CRITICAL ISSUE REPORT

HOW FINANCIALLY STABLE IS
THE INSURANCE INDUSTRY?

Ratings agencies warn insurers to
examine loss reserves adequacy

By Phil Zinkewicz

Despite being the largest liability on insurers' balance sheets, most stakeholders do not critically examine reserve adequacy.

The hard market that currently embraces the property/casualty insurance industry was a long time in coming. Those of us who are old enough to remember the three-year-on, three-year-off cycles of the past can also recall a time when there was a kind of predictability about the industry. Insurance companies were in the business of insurance. They made an underwriting profit and investment income gains during hard market times, and lost money when competitive pressures drove prices down. That may be an oversimplification, but at least that bit of predictability gave buyers of insurance a sense of security. The financial viability of the insurance industry went without question. But those days are long gone. Last year's failure of the Reliance Group will attest to that.

The change in the insurance industry really began taking place during the early '80s, when insurers listened to the siren's song of high interest rates, and cash flow underwriting replaced underwriting for profit. Also, during that time, insurers stopped being just insurance companies and became providers of financial services, moving into areas with which they were not familiar. Then came the debacle of the mid-'80s when insurers paid the price for their cash flow underwriting philosophy and there evolved a hard market like nothing buyers of insurance had ever seen ... until today.

Now, students of insurance will remember that following 1984-1985, insurers returned to profitability once more. They had learned their lesson from the cash flow underwriting years and would not, they insisted, repeat the same mistakes. Except that they did.

The entire decade of the 1990s was a scenario reminiscent of the early '80s, except that this time the siren's song was a robust stock market. By the time 2000 rolled around, with a plummeting stock market, insurers were once again in financial difficulty. Rates began to climb, but oh, so slowly. Then came September 11, 2001. The market was once again a hard one, with reinsurers raising rates and tightening contract conditions, and primary insurers passing down those rate increases to their insureds.

Independent agents have now been forced into a position where they will have to explain to their insureds--who have basked in the glory of an overly competitive insurance market for so many years--why rates are going up drastically. More important, they will have to watch very carefully the financial performance of insurance companies and make certain that their insureds do not opt to sacrifice security for the sake of a lower premium.

It's happening already. There are reports of doctors and hospitals asking their agents to get the lowest medical malpractice premium possible even though the coverage may be with a company that has a lower rating than the previous carrier. So, how financially secure is the insurance industry?

According to Weiss Ratings, Inc., an independent provider of ratings and analyses in the insurance industry, the business of insurance saw only 40 insurance company failures in the year 2001. That's not too bad. Weiss says that this was merely "a modest 5% increase over the 38 failures recorded in 2000." The failure of Reliance alone accounted for 12 of the 34 property/casualty insurance company insolvencies in 2001, but still, the 34 P-C insolvencies represented a disproportionate number compared to the overall 40. While she says she is not prone to making projections, Stephanie Eakins, an analyst with Weiss, says the hardening market in the P-C arena probably indicates that the insolvency situation will not be any worse in 2002 than it was in 2001, barring any surprises.

But then there's a report from Conning & Co. that paints a bleaker picture of the financial stability of the P-C industry. The Conning study warns that insurers need to strengthen their loss reserves to pay future claims and that, although property/casualty rates have been increasing in recent years, reserves are inadequate to cover the rising cost of claims. Conning also found that eight of the nine primary property/casualty lines are severely deficient, with a total that developed reserved deficiency of $16 billion on claims between 1998-2000. Conning says that the recession and widespread impact of September 11 would further pressure insurers' ability to return to profitability. The research firm noted that individual insurers have been slow to strengthen their loss reserves.

Entitled "Property-Casualty Reserve Adequacy: Truth or Consequences," the study points out that many insurers sought profitability by reducing rates and attracting premiums that could be invested in the surging equities markets, but paid little attention to loss reserve adequacy. Despite its being the largest liability on insurers' balance sheets, most stakeholders (employees, regulators, investors and agents/brokers) do not critically examine reserve adequacy, the study says.

Conning also says that rising loss costs and a weaker investment environment have prompted insurers to refocus on underwriting profitability, including greater emphasis on loss reserve adequacy. "Individual company results, particularly for a single line, are likely to differ, often dramatically, from those of the industry," says Geri Riley, assistant vice president and author of the study. Riley added that prudent insurers examine results to identify and explain why they are better or worse than overall industry results.

While Conning says it was optimistic about the longer-term industry outlook, it also noted that the effects of September 11, the economic downturn and the very litigious environment have seriously challenged the industry. The research firm says it believed the survival of some insurers and reinsurers could depend "on their ability to accurately reserve and appropriately price."

Standard & Poor's also believes that the property/casualty insurance industry overall is inadequately reserved. Donald Watson, analyst with S&P, says that, in 1998, S&P reported that the industry was underreserved by about 10%, which he described as "considerable." While, some insurers have been pumping money into reserves, Watson says that it is still not enough.

So what does all this mean to the independent insurance agent who has to obtain the best price for the client but who also has to worry about the stability of the markets chosen? Watson says that even though additional capacity to the tune of $27 billion came into the marketplace post-September 11, rates are rising and will continue to rise. "That's good for the industry because rates were depressed for so long," he says. "And primary companies have no choice but to raise their rates because they are seeing rate increases in their reinsurance arrangements. The danger is, however, that when rates rise in the way they are doing today, it becomes a question of affordability; and insureds pressure their agents to approach markets where there are lesser premiums even if those markets consist of unrated companies, usually start-up operations with no claims history. It's always worrisome to go with an unrated company, especially in the casualty area. In the property area, the deals are usually short term; but in casualty, companies need to be there for the long term. On the casualty side, an agent who places the insured with an unrated company to take advantage of a lower premium might find that the company is not there to pay claims when the loss occurs."

Considering all these things, then, agents today need to be even more alert and astute when choosing markets for their clients. Today's insurance marketplace is chaotic. A few years ago, the market was still soft and agents had a plethora of reputable, high-rated insurers to approach in behalf of their customers. Today, the old-line insurers are, out of necessity, holding the line on rates and conditions. But new capacity is coming into the business--in some cases untried capacity with possibly much more attractive lower premiums. In the new hard market, it is critical that agents either remember or learn how to walk the fine line between the two. *

The author

Phil Zinkewicz is an insurance journalist with some 25 years' experience covering the international insurance and reinsurance arenas. He was the insurance editor of the Journal of Commerce for a number of years, handling all their domestic and international supplements. In addition, he regularly writes for a number of London publications.