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.
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