Expert Commentary

The Insurance Business Is Not For Sissies!

In his Insurance Rx column, Gary Bausom takes a look at where insurance companies are headed after 9/11, what they can expect to find, and "ingredients for success."

February 2002

So, premiums are notably higher! But where are insurance companies going? Currently, most of their energy is being expended to: (1) obtain carloads of data from insureds to purportedly improve understanding of the risks and support higher premiums, and (2) to establish the new pecking order in the marketplace. After a 7-year drought, this is to be expected. What are underwriting firms doing now to sustain a profitable "ride" in 2003 and beyond?

The Harsh Realities

Prior to 9/11 and the World Trade Center (WTC) disaster, the smart underwriting money was focused on improving portfolio risk quality. The industry has been challenged by rate inadequacy due primarily to over-capitalization. In 2001, there was some rate stabilization and/or growth, however, the investment income was shrinking due to declining interest rates. The Federal Reserve cut the Fed Funds Rates 10 times; in January, it was 5.5 percent and in December it was 1.75 percent.

Capital Repositioning

The WTC insured loss estimates are around $40 billion. That should translate to an after-tax loss of approximately $30 billion. Since October 2001, more than 50 insurance companies have raised $22 billion in new capital with another $8 billion in the pipeline. From a capital investment perspective, there is no change from pre-9/11. The general thinking about raising capital has to be that debt capital is relatively cheap, and insurance rates are rising to a level where insurance companies might be able to make an underwriting profit.

Insurance companies have taken the accounting "hit" for 9/11, so what will they do with the new capital to achieve adequate returns? Some non-life actuarial firms have suggested that the capital to written premium ratio for CAT business is about 5:1 and non-CAT business is 1:1. If the industry would underwrite 50 percent CAT and 50 percent non-CAT business with the $30 billion in new capital, that would mean they would need $18 billion in new premiums in addition to their existing books of business.

Insurers have several alternatives in deploying their capital. Options for underwriting firms are:

  1. Use capital to underwrite additional risk.
  2. "Park" capital in financial markets investments.
  3. Acquire companies for expanded product and market reach.
  4. Dividend surplus capital to owners.

Underwriting additional risks begs the question, "Where will all those quality risks come from that have not already been written?" If a Fortune 100 company pays $10 million in pure insurance premiums, and the industry needs $18 billion in new written premiums, that amounts to 1,800 additional Fortune 100 size accounts!

By parking surplus capital in a deflationary economy, insurers are likely to incur a notable opportunity cost. If an insurer's midterm target return is 12 percent, and if a soft market exists where it can underwrite a risk for a 9 percent expected return, the result by "parking" capital may generate 2 percent in the financial markets. The opportunity cost in this example would be 7 percent. However, if the insurance portfolio has more losses and expenses associated with it than premium income, the total return can be negative as well. In no case will premium volume make up for negative operating margins.

Acquisitions may help to further industry consolidation thereby providing greater rate stabilization. However, after the "glow" of doing the deal passes, it will soon come down to achieving acceptable rates of return on the capital invested. Alternatively, if the returns are not forthcoming, it may require finding a buyer who is willing to pay more for the acquired company than the purchase price.

There are continuous announcements made about mergers and acquisitions. If a target company has $100 in revenue, $100 valuation, and a profit of $17, and is acquired for $200, it will need to generate $34 in profit to have a comparable return for the owners. It could also be argued that the increased level of return might be achieved over 3-5 or 10 years. The question is, will the profit be greater than the cost of capital and also provide an adequate return for all stakeholders? The other key question for the acquirer is, how much do they give up in terms of rate of return to achieve diversification, greater market reach, and, it is hoped, future growth?

In economic terms, the insurance industry represents a pure competitive economic model where it needs to balance the demand for insurance and the capital employed to support it. If numerous insurers are raising capital, then the opportunity for achieving attractive returns will be diminished by the oversupply of capital that will force insurance prices to fall.

Quality Portfolios

Profits can be enhanced through acquiring a quality risk portfolio that produces losses and operating expenses which are less than the underwriting and investment income. The real issue is for underwriting firms (not merely the individual underwriters) to be able to balance underwriting profits against the need for gains in market share. Underwriters have a challenge to understand, in any depth, the diverse number of businesses and industries for which they accept risk. Underwriters have to look at dozens of risks every week and make accept/reject decisions. The premium and potential profit on each deal is relativity small in order to attain the desired spread of risk.

Building and maintaining a quality risk portfolio is a combination of the physical risk attributes and the individuals who manage the risks daily, weekly, etc. The rate of change within most clients' businesses is very rapid, and an underwriter obtains, at best, an annual snapshot representing a moment in time. Underwriters need to further improve their ability to assess and base their underwriting decisions more on the creditability of the people with whom they are dealing.

Ingredients for Success

If no one insurance company can influence the market demand for its products nor the amount of available capital, then it must control the amount of capital it allows to be used to underwrite risk in any period of time. The other challenge is to employ the excess capital productively without engaging in an acquisition-buying spree that could generate negative rates of return on the capital invested.

The key question is, what does the acquiring company bring "to the party" that will made the acquired company worth more than it paid to purchase the target firm. There are numerous companies that have money, however, it takes people with skills that clearly exceed simply following a set of procedures contained in a corporate manual.

Customers need to believe that a firm offers superior value to other alternatives in the marketplace. Insurance is a service business based on conditional promises, which requires the utmost credibility. Credibility is delivering, as represented, every time.

Most firms believe they have good personnel. Perhaps they do, but have these people been given adequate opportunity to prepare for the next real challenge? If employees' "leashes" have been lengthened from 6 to 9 feet, does that prepare them to deal with customers, distribution channels, and deliverables that are truly different? Embarking on a new product line or acquiring a firm and integrating it will require people without a leash or any fences … these people will have to assist in developing a new order for success. If these people have been engaged in the mode of fine-tuning "business as usual," be careful about thinking they are prepared for spanning different corporate cultures, migrating from one customer model to another, and/or integrating them without losing customers, dealing with different distribution channels, etc.

Insurance firms have many qualified people who know the technical aspects of the insurance business, but those individuals are not necessarily prepared for dealing with new business models and customers' needs if they have gained most of their experience from habitual past practices and company management manuals.

For firms that have people who are creative thinkers with an "open range," there is likely to be greater opportunity for successful growth through acquisitions or truly new products. The large management-consulting firms may be helpful in designing certain aspects of a go-forward plan, but someone has to implement a plan and make it successful. Larger consulting firms are too expensive and not always completely versed in implementation. After consultants deliver a report and are paid, how much "skin" do they have on the line?


Being successful involves refocusing and acting now … with a vision that incorporates the following ideas:

  1. Financial capital is only one raw ingredient to being successful.
  2. Customers need to clearly recognize value offered, relative to competitive offers. In the insurance marketplace, the only differentiator may be the people and their credibility
  3. Employees who have leadership potential will require current leaders to "tear down the fences, and throw away the leashes."

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do 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.

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