This is the second in Viewpoint’s series of
guest essays submitted by organizations that are associate members
of AAIS. For information on associate membership, contact Rick Maka,
director of marketing, at rickm@AAISonline.com
or by calling 800/564-AAIS.
The one-two punch of Hurricanes Katrina and Rita
are poignant reminders of nature’s power and the high level of
risk the insurance industry faces when writing catastrophic flood,
windstorm and earthquake exposures.
It is widely recognized that losses from Katrina
could be as high as US$60 billion,1 which would make it
the largest-ever insured loss - even greater than the September 11
terrorist attacks. Further, early estimates put Rita’s losses as
high as $7 billion.2
The impact of these hurricanes is one of the
many factors that will change the dynamics of the marketplace.
Katrina and Rita come on the heels of last year’s
record windstorm claims of approximately US$38 billion - principally
from hurricanes and typhoons in the United States, the Caribbean and
Japan. In 2005, five air crashes, typhoons in the Pacific, summer
storms in Canada and losses from northern Europe’s storm Erwin in
January have compounded industry challenges.
Despite the claims experience and the enormous
past and future exposures, insurance and reinsurance property rates
continued to be under pressure in the first half of 2005. Did this
simply represent a correction from rate levels that rose after
September 11 or does this indicate the industry is jumping headlong
into yet another self-destructive soft market?
Or could there be another possibility for the
industry? Perhaps there are other forces that are influencing the
industry to take a more disciplined road?
As in any market, the law of supply and demand
drives the
insurance industry’s cycles. When the industry
has excess capital, there are strong urges to deploy it. Rates begin
dropping, technical pricing is often forsaken, terms and conditions
weaken and companies enter into lines they otherwise would not. The
refrain is a familiar one.
There have been ominous signs that insurers and
reinsurers might again be swayed by the power of these forces. In
the first quarter of 2005, surplus (pre-Katrina) was at an all-time
high - reaching US$401.8 billion3 for the U.S. property
and casualty industry. At the same time - after several lackluster
years - investment income is once again increasing.
Further, there are other worrying indicators:
although returns generally have been increasing, market rates have
been turning downward in varying degrees.
The most significant rate softening in the
United States has occurred in large P/C commercial accounts. During
the second quarter, rates for large commercial customers dropped on
average by 12 percent, according to data compiled from the Council
of Insurance Agents and Brokers and Lehman Brothers Global Equity
Research. As underwriters are attracted by the large premiums
provided by commercial accounts, they often are an early indicator
of a softening market. During the same quarter, premiums declined
for all accounts by an average of 9.7%.
But price is not the only factor in a softening
market. While industry commentators like to focus on declining
rates, of even greater importance is that deductibles are decreasing
and terms and conditions are becoming broader - particularly in the
primary market.
When primary carriers accept weaker terms and
conditions, it is not always transparent to their treaty reinsurers
- but it can be a significant factor in the increase in loss ratios.
Do all these factors add up to a market that is
heading into another period when premiums are pursued at the expense
of profits, financial stability and, in many cases, solvency? The
historical behavior of the industry would indicate irresistible,
unshakeable market forces at work.
Are boom-and-bust cycles a fact of life like
death and taxes? Will a lengthy soft market always be followed by
severe industry losses, ratings downgrades and the inevitable “correction”
when rates shoot upward?
Or are there other forces at work?
Market forces indeed are strong, particularly
for the insurance industry. And certainly there will always be rate
cycles, as long as there is a market economy. However, there are
some new factors that could ensure that underwriting rigor will be
maintained, thereby smoothing the highest rate peaks and lowest rate
troughs. They range from psychology, to business realities, to
regulation.
-
Hurricanes Katrina and Rita.
Hurricane Katrina may prove to be the most expensive catastrophe
ever - natural or manmade. Not only could Katrina potentially
have unprecedented insured losses, but Risk Management Solutions
(RMS) has estimated that its economic costs may be greater than
US$125 billion. Hurricane Andrew, which blew across southern
Florida in 1992, cost the insurance industry US$21.5 billion (in
2004 dollars), while the September 11 terrorist attacks are
expected to top US$31 billion.4
RMS has also estimated that
insured losses for Rita will range between $4 billion and $7
billion.5
The psychological
influences of such large events are strong - especially when
heading into a renewal season. With a rebuilding effort that
will take months, it is difficult for underwriters to forget
about the exposures that are possible in this business. Indeed,
Hurricanes Katrina and Rita have created a new understanding of
what is possible with catastrophic exposures. As a result,
insurance and reinsurance buying is likely to be affected in the
coming renewals, with buyers seeking greater protections.
In addition, there is real
likelihood that reinsurers will shoulder a good portion of
Katrina’s losses, which will focus their minds in the coming
renewals - even if the industry is carrying excess capital and
surplus.
The primary market absorbed most
of the losses from Hurricanes Charley, Ivan, Frances and Jeanne,
which hit Florida in 2004. As four separate events, claims did
not reach as many catastrophe layers.
-
Katrina’s tail. Although the low
end of Katrina’s losses at this printing are estimated at
US$40 billion,6 there is a strong possibility they
could rise to higher levels. Not only will business interruption
losses increase the longer flooding remains, but there is also
the issue of a phenomenon known as “demand surge.” With
demand surge, insured losses creep upward due to the increased
price of construction materials and labor following large losses
such as Katrina and Rita. As Katrina created a coastal flooding
deluge, assessment of damage could take weeks or months, while
reconstruction may take months, even years.
