24 March 2009

Published in: Insurance risk, Investment risk

Insurers face up to underwriting for profit

Without their usual solid investment returns to fall back on, insurers will have to work harder to make a profit in 2009. Helen Yates considers their options.

The term "underwriting discipline" is one that is frequently used in the insurance and reinsurance industry. It essentially involves underwriters sticking to their guns until a risk-adequate price has been agreed upon. Most insurance professionals would baulk at the suggestion they have relied on investment returns to prop up premiums. The bad old days of cash-flow underwriting are safely back in the 1980s, they insist.

Things have improved. Since the World Trade Center loss in 2001 "insurers have maintained incredible focus on underwriting and controlling the untold aggregations that can occur," says Bryon Ehrhart, CEO of Aon Benfield Analytics. The reliance on investment profits diminished - but it didn't completely disappear. "We spent a significant portion of the 2007 and 2008 years focusing on the left hand side of the balance sheet. Now with investment yields so low and the investment style so conservative it really does add emphasis to making sure combined ratios are low from the underwriting segment."

A bad year for investments

Insurers are generally very conservative investors, preferring to take risk on the liability side of the balance sheet. They have very little exposure to debt (in the 20%-25% range) and a moderate proportion in equities (roughly 10% for the average non-life insurer) - which tends to be higher for European insurers than North American - spread among highly-rated assets. But insurance companies weren't immune from the financial crisis, which climaxed in September 2008. As the contagion spread, it passed from asset class to asset class.

"Insurers didn't feast at the table of debt," says Ehrhart. "That has served them very well - you don't see many insurance companies with federal bailouts because of insurance reasons. Unfortunately we did have a decent amount of asset leverage and that has definitely impacted capital."

A sample of large global insurers suffered an average reduction of shareholders' equity of 20% in the first nine months of 2008, according to Aon Benfield's Reinsurance Market Outlook 2009. There have been further drops since then. Experts estimate that over $100bn of capital left the industry last year - the bulk of it as a result of investment losses (48% unrealised investment losses, 44% realised losses and 8% from hurricane claims, according to Aon Benfield). The S&P Insurance Index fell 60% in 2008, although this was exacerbated by AIG.

With interest rates now at 0.5% in the UK and close to zero in the US, short-term returns are extremely low. This has introduced a lot of uncertainty, says Karl Murphy, a partner at EMB. "One year ago it would have been a very bold move to have projected interest rates of 0.5%. So hopefully people will just ignore investment returns when they are setting their pricing strategy."

Ignoring investment returns when setting pricing is not something insurers have had to do in recent years. In fact, the whole principle of taking a premium up front and potentially paying out in claims in one or two years - having made a handsome return by investing those initial funds - is a practice the industry is based on. "A couple of years ago a typical UK motor insurer would probably be making about a 7% return on premium in terms of investment performance," says Murphy. "Given current yield curves I reckon a typical UK motor writer could at best make about 3% on investment performance now."

This has a dramatic affect on pricing calculations. "It would be a key part of calculations to say, ‘We can write to 107% combined operating ratio and that would be break even for us'," says Murphy. "Now at best they can write to 103%. Given the relatively small margins in the insurance business, that four points is the difference between having an absolutely bumper year and being a hero, or having to explain to your shareholders why you've lost a whole load of cash."

Bringing back discipline

With such low investment returns, underwriters have no choice but to insist upon higher premium rates if they have any hope of making an underwriting profit in 2009. So why haven't prices gone up more? Rates in primary insurance lines have yet to show any real signs of hardening, while for reinsurance lines, increases have mostly been limited to property. Further increases are needed if the industry is to realise its profit targets for 2009, in particular on casualty lines of business that have combined ratios close to 100%.

Some in the industry have expressed surprise that prices didn't harden more at the 1 January renewals. When vast amounts of capital had left the industry after previous events, such as Hurricane Andrew, 9/11 and Hurricanes Katrina, Rita and Wilma in 2005, there was a far greater reaction. One theory is that because most of last year's losses came from the asset side of the balance sheet it has been difficult to translate this into an underwriting response.

Or it could be the combined impact of continuing competition and recession, explains Ehrhart. "There's still significant supply of insurance for most of these lines like workers compensation, commercial auto and general liability around the world. So while there is still capacity and competition for those lines you can't really get much rate to begin with. Then the businesses that are buying the insurance are all suffering from likely revenue declines themselves. So they're feeling it as well and their ability to afford to pay more for insurance is lessened."

Jeremy Brazil of Markel International Insurance Company: "Those that use investment as a makeweight to turn a gross underwriting loss into a net underwriting profit will have to revisit their model."

Despite these wider recessional challenges, prices are expected to rise further over the coming months. "Equity investments have got to be down 30%-40% - so you've got a much smaller investment fund with a much smaller chance of making any sensible returns on it," says Jeremy Brazil, president of Markel International Insurance Company. "Those that use investment as a makeweight to turn a gross underwriting loss into a net underwriting profit will have to revisit their model. Our sense and view is that rates will continue to increase - across all lines - because at the end of the day capital is capital and there's a cost associated with it."

