Looking ahead
by Phil Zinkewicz
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Analysts foresee bottom-line woes for insurers in ’05
Higher costs tied to Spitzer investigation; softer market pressures lead concerns
By the first of the year, insurance industry analysts and investment firms have usually already prepared their industry forecasts, predicting market conditions, possible regulatory changes and potential individual insurance company performance. But insurance analysts have not been as forthcoming with their predictions this time around, perhaps because those predictions might be affected by a totally unexpected development that took place in the insurance industry late last year.
We’re speaking, of course, about New York Attorney General Eliot Spitzer’s investigation into insurance industry operations, a development that is sure to take up a good part of the 2005 insurance industry schedule.
The tort liability situation has been a costly problem for the insurance industry for years and it is one that is expected to rear its ugly head this year again, although the new Republican-dominated Congress might break new ground in the area of tort reform. (See Manny Levy’s column). A softening market usually bodes ill for the property/casualty insurance industry, with cutthroat competition for business. However, most industry solons believe that company CEOs have learned their lesson from the previous overly long soft market and will emphasize underwriting discipline during the coming competitive marketplace. The industry’s asbestos liabilities never seem to go away, but there are indications that Congress might make some headway this year in addressing the problem.
However, the Spitzer investigation is an animal that the industry is not used to dealing with and there are strong indications that it will remain not only frustrating and embarrassing, but also costly to the entire industry—so costly that, following the announcement of the investigation last year, Standard & Poor’s changed its entire property and casualty insurance industry outlook in the last quarter of 2004 from stable to negative, to reflect the dollars that may be spent.
“We expect that this investigation will result in lower revenues and higher expenses for many insurers,” stated S&P, “casting doubt on prior expectations of ratings stability and ongoing improvement in profitability for the industry over the medium term.”
Along with Marsh & McLennan, the four insurers mentioned in the Spitzer complaint are American International Group, ACE Ltd., The Hartford Financial Services Group, Inc., and Munich American Risk Partners. “However, New York Attorney General Spitzer has left little doubt that these and other insurance companies will be pulled into the investigation. We believe that this investigation will lead to lower revenues for many insurers,” said S&P credit analyst John Iten. “Because the bid rigging inflated the premiums paid by insurance buyers, it is to be expected that the cessation of this behavior will lead to more competition and lower premium income for insurers, at least in the excess casualty business line.”
Iten said that this will exacerbate the softening market conditions that have already begun. He said that the cost of complying with the attorney general’s requests for information and contesting any charges is likely to become a significant expense for many companies over the next several months. “Making matters worse is that other state and federal officials are conducting their own investigations into the same practices. Senior managers and their staffs will be forced to spend a large amount of time responding to these requests for information. With senior management’s attention diverted, there is the potential for companies to lose their underwriting focus just as the industry pricing cycle is turning downward. Over the long term, the entire insurance industry will have to absorb the cost of complying with additional regulatory oversight measures that will likely be put in place to prevent future misconduct.”
For companies that are publicly named in these investigations, the costs would include legal bills for defending themselves against any lawsuits brought by Spitzer or others as well as the cost of any fines or penalties, said Iten. “We believe that prior investigations by the attorney general into the mutual fund and investment banking industries could provide a reasonable indication of how insurers could be affected. For insurance companies implicated, there would likely be settlement discussions that result in fines and agreements to change business practices to prevent abusive practices from recurring. The size of the fines would vary, depending on how large the company is and the amount of incriminating evidence the authorities have, but the fines would very likely be substantial. There would also be the cost of defending and settling any class action lawsuits brought against the companies by policyholders or shareholders. In addition, there will almost certainly be organizational turmoil as executives of companies being investigated either leave voluntarily or are forced out.”
Despite these concerns, said Iten, S&P has not taken any rating actions on specific insurers because it is not yet possible to assess the potential impact of these developments. “Nevertheless, Standard & Poor’s anticipates that rating actions on insurers will occur as more information becomes available.”
Meanwhile, U.S. investigations into alleged bid rigging between brokers and insurers have rattled the industry and could trigger takeovers as players react to increased scrutiny and higher compliance costs. “It is a hurricane that will have long-term repercussions,” said Andrew Cornish, chairman of Airmic, which represents major U.K. corporate insurance buyers. “Confidence (in the industry) has been knocked and will continue to be knocked as this thing works itself out,” Cornish told an industry seminar.
Clive Tobin, chief executive of XL Insurance, a unit of insurance giant XL Capital Ltd., said the Spitzer probe could contribute to more mergers and acquisitions as insurers, trying to offset the higher cost of regulation, look to acquire rivals. He said the cost of complying with any new Spitzer-related regulations, on top of the high cost of Sarbanes-Oxley corporate governance regulation in the United States, “could lead to bigger M&A activity as insurers start to buy growth” as prices for risks continue to fall. But Tobin said the bid rigging allegations had to be put in perspective. “Right now, bid rigging seems to be confined to one product line, to one broker, and to one location,” he said. “It would be wrong to see it as widespread.”
John Scheid, Global Insurance Industry Services for Pricewater-houseCoopers, agrees that the investigations into insurance industry operations are “not done yet.” He says that transparency is going to dominate insurance company/broker/insured relations in the future. “Any type of commercial insurance transaction in the future is going to require transparency,” he said. Among the questions the industry will have to ask itself in the future, are: Will there be a big push for federal regulation in 2005; will there be insurance company failures in the coming year; and what will be the effects of Sarbanes-Oxley on the industry in coming years?