As a result, Katrina will have a
“tail”, making it harder to initially gauge loss estimates
and - more than likely - adding to the financial burden on the
insurance industry. The situation for Rita will be similar,
albeit on a smaller scale.
-
The financial factors. The industry
now places much more emphasis on underwriting profits than in
the past, when investment income helped supplant lackluster
results. This is no longer possible to any significant degree
because of the lower investment income. In 1987, a 10-year
Treasury bond provided a return of 10%, while current rates run
at 4.15%.7
Consequently, the industry has
shifted from a 17% return on equity (ROE) in 1987 to an 11% ROE
in 2004, despite the hard market rates of the past several
years.8
And there is another, more
immediate financial factor to consider: while Hurricanes Katrina
and Rita will put a dent in the industry’s surplus and
earnings, many companies continue to operate with very strong
balance sheets. However, the hurricane season is not over yet.
More losses from other major hurricanes could begin to affect
ratings and the industry’s capital position.
-
Modeling. Models have created a
scientific basis for pricing decisions. By using tools that
permit strong underwriting discipline and a better understanding
of loss costs, underwriters have a scientific basis to say, “yes,”
for the right price and right risk.
As a result, modeling can act as
a behavior modifier for rogue underwriting throughout the
industry.
While models are good tools that
can help stabilize the emotional drivers of a softening market,
they have some limitations. This lesson became clear after last
year’s four Florida hurricanes; some insurers with smaller
portfolios and localized losses had higher claims than their
models predicted. As a result, underwriters need to employ other
tools to help them manage their aggregates.
-
Rating agencies. Some analysts and
observers believe rating agencies have become insurance industry
quasi-regulators. The threat of a ratings downgrade applies
pressure on the industry to maintain operating performance and
capital levels, which might help companies avoid carelessness in
underwriting decisions.
-
Regulatory factors. The
investigations into finite reinsurance arrangements and broker
practices have helped create an environment where increasing
transparency and regulatory clarity have emphasized strong
business fundamentals. This has put a renewed emphasis on making
money the old fashioned way - through underwriting profits.
Bad results from aggressive
competition in a soft market quickly will become apparent to
shareholders, employees and customers.
-
The SOX effect. Sarbanes-Oxley (SOX)
and its European sisters have also played a significant role in
making transparency a business norm. Few companies can now
justify losses from insurance products that have slipped below
technical margins.
-
Job security. A host of insurance and
reinsurance CEOs have left office after the last soft market.
The new generation of CEOs has a fresh perspective and stated
commitment to enforce underwriting discipline during a softening
market.
-
Tort costs. The industry is still
shouldering the burden of casualty business written during the
soft market of 1997-2001. Since 2001 the P/C industry has had to
bolster reserves by US$54 billion.9 This is a
constant reminder to those new CEOs and others who survived the
recent corporate purges that casualty risks were underpriced at
a heavy cost.
Litigiousness is not just an
American phenomenon; it is increasing throughout the world. The
latest estimates from Tillinghast-Towers Perrin show that U.S.
tort costs could rise in 2006 to US$297 billion annually, which
is 2.3% of the U.S. gross domestic product.10
While casualty models exist, they
are usually created by individual companies, so there is little
market standardization similar to those provided by property
models, which are used by the entire industry. As a result,
casualty pricing is much more challenging, given the vagaries of
court awards and emerging risks.
The combination of Hurricane Katrina and the
other elements in the mix of our current business environment send
clear signals for underwriting discipline and rigor. Good progress
was made last year when the U.S. P/C insurance industry made its
first underwriting profit since 1978 - of approximately US$5 billion11.
If the industry is to remain strong for its
policyholders and shareholders in the long-term, it must continually
take a realistic assessment of risk and respond with technical
pricing levels. Not only are the exposures enormous, but there are
an array of business, economic and regulatory realities that will
continue to exert considerable influence on underwriting decisions
for the foreseeable future.
Lisa S. Howard is a communications manager
for GE Insurance Solutions in London. Prior to joining GE in 2003,
Ms. Howard had been a reporter adn editor for National Underwriter
for 18 years.
1 Risk Management Solutions (RMS)
estimates. Press release: “Great New Orleans Flood To Contribute
Additional $15-25 Billion In Insured Losses For Hurricane Katrina,
Bringing Estimated Insured Losses To $40-$60 Billion,” Sept. 9,
2005.
2 RMS estimates. Press release: “RMS Provides Preliminary
Breakdown of Estimated Loss Components for Hurricane Rita”,
Sept. 25, 2005.
3 Insurance Services Office
4 From Insurance Information Institute’s Facts and
Statistics. Data accessed Sept. 27, 2005. www.iii.org/media/facts/statsbyissue/catastrophes/
5 RMS estimates. Press release: “RMS Provides
Preliminary Breakdown of Estimated Loss Components for Hurricane
Rita”, Sept. 25, 2005.
6 RMS estimates. Press release: “Great New Orleans
Flood To Contribute Additional $15-25 Billion In Insured Losses
For Hurricane Katrina, Bringing Estimated Insured Losses To
$40-$60 Billion. Sept. 9, 2005.”
7 US Federal Reserve Statistics. www.federalreserve.gov/releases/h15/current/
8 Aggregate data compiled by the Insurance Information
Institute. Data used with permission from III.
9 GE Insurance Solutions analysis of statutory filings.
10 Tillinghast report entitled “U.S. Tort Costs: 2004
Update,” Jan. 12, 2005.
11 Data compiled by Insurance Information Institute
(III). Data used with permission from III.
|
by Lisa Howard
