Insurance Industry Sings the Back Door Blues

March 2008

One of the great blues men, Eddie "Cleanhead" Vinson wrote sometime in the '60's "I kicked the front door in, but I had to take the back door out." And so it may well be, as 2008 rattles on, with the insurance industry, which—despite protestations to the contrary—appears to be heading toward what may eventually become an unprecedented hard market.

by Peter M. Polstein

I can hear it now, "Pete, that's a hoot, the market has been so soft for so long that it can't possibly turn hard just like that." Really? Well, let's think about it.

The Investment Factor

While a limited, yes limited, number of insurers in 2007 saw unprecedented profits, they came mainly from the reinsurance marketplace. However, a substantial number of insurers, both domestic and foreign, either reported limited profits, decreasing profits, or substantial losses in the third and fourth quarters, resulting from those interesting investments that were made in collateralized debt obligations (CDOs). These are the very same CDOs that had been rated by any number of investment houses as triple A.

This brings about the question, which is painfully obvious now, how do you rate CDOs that are ripe with sub-prime paper, much of it junk, as triple A? We have not heard the last nor seen the finalization of the potential loss from the sub-prime debacle. The relaxed underwriting of the past half decade within the so-called traditional marketplace, which has moved the admitted insurer to being a virtual surplus lines market, begs the question as to whether these insurers have the underwriting expertise in that arena to support not only the rate erosion, but additional risk.

Additionally, there have been more suits brought to date relative to the overall sub-prime "problem" than were brought during the late '70s and '80s in the savings and loan episodes. They aren't going to go away, and are going to have what may well be unprecedented legal costs and potential judgments, which will impact both investment entities and insurer. To exacerbate this, there are now various state and governmental agencies that are beginning to closely investigate these matters, which may mean significant additional costs, fines, and perhaps criminal prosecutions.

Then, to add insult to injury, insurers took some interesting losses on a wide variety of capital investment deals, including credit default swaps, with AIG apparently leading the way most recently in having to recast numbers by virtue of their auditors insisting on disclosure. Certainly, AIG is not alone, as a substantial number of offshore reinsurers are virtually hedge funds in disguise, where "mark-to-market" investments in their portfolios may well be suspect, given the current and potential future of these instruments.

Part of this intriguing situation which amused and astonished me was the announcement in late October 2007 of the Guy Carpenter product, which would provide a hedge, guaranteeing the under-reserving of so-called long-tail risk. I wondered both privately and in writing if this was yet another way to cheat on reserving practices, a practice not unknown in our industry. This program also gave rise to the speculation as to whether it would make the underwriter a co-conspirator in that age-old  bid to manage profits, which would have a material effect on per-share efficacy. It caused me to wonder how they could "model" a program and produce any legitimate actuarial basis by which you could predict market cycles, but more importantly, legal theories from adjudicated law that could be tested and succeed.

For the most part, margins and profits have been substantially hit by falling prices, some loss portfolios, luckily no cat claims, and the continued rise, albeit slowly, of expenses. The one thing the industry can't do is reduce substantially its employee count, as the marketplace does not dictate the numbers of employees, as is the case in other businesses. You simply cannot reduce your workforce and expect at some later point to be able to hire them back. It doesn't work in our industry; we're not manufacturing automobiles.

The Reinsurance Factor

Further possible problems may become apparent in 2008 from the increasing use of so-called unauthorized reinsurance, which has increased exponentially over the past 5 years. Ceded premiums continued to rise in the mid-double digits, overdue recoverables increased by over 25 percent, and we have yet to see the potential of loss within the cede community and those to whom they have ceded. I suspect that the regulators who have not relaxed the collateral requirements on offshore reinsurers may eventually play an important part in the ability to adequately resolve claims.

Affecting foreign insurers and reinsurers is the Solvency II compliance issue. The proposed risk-based capital system has been reported to cost in excess of $780 million, which is, at best, a rough estimate. And, speaking or risk-based capital systems, domestic insurers will soon be scrutinized by both rating agencies and regulators on similar terms.

What would quickly tip the scales in the direction of disaster, which has been absent for the past year or so, are substantial cat claims. Push the sort of numbers that were seen in 2005 into the equation, and voila, you know the end of the story.

In the End, Where Does All of This Take Us?

I suspect that those of you who are negotiating cover in this current marketplace undoubtedly have found it worthwhile to attempt to elongate cover terms. Where possible, I'd look toward at least 2- and 3-year contracts, with as little amendment change as possible. Where you have loss-sensitive programs, the time to work these out is now, if they have not already been negotiated prior to January 1, 2008. I have this uncomfortable feeling, that given the right circumstances, this marketplace could turn very ugly, very quickly. All of the ingredients are in place … all you need is the heat.

As the man said, I kicked the front door in, but I had to take the back door out.

That back door might well be the saving grace for you—and your clients—irrespective of which side of the business you hail.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author’s employer or IRMI. This article does not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.