Insurers may decide to exit certain classes of business where rates don't harden or if there is too much volatility. Many have already cut back their exposures to financial institutions because of the deterioration in the sector. But it's best to stick to your knitting, warns Brazil. "Sometimes in an attempt to grow the bottom line people start straying into areas which they are unfamiliar in. You have to ask the question: ‘If we weren't doing it in a hard market, why are we doing it in a soft market?'" Where insurers stray into the unfamiliar, "unfortunately history shows that it tends to end in tears".

Back to the future

So with a disciplined approach to underwriting, could the insurance industry dare to hope to make a profit in 2009? History tells us that the industry has not just survived but flourished in previous recessions. It even got through the Great Depression intact, reveals Jeremy Adams, CEO of Novae Syndicates, in a recent speech. "We're heading for something no-one has been through so we have to dig out the history books and look at what happened to the insurance industry then. Lloyd's went through the Depression making a small profit - steady as she goes. The insurance industry is very well positioned to survive the current crisis."

There is a counter-cyclical element to insurance, says Simon Harris, team managing director, European Insurance at Moody's. "There's really no direct connection between economic recession and insurance profitability - in fact non-life profitability could be maintained even in a recessionary environment."

Rates may not need to rise dramatically for the industry to remain profitable, adds Harris. Moderating inflation could have a favourable impact on claims. "Oil prices have fallen and a lot of commodity prices have fallen and wage increases are at lower rates. You'd imagine that might mean claims inflation might start to moderate through 2009. That might be a reason why rate increases might not be required."

"But most companies would still say they'd like rate increases to go higher," says Harris. "Mainly people are putting rate increases through because they're hurting on the asset side of the balance sheets to varying degrees and one way to offset that is try and improve the underwriting side." Targeting a combined ratio of under 90% is "where you want it to be", he adds.

Claims of business past

Lower claims inflation may help insurers through 2009, but claims' frequency will add to their list of challenges. The link between recession and greater claims is well established. Instances of claims' fraud are also set to grow. Most claims' fraud is likely to affect personal lines insurance. Greater instances of arson are often a clue that scams are on the up.

Axa has set up a specialist anti-fraud team while loss adjuster Cunningham Lindsey doubled its investigations team in anticipation. According to CIFAS, the UK's fraud prevention service, there was a 16% growth in fraud over 2008. "If that starts to come through on insurance claims - and no doubt it will - that's going to have quite a big impact on the claims side," says Murphy.

And then there are the really big deceptions such as the $50bn fraud by Bernard Madoff and the $9.2bn alleged fraud by Allen Stanford that are likely to see professional liability claims hit some of the bigger insurers and reinsurers. "The rates need to increase, if not least because of potential increase in claims but also because of fraudulent activity," says Murphy.

Claims related to the financial crisis could take years to come through the system. Current estimates are that claims will ultimately cost the industry anything from $6bn to $25bn (according to statistics from Swiss Re). It's difficult to be certain with long-tail lines of business, says Brazil. "The good thing about short tail is, when you have a major loss, the market does react immediately because you have a good idea what it's going to cost you, whereas with casualty, the losses take time to manifest themselves so the market takes longer to correct pricing."

Consolidation coming?

With unknown casualty claims still to come through and reduced investment returns, the more capital-starved insurers may take more drastic action. Drivers behind M&A activity will shift from being opportunistic to being forced in 2009, predicts Ehrhart. AIG alone has flooded the mature insurance markets with some rich pickings. "Had there not been such significant government intervention, you would have seen more consolidations - out of desperation not opportunity."

The problem for any prospective seller in today's market is that few insurers have excess capital with which to fund acquisitions. "Most insurers and reinsurers have lost about 25% to 35% of their capital through the course of 2007 and 2008," says Ehrhart. "At these levels they have certainly maintained the capital that has been necessary to renew their core lines of business but moving on from here, either limits are being reduced or classes are being eliminated."

"I think it's likely there will again be some future consolidation," says EMB's Murphy. "The difficulty in the current market environment though is who is going to buy? Some of the deals that happened a year or two ago wouldn't happen now because of access to funds to fund those purchases."

Should rates harden further it should encourage capital to return to the industry. After Hurricane Katrina, rates soared for US catastrophe-exposed lines of business. Encouraged by the potential returns on offer, over $30bn flowed into the industry in a matter of months. Such a flood of investors is unlikely in the current climate, but there are reasons to expect a small recovery. Several Lloyd's insurers, including Beazley, Catlin and Hardy, have raised capital in early 2009, signalling a potential end to the drought.

And once the equity markets begin to recover, insurers will happily return to their old practices. Investment returns will once again become an important part of premium rate calculations. "I wouldn't expect in five year's time, if investment returns are back to normal, that people will be ignoring investment returns and not factoring it into their premium calculations," says Murphy. "It's too much money to do that."

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