U.S. Market Outlook: For Richer or Poorer

While the strong price firming witnessed across nearly all lines of business of the North American property and casualty insurance industry will likely maintain momentum through this year and into 2004, company CEOs and investment analysts who partook in this year’s Joint Industry Forum hosted by the Insurance Information Institute (III) in New York City believe that insurers still face many financial challenges on the road ahead. A survey conducted by the III of the 250 senior management audience supported this perspective, with capital availability and the vulnerability companies are exposed to through ailing investment returns likely to be driving factors influencing the industry’s prosperity in the year ahead. Specifically, the speakers and audience members expressed concern over the lack of tort reform in the U.S., as well as the long-term risk associated with terrorism coverage.

Roughly three-quarters of the 250 senior management attendees at the recently held seventh annual Insurance Joint Industry Forum believe that profitability will increase in the North American property and casualty insurance industry this year, according to an audience survey conducted by the forum’s host, the Insurance Information Institute (III). The survey respondents expect the industry’s combined ratio for this year will show marked improvement on the anticipated 103.3% for the full 2002 financial year, with the reduction in cost mainly resulting from better rate adequacy. More than 80% of the attendees expect price firming will continue in personal lines with about 90% seeing further price improvement in commercial lines. However, only 12% of the respondents believe that commercial business (excluding workers’ compensation) will show increased profitability this year, despite ongoing price strengthening.

Less than half of the forum attendees expect an improvement in the equity markets this year, with only 20%-25% holding a positive view toward tort reform legislation being passed this year in the U.S. As the III’s chief economist Robert Hartwig notes, tort costs currently consume about 2% of U.S. gross domestic product (GDP), equal to about US$200 billion a year. “Businesses in every industry are crying out for tort reform. Yet only 23% of survey respondents think Congress will pass and president Bush will sign meaningful tort reform legislation in 2003. Likewise, just 20% [of respondents] expect Congress to pass and president Bush to sign legislation in 2003 that will help contain the current asbestos crises.”

Asbestos and mold exposures were central concerns of the CEO audience, with only 38% of the survey’s attendees believing that mold claims have peaked. And, while the vast majority of the attendees see the Terrorism Risk Insurance Act of 2002 resulting in easier access of terrorism coverage, insurers are concerned with the longer term exposure of this particular peril to the industry.

ANALYSTS TORT WARY

The major buzz of conversation at this year’s Joint Industry Forum was the announcement by Travelers Property Casualty of a special US$2 billion reserving allocation for asbestos exposures. As Vincent Dowling, managing partner of Dowling & Partners Securities LLC, observes, “it’s [the cause of excitement] not about the US$2 billion, it’s about the level of disclosure [made by Travelers]”. Dowling, who partook in a financial analyst panel debate, believes that this latest move on the asbestos front will increase pressure on insurers to disclose their true asbestos exposures relative to reserving. “I think this [the Travelers’ announcement] will see people [regulators, investors and analysts] asking questions [of the industry].”

Alice Schroeder, a managing director at Morgan Stanley, concurs that Travelers has raised the bar on asbestos disclosure. “Clearly, Travelers has set a new standard on disclosure, companies are going to have to scramble to catch up.” Notably, she points out, the “open book” approach taken by Travelers is based on information readily available within the industry, “it’s always [the information] been out there”. While concern remains over the industry’s reserving relative to asbestos exposure, Schroeder notes that the industry’s total under-reserved position has improved over the past year. The industry faced an estimated US$55 billion under-reserve in 2001, she observes, which equates to about 50% relative to total claims exposures. During last year, the ratio fell to about 40%, she adds.

Although there are numerous issues out there on the “litigation front”, Dowling does not believe that there is any one specific peril that could turn into another “asbestos” for the industry. Schroeder supports this view, “nothing could be like asbestos when you take into account the factors that created this situation”. However, she believes that insurers will continue to feel cost pressure on the litigation front from a multitude of known exposures such as mold as well as emerging risks. “I do believe that there is now a ‘tort tax’ on the industry.” Michael Pritula, a director at McKinsey & Co., is more cautious of the extent of potential litigation exposures facing the industry, primarily as a result of “unknown” threats. “I believe there are new risks out there…I just don’t know what they are. I just feel this way because of the increased activity by the plaintiff’s bar.”

CAPITAL CRUNCH

The “capital hit” insurers took last year as a result of declining investment returns is really “the story of 2002”, comments Schroeder. The decline in interest rates during 2002 took analysts by surprise, she says, which combined with the reduction in equity prices, had a devastating impact on the global insurance industry’s capital position.

“The industry lost about US$200 billion in capital last year,” notes Dowling, with European insurers particularly hard hit due to their relatively higher exposure to the equity markets. The result has been numerous financial rating downgrades of top players in the industry, he adds. “Who would have though of Munich Re holding less than a ‘AAA’ rating?”

“It’s shocking that over a short period of 12 months the loss of capital value in the global insurance industry,” says Pritula. The result has seen increased pressure on company management, “and I’m seeing fewer of management being able to work through these turbulent times”. Surprisingly, the industry has not witnessed the extent of consolidation through merger and acquisition activity that would be expected under the circumstances, he adds. “I think insurers are saying ‘why buy the business when we can compete for it? Also, potential buyers are looking for financial guarantees.” That said, Pritula points out that performance pressures have resulted in some of the major European parent head-offices of companies bringing in management to North America. “…which would never have happened three years ago”.

