that. When it rained, we blamed the broker. We knew that we were riding the ‘gravy train’.”

That said, Ewing describes the current hard market reaction to be like “nothing we’ve seen before”. Marketplace predictability is gone, he adds, “it’s like a roller-coaster more than the merry-go-round of past cycles”. In response, corporations are now evaluating their insurance covers and looking at ways of cutting back on costs. “Corporations are now asking what is their appetite for risk…I think this will affect where the [insurance] market goes from here.”

Furthermore, based on the media attention given to the weakened financial strength of insurers, corporate insureds are beginning to pay close attention to the financial rating of companies, Ewing says. “Risk managers are taking a really good look at insurer financial strength.”

Hyatt Brown, president of brokerage Brown & Brown Inc., concurs that there is an “increased sense of caution” among brokers and insureds with regard to the financial stability of insurers. It is apparent that the “front line risk takers’, being primary insurers, are facing the greater risk, he adds. In terms of the role brokers may have played in aggravating the soft market conditions of the past cycle, Brown does not believe that brokers have significant influence or control over the industry cycle. “We’re [as brokers] always going to be pushing the envelope,” which is the function of the broker. The real issue, he notes, is that “risk bearers” have to make tough decisions. “If they [insurers] can’t make a profit in a line, then they have to exit it.”