2008 industry forecast

Analysts see the calm waters of 2007 becoming more rippled in 2008

By Phil Zinkewicz

The year 2007 was not a watershed for the property and casualty insurance industry. There were no surprises in terms of pricing except for a slight deterioration in rates, indicating the beginnings of a soft market. There were no catastrophes like Katrina to drain the industry’s coffers. The California wildfires in October and November caused widespread property destruction, but industry solons described them as manageable in terms of claims payouts.

“Really, the only major develop-ment of 2007 was the lack of major developments,” says Sean Mooney, chief economist for Guy Carpenter & Co., LLC, a leading global risk and reinsurance specialist and a unit of the Marsh & McLennan Cos. “Last year was another profitable year for the property and casualty insurance industry—not as profitable as 2006, but profitable. There was a slight downward trend in rates, but not much. On the reinsurance side, there was a diversity of losses rather than intensity, at least in the United States. The real question is how long the new soft market will last and how the industry will respond.”

Dr. Robert P. Hartwig, president of the Insurance Information Institute, also views 2007 as a year with few major developments, calling it a year that was “A Glass Half Full or Half Empty.”

“The financial performance of the property/casualty insurance industry during the first half of 2007 was generally excellent and so far has proved surprisingly resilient in the face of an increasingly price-competitive environment,” he says. “But, at the same time, the first-half results provide confirmation that the industry is now past its cyclical peak in profitability of 14.0% achieved in 2006. In my analysis of the first-quarter 2007 results, I suggested that if the historical trends observed during the past four market cycles hold (dating back 35 years), the industry can expect ROEs to bottom out in 2011 at about 1%.”

Hartwig observes that the 2007 first-half results provide a telescopic glimpse into the future. He says it is apparent that insurer profits going forward will become increasingly dependent on investment earnings as underwriting profit steadily deteriorates. He points out that, despite a $619 million drop in underwriting income, profits actually rose by $3.2 billion, or 5.5%, to $30.6 billion during the first half of 2007, up $25.4 billion over the first half of 2006. “The increase in profits is entirely attributable to modestly higher investment income—up $1.6 billion, or 6.6%, to $26.1 billion,” says Hartwig.

Jeffrey Berg, senior vice president at Moody’s Insurance, says he expects the insurance business to remain profitable throughout the end of 2007; but in 2008, as profits begin to decline due to increasing competition, he believes property/casualty companies’ will seek growth beyond underwriting results. “Merger and acquisition and return of capital transactions will increase as companies search for growth and expansion of distribution capabilities; and capital management actions will remain in the forefront as companies return capital via share buybacks,” Berg says.

Interestingly, at the recent Conference Board annual meeting, Vincent J. Dowling, managing partner of Dowling & Partners, also predicted an increase in merger and acquisition activity in the coming year. However, he also said that the weakness in the dollar will provide a better chance for foreign acquisitions of U.S. insurance entities. He said that premium growth would be flat in the new year and that any companies growing at faster rates would be doing so by drastically cutting prices.

Berg also addresses the subject of increasing competition in the property/casualty industry. “In order to offset the effect of competition, companies are retaining more risk and are stepping up efforts to renew existing policies early, with only modest rate cuts, in order to head off the insured/distributor shopping the policy to other carriers. Pricing on new business reflects steeper discounts than business retained by the incumbent insurer.

“Carriers are also more focused on distribution: deepening penetration within an agency plant; acquiring distribution channels; appointing new agents and brokers; and cross-selling,” Berg says. “These efforts are all signals that the market is softening. Another phenomenon indicative of a softening market occurs when business placed in the E&S specialty market makes its way back into the traditional market.”

Asked whether insurers will be able to maintain underwriting discipline during the new soft market or whether they will begin cutthroat competition as they have done in the past, Berg says: “Many companies have put monitoring mechanisms in place by region or branch and even by individual underwriter to help monitor compliance with pricing/underwriting guidelines.

