Fitch: Insurers’ Reserves Deficient by $77 Billion

By Gary Mogel

NU Online News Service, Nov. 19, 4:20 p.m. EDT?Despite recent well-publicized reserve strengthening by many insurers, loss reserves may still be deficient by as much as $77 billion, according to New York-based Fitch Ratings Ltd.

Fitch executives said some reserving problems may have been exacerbated with some companies that counted on legislation to help with asbestos losses.

The $77 billion shortfall, Fitch said, equates to approximately a quarter of the property-casualty insurance industry’s statutory capitalization.

During a teleconference today, explaining and expanding upon a special report released this month by his company, James B. Auden Fitch’s Chicago-based senior director noted that the reserve shortfall is attributable to three factors.

“First, there is up to a $38 billion deficiency for accident years 1997 through 2002,” Mr. Auden said. “In addition, asbestos reserves for policies written prior to the early 1970s are short by as much as $29 billion. There is also an up to $10 billion deficiency related to ?latent’ exposures, such as environmental damage, silica, tobacco, and future mass tort litigation.”

According to Keith M. Buckley, a Chicago-based Fitch managing director who moderated the teleconference, “cheating” and “being wrong” are the two main reasons for the deficiency problem.

“Cheating is when insurance company management ?smoothes earnings’ by booking reserves at the low end of the range,” Mr. Buckley explained. He noted that reserves are by their nature an estimate, giving creative managers room to manipulate. Mr. Buckley pointed out that such manipulation is more apt to occur when management wants to minimize reserves for losses [and resulting loss ratios] under policies with low premiums that were written during the soft market.

On a hopeful note, Mr. Buckley predicted that heightened scrutiny by state regulators, combined with corporate disclosure requirements of the Sarbanes-Oxley Act, would diminish such cheating.

“Being wrong,” Mr. Buckley continued, is when reserves are in good faith miscalculated. “Actuarial science is sophisticated guesswork,” he said. “Even best practices can lead to the wrong assumptions.”

“It’s not that actuaries are dumb,” Mr. Buckley assured his audience. “It’s more that the future just doesn’t like to be predicted.”

Resuming his outline of the industry’s reserving woes, Mr. Auden noted that the largest deficiencies are in the long-tail casualty lines, with general liability, medical malpractice, and workers’ compensation having the highest reserve shortfalls?up to 25 percent for recent accident years.

“The chronic underpricing of the late 1990s” was the main culprit, according to Mr. Auden. He also mentioned rising medical, litigation, and settlement costs as contributing factors.

“All of this has a material?but not devastating?impact on the industry’s capital position,” added Mr. Auden. “Statutory capital was overstated by 10 to 17 percent of year-end 2002 surplus.”

Turning to the asbestos factor, Mr. Buckley stated that Fitch is increasing its target “survival ratio”?the ratio of asbestos reserves to average paid losses for three years–to 17.5-times from 16-times.

“Altered loss cost estimates” was cited by Mr. Buckley as the principal reason for the increase in this ratio. He also noted that Fitch’s ratio for the asbestos exposure is considerably higher than other rating firms. “The difference is that Fitch’s calculation does not discount for the time value of money as much as these other firms,” he said.

“Asbestos reserves were increased by about $12 billion in 2002, so the hole is getting filled, but not on a dollar-for-dollar basis in relation to the shortfall,” Mr. Buckley said.

He also flatly stated that he sees little or no chance for meaningful asbestos reform in the near future. “The Hatch bill [which proposed a $108 billion trust fund for people with asbestos injuries] was a good concept, but it was destroyed by the political system and special interest groups,” noted Mr. Buckley.

According to Mr. Buckley, the Hatch bill would have had the harmful albeit unintended effect of exacerbating the asbestos reserving problem. “Some insurers slowed their recognition of reserves because they expected relief from the bill,” he explained. “We may be seeing more ?catch-up’ charges,” he added, as insurers increase reserves to account for the lack of a governmental solution.

“Reserve shortfalls are a drag on future earnings, as well as being the number one cause of insurer insolvency,” Mr. Buckley pointed out. “These shortfalls are also the key reason Fitch is maintaining a ?negative’ outlook for the property-casualty insurance industry,” he said.