To The Point

The end of insurance?

I.I.I. Warns industry to beware of "mega-trends"

By Michael J. Moody, MBA, ARM

Change is constant and, as risk managers, we need to be aware of those changes and, to the extent possible, plan ahead for them. Changes, actually large changes, will be occurring in the property and casualty insurance industry according to Dr. P. Robert Hartwig, CPCU, president of the Insurance Information Institute (I.I.I.). He talked about these changes or “mega-trends” as he calls them, at the NCCI Annual Issues Symposium in Orlando last fall. Hartwig believes that five mega-trends will cause a fundamental transformation within the insurance industry. Further, he notes this transformation is already underway.

The specifics of each of these trends will have a different effect on the property and casualty insurance industry. However, taken in total, Hartwig believes, these trends “point towards a diminishing role for traditional insurance.”

Reshaping the Industry

One of the mega-trends that Hartwig identified is “stagnant growth.” It’s no secret that during this softening market, growth has pretty much come to a standstill. And while he notes that current growth is at the lowest rate in more than 40 years, the outlook is no better for the next year or so. During that time span, Hartwig says, the industry may actually shrink by about 6% to 7%. As a result, he says that recent growth figures are “eerily reminiscent of the soft market of the late 1990s” when growth rates hovered around 2%.

Another trend Hartwig observes is overcapitalization. He points out that the insurance industry had a record $513 billion in policyholder surplus in 2007, and he estimates that as much as $100 billion of that number would be considered “excess capital.” According to Hartwig, this overcapitalization is considered by many as “the P-C insurance industry’s historical seed of self-destruction.” And while this may only lead to inefficient returns on investment for some insurers, all too frequently it leads toward seeking growth at any cost and ultimately starts costly battles to maintain market share and ends with massive underwriting losses.

“Invasion of the regulatory zealots” is another of Hartwig’s insurance industry mega-trends. This is a recent phenomenon that comes primarily from the fact that “everyone thinks they’re in charge of regulating the insurance industry.” In the past, insurance regulation has been quite easy—it has been left up to the individual state insurance departments—but of late, Hartwig points out, many more entities have become involved. This expanded list includes a number of state attorneys general who have followed in Eliot Spitzer’s footsteps with attacks on the industry’s contingent commissions. Additionally, members of both the United States Senate and House have held hearings on a wide variety of insurance-related matters. Hartwig also notes that even some state governors have recently gotten into the act.

Erosion of tort reform is another of Hartwig’s mega-trends. Further, he points out that over the past six years, the tort environment has become more pro-business, which is driving down the overall cost of insurance. While this has been good news for many business owners, there is “a genuine concern in the business community that the tort pendulum will soon begin to swing against corporate defendants.” Hartwig notes that much of this concern stems from a Democratic Congress which “enjoys greater support from trial lawyer groups.” Ultimately, he says, this could become a significant negative development for commercial insurers.

The big one

Any and all of the above noted trends will adversely affect the entire insurance community, but they are nothing compared to the number one trend: disintermediation. Yeah, I know most people are thinking that disintermediation is just some “urban legend,” but it is not. While there are many definitions for this term, most center around the concept of being “effectively removed, excluded from, or simply left out of the core function of risk transfer that insurers have performed for centuries.”

The concept of disintermediation actually became part of the lexicon and started in the financial markets when banks found themselves on the outside looking in with regard to raising capital for lenders. For years, banks acted as financial intermediaries for debt by borrowing from depositors and lending to borrowers. But in the 1970s, borrowers found that by selling securities such as bonds, they could go directly to investors and bypass the banks entirely.

Today, a similar series of events is occurring within the insurance industry as disintermediation is occurring in a variety of ways. The first and most obvious way is the continual movement by organizations into the alternative risk transfer (ART) market, namely through the use of captives, self-insurance, risk retention groups and large deductible programs. While many insurance experts agree that it is important for policyholders to have “skin in the game,” these ART market programs have been taking a chunk swath of premiums out of the commercial insurance market, notes Hartwig.

It is certainly true that many corporate insurance buyers have, in fact, been forced out of the traditional insurance market by prior hard insurance conditions. And while the current soft insurance market will undoubtedly attract some of these ART market participants back to the commercial market, most will not return. According to Hartwig, many of these buyers have “grown comfortable with the assumption of risk,” and most will not return to traditional insurance solutions.

The primary reason for this comfort within the ART market is that many insurance buyers have found that “investing” in one of the large retention type programs is economically efficient. This is because “the return on the investment meets or exceeds most companies’ internal hurdle rate for any investment,” says Hartwig. Given that situation, “Why fork over the money to an insurer?” Obviously he points out that there are a number of reasons for “forking over the money,” but insurers are finding it harder and harder to make their case to their larger corporate customers.

Additionally, for many large corporations, the insurance industry is simply failing to meet their long-term needs. Whether it’s the retention programs, or even the higher catastrophic loss limits, today’s insurers are not fully solving the larger corporations’ risk-related issues. Over the past eight to 10 years, with increasing frequency, the insurance industry has failed to respond to high-risk, high-limit exposures. Many of these corporations are left on their own to solve these sticky issues. As a result, traditional insurance is becoming less and less an integral part of large corporation insurance programs. Thus, insurers are in effect disintermediating themselves from the insurance purchasing function.

And the current movement to an enterprise risk management (ERM) approach will only serve to increase this divide. As corporations begin to develop sophisticated risk management programs that incorporate an enterprise view, it will be important for the company’s risk officer to consider all of the potential solutions available. While there is little doubt that insurance will be one of the solutions that will be considered, the question is how well will insurance fit into an ERM world?

Conclusion

In order for insurers to continue to have a central role in large corporations’ risk management programs, they will need to adopt a more strategic approach for their insurance products. As currently available, few of today’s array of insurance products match up well with most ERM programs. As a result, it’s clear that the ball is now in the insurance industry’s court. It needs to realize that failure to change and adapt with the advent of ERM could well make insurance irrelevant for large corporations. They have only to see how banks fared in the 1970s. Banks soon found out the true meaning of disintermediation when the music stopped and there was one less chair at the table.