“In the meantime,” said Scheid, “insurers should strive for continued strengthening of underwriting standards, a strong focus on their core businesses and a loss ratio that is under 100.” *
Conference of CEOs debates challenges to the industry
Panelists focus on state of reinsurance market, capital management
Late last year, Standard & Poor’s and PricewaterhouseCoopers sponsored a property/casualty executive conference in New York, which delved deeply into just about every challenge that currently affects the property/casualty insurance industry. Indeed, speakers made it clear that these challenges are long term and audience response indicated a clear understanding of the seriousness of the material presented.
Ramani Ayer, chairman, president and CEO of The Hartford Financial Services Group, Inc., addressed the constant threat of terrorism, saying that the United States is on a “collision course” with enemies and battlegrounds that aren’t easily identifiable. He said that the insurance industry needs to get TRIA moving because terrorism is a threat not only to the insurance industry, but to the entire economy as well. Noting that terrorism is a threat to property and life, Ayer insisted that, under the Constitution of the United States, the federal government is responsible for whatever affects the loss of property and life among the U.S. citizenry. He said that facing the threat of terrorism requires a partnership between the insurance industry and the federal government. “To provide recovery from the largest of disasters, the nation’s response requires a joint effort of federal, state and local government, the insurance industry and the private sector in general,” Ayer said.
The future of insurance regulation has long been debated, and at the conference it was once again. Gregory Serio, superintendent of insurance for the state of New York, and Craig A. Berrington, senior vice president and general counsel for the American Insurance Association, took opposing views as they discussed state regulation vs. federal regulation—Serio defending state regulation and Berrington opting for federal involvement. Both agreed that the debate will continue throughout this year as Congress makes further inquiries into the adequacy of state regulation.
Other panels at the conference included one on how to manage capital in a softening property and casualty market and another on the state of the insurance industry in terms of where growth and profitability will come from in the next few years.
Notable among the trends affecting insurance markets has been the change in executive management among global reinsurers. This new management group is credited with renewed underwriting discipline; a commitment to technical, analytical underwriting; greater attention to reserve adequacy and investment practices; and conservative attitudes for new, emerging risks. In addition, legacy companies are being challenged by new start-up companies with no long-tail liabilities to be concerned about. A special panel including Ronald Pressman, chairman, president and CEO of GE Insurance Solutions; James Veghte, CEO of XL Reinsurance America, Inc.; Dr. Nikolaus von Bomhard, chairman of the board of management for Munich Re Group; and Salvatore Zaffino, chairman and CEO of Guy Carpenter & Co., discussed these issues. Moderating the panel was Franklin W. Nutter, president of the Reinsurance Association of America.
According to panel members, the global reinsurance industry appears to be a mass of contradictions these days. Nutter pointed out that the industry’s loss ratio for 2003 was 101, down from 117 in 2002. However, he said only a handful of reinsurers showed profits for 2003. Return on equity was only 6.6%, he said; and reinsurance recoverables on insurers’ balance sheets was $264 billion in 2003, way up from $177 billion in 1999. That $264 billion, Nutter said, represents a significant part of surplus for the reinsurance industry.
Panelists noted that the reinsurance industry has “digested” September 11 losses fairly well and that catastrophe rates were “pretty flat” at the end of 2004, although the figures available at press time did not include last year’s spate of hurricanes. On the other hand, panelists agreed that there is, at present, excess capacity in the reinsurance business and that that capital has to be managed effectively and deployed properly if the industry is to be profitable. “That goes right back to underwriting discipline,” said GE’s Pressman.
Von Bomhard said that Munich Re is among those companies with excess capital on their balance sheets and that his company has been forced to aggregate that capital in different countries.
Finally, Nutter asked the panel whether the excess capital that the industry enjoys will lead to further acquisitions in the coming year. The panelists didn’t commit themselves on further acquisitions, but all agreed that diversification was “key” to further growth for the reinsurance industry. Pressman, however, offered a caveat. “We all agree that it is important to have diversification in our risk portfolios, but we must make certain we understand the volatility that diversification can have on capital. The question we have to ask ourselves is: Are we truly optimizing the diversity of our portfolios?”
Between panel discussions, Rough Notes spoke with John S. Scheid, Global Insurance Industry Services, Pricewater-houseCoopers, to elicit his views on what challenges the industry is facing. Scheid had participated in a point/counterpoint session earlier in the conference with Steven J. Dreyer, managing director and North American practice leader for Standard & Poor’s. Scheid said one of the most important challenges to the industry is the current attack on the insurance brokerage community by New York Attorney General Spitzer. He said that, until there is total transparency among insurance brokers, the attacks will continue. “It started with the P-C business, then moved into life and health and then reinsurance.” Spitzer is now working with state regulators to determine whether the alleged improper activities of two major insurance brokers represent isolated incidents or whether the industry is rife with such behavior. “What’s certain is the broker model is going to have to change. In the short term, brokers will lose a considerable amount of money, and they will have to make it up somehow in the longer term.”
Another challenge the industry faces is the softening market, said Scheid. Rough Notes asked Scheid whether the property and casualty insurance market might be headed for the overly competitive market of the early 1990s. “I think company CEOs are getting a lot more religion when it comes to measuring underwriting results,” he said. “I think companies are evaluating their underwriting, claims and marketing departments, each individually instead of looking at the overall bottom line.” *