Schroeder notes that the “shakeout” of companies over the past year, mostly through more poorly capitalized operations going into run-off, should reduce concern over the industry’s financial security going forward. “But, there is still definitely a lot of concern out there on the primary insurer front.”

Dowling believes that 2003 could mark a shift in the industry’s fortunes. “This [year] will likely be the bottom of the investment cycle.” As such, he believes that next year will likely see a significant increase in industry investment returns. Schroeder holds a similar view, expecting industry investment income will remain static this year, with realized gains improving in the fourth quarter. While the industry’s financial landscape may be improving, and investor expectations have been lowered as a result of the general decline in the investment markets, Dowling says insurers still face tough challenges in attracting new capital. “Investor return benchmark in this current low investment rate environment is about 12%. But I don’t see the [insurance] industry even making 10% [shareholder return] this year.” Perhaps the biggest positive outcome of the current capital and return pressures on insurer
s is that the hard market is here to stay, observes Schroeder. “I can’t believe that market [price] weakness will return.”

CAPITAL CHASE

A CEO panel debated a host of industry issues from the long-term impact of the new terrorism insurance legislation in the U.S. to cost-drivers impacting the business overall. However, the panel’s focus soon drew to the cost of capital, attracting new capital and how these factors will influence the future growth of the industry. Edward Liddy, president of Allstate Insurance Co. and panel moderator, notes, “we seem to have the lowest ROE in the financial services sectors, so what can we do to attract capital?”

The future of the industry, and its ability to attract capital, has less to do with “strategizing” and coming up with “new business models” than simply getting “back to basics”, observes James Schiro, CEO of Zurich Financial Services. “This is a time for good management, it’s about discipline and focus.” Only once the industry has got its ship in order can insurers ask the question of how to attract capital, he adds. “And we’re not going to get there unless we can prove we can deliver.”

The poor quality of leadership in p&c insurance has really been the cause of the industry’s financial problems and lack of confidence of investors, says Brian Duperreault, CEO of ACE Ltd. “Leadership has not been the best. You can give capital to a moron, and…well you know…” As a result, the shakeout within the industry will continue, he predicts, and capital will only become available to those insurers who can prove their efficiency and ability to deliver to shareholders based on a sound performance record.

Joseph Brandon, CEO of General Reinsurance Corp., agrees that the industry’s problem is not knowing what to do to bring about sound financial performance, but rather the need for companies to “actually do it”. Brandon notes that making money in the 1980s and 1990s came from “financial engineering” and asset management. “I think leadership in the industry is realizing that we’re in a new era, one where we need to build back the basic skills of the business…We’ve all heard the rhetoric, but we still have to see it [in practice].”

Walter Kielholz, vice chairman of Swiss Re, believes that the industry’s capital woes are more complicated than insurers simply “getting their houses in order”. Kielholz points out that the p&c insurance industry’s use of capital is significantly different to the other financial services sectors. “Unlike the banks, we only need capital in the event of a loss, and in between, we have to invest this capital in risky assets to make it work.” Based on the changing risk environment, Kielholz feels that new capital solutions have to be found by the industry to accommodate its specific needs. “We need to find flexible capital solutions.”

TERROR IMPLICATIONS

The enactment of the U.S. Terrorism Risk Insurance Act toward the end of last year, which effectively provides a U.S. federal government backstop against insured terrorism losses, came as a welcome surprise, the CEO panel members concur. However, with the legislation now in place, insurers have the difficulty of implementing cover to avoid a public backlash against the industry not doing enough, the CEOs warn. Also, the industry has to assess its own exposure to terror risk, both in the short and the long-term, they add.

Edmund Keely, president of Liberty Mutual Group, warns that insurers could face a public backlash by mid-year if in sufficient action is taken by insurers to implement terrorism cover. The problem lies in the pricing, he adds. “I’m concerned that there’s a false sense of predictability, that we as insurers should know how to price [terrorism risk],” comments Jeffrey Post, president of Fireman’s Fund Insurance Cos.

The prime benefit of the terrorism insurance legislation is that it removes the risk of an attack causing an insolvency within the insurance industry, observes Brandon. However, insurers should be cognizant of the fact that under the structure of the government plan, their exposure to the terrorism risk will increase over three years, whereupon the backstop will cease. At this stage, insurers will bear full exposure to terrorism risk, Brandon notes. “So, how we handle it now is going to be critical.” Ramani Ayer, CEO of The Hartford Financial Services Group Inc., agrees with this sentiment. “The government says that another attack is likely, so we can’t forget that. We are going to have to retain a fair amount of the risk.”

FEDERAL REGULATION

“I think the current system of state regulation is absolutely broken. We should have a dual regulation system, through which insurers can choose their ‘poison’,” says Libby. The discussions which took place around the creation of a national terrorism insurance mechanism opened the door to effective industry regulation, he notes. The question is, should regulation of insurance across-the-board be shifted to a federal regulator?

Post concurs that the debate around the terrorism insurance legislation may have presented a “springboard” opportunity for the possibility of federal industry regulation. “This [the terrorism insurance discussions] may turn up the heat on the state regulators, and make Washington understand our frustration.” Needless to say, both Libby and Post are among the growing group of insurer CEOs frustrated with the political interference and bureaucratic cost of regulation at the state level. Ayer also feels cautiously optimistic that a shift in regulatory approach could be achieved through the terrorism legislation. “We need to take the long road here, but I think we can improve our regulatory framework through federal regulation.” Kelly is less optimistic of regulatory streamlining through a federal approach, noting that the main difficulties on the state regulatory front lie with personal lines. “I don’t think federal regulation will work in personal lines.”