“Improvement in management information systems should also help identify issues quicker than in the past,” Berg continues. “As the market softens further, companies may also increase the frequency of internal underwriting audits in order to capture changes in terms and conditions and actual pricing relative to targeted pricing. Given these monitoring tools, the peaks and valleys of the underwriting cycle might not be as severe as in the past. However, we at Moody’s believe that the pricing cycle is alive and well because the fundamental nature of P&C behavior doesn’t change.”

John Iten, a director at Standard & Poor’s, also anticipates profitable 2007 results for the industry, but he echoes the views of his fellow analysts regarding a deterioration of the industry’s pricing structure in 2008. “Standard & Poor’s is increasingly concerned about the growing evidence that the commercial lines market is becoming more competitive,” he says.

“Market surveys show accelerating rate cuts in virtually all lines. Large brokers confirm that they are seeing rate cuts similar to those indicated in the surveys. Insurance company managers are complaining both publicly and privately that certain, usually unnamed, competitors are becoming more aggressive as they attempt to grow premium volume,” Iten explains. “Another sign of deteriorating underwriting standards is the apparent willingness of standard market insurers to again compete for business that had migrated to the specialty lines market during the hard market years.”

Subprime crisis

Besides the softening market, another area of concern for all those interviewed is the current subprime lending crisis and its implications for the insurance industry. All agree that it is unlikely that the industry will take a hit on the investment side because insurers have, over the years, become conservative in terms of investments. However, they say there could be significant lawsuits in the D&O and E&O areas.

Hartwig put it this way: “As major purchasers of bonds and stocks, and through the nature of the products that some insurers provide, insurers are potentially exposed to the effects of the recent turmoil in the sub-prime and other credit markets. A September 2007 analysis by the Insurance Information Institute examining the property/casualty and life insurance industry’s exposure to the subprime issues concludes that, based on information currently available, the industry will not be materially affected by credit market developments.

“This conclusion is based on the recognition that both by law and by the nature of their business, insurers generally limit themselves to the low-risk end of the investing universe,” explains Hartwig. “Even for the very small share of their investments directly exposed to subprime and near-prime loans, insurers mainly invest in ‘slices’ of those investments that, according to the bond rating agencies, are as safe as the safest corporate bonds.”

Noting that only a small number of P-C insurers provide insurance on the creditworthiness of mortgage-backed securities, Hartwig points out that the loss ratios for credit insurance products of these companies are likely to rise due to increased delinquencies and defaults. Yet at least half of these companies, he says, are parts of larger financial services groups, so that experience in this line of business is a small part of their overall operation. The others are, in general, broadly diversified, he says.

“A limited number of P-C insurers offer directors and officers liability insurance and errors and omissions liability insurance. It is likely that some actions will be brought that will trigger the defense benefits in these policies, and possibly some payouts under the liability benefit provisions,” Hartwig continues. “Typically, these claims take a long time to develop. As such, it is much too early to estimate the dimensions of the claims experience that may emerge from the recent credit market developments. Of course, some companies will be affected more than others, and the depth and length of the credit market ‘challenges’ might be more adverse than many experts currently foresee.”

Experts at Guy Carpenter, however, are already warning of hits that may be taken by one segment of the industry as a result of the subprime crisis. In a briefing paper titled “Credit Market Aftershock Threatens Professional Liability Profits,” Guy Carpenter says that, although insured D&O losses are expected to reach $2 billion for claims filed in 2007, the full impact of the subprime crisis on the market may not be clear until 2008 or 2009, with total losses expected eventually to be substantially higher.

The year just past “could be considered as an ‘incubation’year, with professional liability insured losses relatively contained,” says Kevin Griffiths, leader of Guy Carpenter’s global casualty specialty practices. “However, as the subprime credit crunch continues to evolve, its impact on insurers will likely continue to grow. We expect losses to rise significantly in 2008-2009, due to increased stock market volatility and put/call ratios, litigation tendencies and an ever-lengthening list of subprime market casualties.” *