Sector's cash flow suggests hard market in 2008; finite reprobes hasten cycles

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The power to predict property-casualty pricing cycles accuratelyhas long eluded the best minds in the industry–but analysts atCochran Caronia & Company have developed a technique that mightbe quite useful for anyone trying to guess where prices areheaded.

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We believe cash flow is a reliable tool to predict pricingcycles, and based on current industry conditions, we're predictinga significant drop in industry cash flow in 2006, and the bottomingout of the pricing cycle by 2007.

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To a remarkably consistent degree, we have found that premiumpricing in the p-c sector more than doubles about one year after ameaningful drop in industry operating cash flow. In the nineup-and-down cycles of p-c underwriting since 1942, cash flowsharply hit bottom one year before each of eight upturns inpremiums. (There was one exception, though. In the current cycle,there was a two-year delay between negative cash flow and the cycleuptick.)

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The reverse of this pattern is also found to be true. When cashflow rises significantly, p-c premium price hikes lose steam,bringing earnings down with them. If the past is any guide, we canexpect a particularly sharp deceleration in premiums in 2006.That's because cash flow historically rises one to two years beforecycles hit bottom and premiums flatten. The last peak in cash flowtook place in 2004.

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The timing of industry slumps varies somewhat more than itspeaks. In four instances, cash flow rose one year before theclosing of a cycle. In three instances, the updraft occurred twoyears before the cycle's end. The two-year gap occurred in three ofthe last four cycle-ending points. In each of these cases, therewas a significant cash-flow drought preceding the cycle upturn.

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Now, looking at end of the 2000 to 2003 hard market: At theclose of 2002, cash flow showed that the up cycle would end in2003. Cash flow began to improve in 2001 and hit an “inflectionpoint” in 2002. The inflection signals that premium growth likelywill slow down within 12 to 18 months.

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Cash flow to premium typically approximates 20 percent as aprelude to the end of the up cycle. The ratio crossed the 20percent level in mid-2002 and continued to rise thereafter. Basedon this we predicted that premium growth would decelerate in2004–and it did. In 2004, premium growth was less than half thelevel of 2003.

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One crucial forecast we are making is that going forward, theindustry will see shorter cycle durations. If the p-c marketplaceis a melody of ups and downs, it is growing decidedly moreup-tempo. We believe that the pricing cycle's pace is quickening.The time from cycle peak to trough should fall from an average ofeight years to two to three years for the current cycle.

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This is because the increasing difficulty to use finitereinsurance, heightened scrutiny by rating agencies and an overallemphasis on transparency all contribute to hastened shifts frompricing peak to trough.

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The continuing investigations into finite reinsurance play a bigrole in all of this. As insurers begin to use less finitereinsurance, that should hasten the shift from pricing peak totrough.

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Finite risk transactions are based on the premise of transfer offinancial risk but limited transfer of insurance risk. Finitereinsurance covers are sold by reinsurers and purchased byinsurers. A reinsurer's exposure to loss is traditionally capped byan aggregate limit that usually meets minimum requirements for risktransfer (defined by FASB 113).

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The coverage provides an insurer with temporary earnings and/orsurplus relief from major loss events or reserve deterioration.However, the differential between actual and contractualloss/reserve deterioration is eventually refunded through a varietyof mechanisms (that is, multi-year premiums, commutations, and/orprofit commissions).

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Finite reinsurance was used by insurers in the late 1990s tomanage the high level of losses stemming from the poor underwritingenvironment. These covers helped to mask the level of adverse lossdevelopment from 1997 to 2001 and were one of the factors thatextended the soft pricing cycle into the 2001 underwritingyear.

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However, going forward, the ability to extend the cycle withfinite re likely will not be an option. As a result, it will bemore challenging to mask the expected significant deterioration inresults in 2006 and 2007. Inability to prop up balance sheets,therefore, should translate into pressures to raise pricespotentially by 2008.

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Looking ahead to 2006, industry cash flow now is showing anearly warning signal that “real industry earnings” (which excludematerial reserve swings) are on the edge of a big deterioration.Operating cash flow is a good precursor for real industry earnings,as cash-flow trends usually show movements in industry earnings 12to 18 months in advance.

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Growth in our Cash Flow Index slowed rapidly and actually fellfor the first time in the 2004 fourth quarter. The growth rate forthe index has slowed from an average of 60 percent for 2003 down to16 percent for 2004 with an actual decline of 6 percent in the 2004fourth quarter. (Only a portion of the decline was caused by a highlevel of hurricane activity.)

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Our data project that industry cash flow will drop to between$40 billion and $45 billion in 2006, down from about $75 billion in2004. The fall is caused by a post-hard-market pattern in whichheightened competition drives down premium rates, loosensunderwriting standards and ultimately results in higher paid losslevels.

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Historically, two years after a hard market, paid losses rose byan average of 12 percent to 13 percent. This suggests that the paidloss ratio will likely rise from an estimated 65 percent in 2004 to72 percent to 73 percent in 2006, which, in turn, should lower cashflow by almost 50 percent from 2004 levels.

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Another factor that indicates there will be a severe inflectionin “real earnings” levels in 2006 is a relatively low historic cashbuildup.

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In the up part of the pricing cycle, the industry normallydevelops a cushion where cash flow exceeds reported earnings by asignificant margin. This cushion provides for a good base to growinvestment income, protect against accelerating claim costs, andultimately serve as a source of earnings when underwriting resultsin future years turn negative.

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However, this cushion between cash flow and earnings is athistoric lows for a post-hard-market period. The cushion hasaveraged 17 percent of premium in the 1975-1978 hard market and 22percent in the 1985-1987 hard market. In contrast, however, thecushion built up in the most recent up cycle of 2001-2004 averagedonly 11 percent of premium.

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So, all this means that the current cycle could hit bottom in2007.

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The expected sharp drop in operating cash flow–combined with arelatively low cushion–means that the underwriting cycle willlikely go from peak to trough in a mere two to three years' timeframe (2004 to 2006/2007). As we said before, this is in contrastto the eight-year duration from peak to trough of the last twounderwriting cycles.

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The p-c industry is on a course to return to 1997 operatinglevels. By 2006, underlying fundamentals of the business should beon par with those experienced in 1997–10 years after the lastpeak.

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Cash flow divided by paid losses is a good measure ofunderwriting health and financial flexibility. In robust periods,cash flow equals 30 to 40 percent of paid losses. We expect theratio to decline to 13 to 15 percent by 2006, in line with the 1997level.

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Additionally, investment income should represent 100 percent ofcash flow, as it was in 1997. By 2007, cash flow has the potentialto drop to 5 percent of paid losses and investment income shouldrepresent more than 200 percent of cash flow.

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Adam Klauber is an analyst at the New York-based investmentresearch firm Cochran, Caronia Securities LLC.

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“Going forward, the ability to extend the cycle with finite relikely will not be an option. Inability to prop up balance sheets,therefore, should translate into pressures to raise pricespotentially by 2008.”

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==Adam Klauber

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Callout (no mug) for page 17 jump, if needed:

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“As insurers begin to use less finite reinsurance, that shouldhasten the shift from pricing peak to trough,” says Mr.Klauber.

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