In spite of competitive conditions in the specialty programbusiness segment, an insurance industry analyst doesn't see anyflashing red alerts signaling major troubles ahead for programcarriers so far in 2011.

David Paul, a principal for ALIRT Insurance Research, LLC inWindsor, Conn., gave NU a glimpse last week of theproprietary scoring method that his firm uses to analyze thefinancial strength of roughly 1,600 property and casualty insurancecompanies.

For the most part, the scoresreveal that program carriers are as healthy as carriers playing inother industry segments, with only a handful of insurers lookingweaker than they did a decade ago.

Paul also provided his assessment of the proximity of the nextmarket turn from soft to hard, which he based partly on recenttrends in the composite level of ALIRT scores for the commerciallines segment of the P&C industry.

“It is definitely coming, but maybe not as fast as some peoplewould think if they did not have this type of look,” he said,referring to a line graph of the composite ALIRT scores over thepast 15 years.

ALIRT scores—derived every quarter from the analysis ofoperating and investment ratios as well as other financial strengthmeasures—range from 0-100, with higher scores assigned to strongerinsurers. The 10-year median industry score is right in themiddle—at 50.

Although carrier scores have been trending downward since 2007,the composite has been above 50 since the middle of 2005, accordingto the graph. In contrast, back in 2001, the composite was closerto 35 as the market turned from soft to hard.

PAIN GAUGES

Paul intends to include this graph, titled “Pain Gauges,” in apresentation he will deliver to members of the Target MarketsProgram Administrators Association at their midyear meeting inBoston next month. (For more meeting information on the meeting,see related article.)

Giving NU a preview, Paul begins his analysis with ahistorical review of industry surplus levels, which trendeddownward from 1999 to 2002, to a low point of just under $300billion. Surplus levels have been rising since 2006, but Paul notesthat “just because there's a lot of surplus doesn't necessarilymean that people are going to continue writing business.”

Capital (or policyholders surplus in the worldof insurance statutory accounting) is not the same as capacity, hesays. Capacity reflects this financial capability to write, butalso the willingness to do so. “We could end up with a lot ofsurplus, but with underwriters and managers just saying enough isenough”—and that could cause the market to harden, he suggests.

“That's what we hope for. But history has shown there has to besome type of pain” for this to happen. Alluding to the competitivenature of the market, Paul says, “You really have to hit them overthe head.”

That's where this concept of “pain gauges” comes in, Paulcontinues, noting that his firm is uniquely positioned to measurethe relative financial strength of companies over time through itsquarterly analysis of pain points—surplus losses, rising combinedratios, reserve hiccups and investment risks. All these factors arecaptured in the derivation of ALIRT's numerical scores.

Turning to the graphical representation of historical compositescores for the top 100 commercial lines writers, he notes thatALIRT started seeing a downward trend in the stability of companiesin late 2000 as the market started to turn. The composite scoresfell from 50 in 1998 to around 45 in 2000 and plummeted to about 37in 2001.

Turning his attention to current scores, Paul says that “as apain gauge, we'd really need to see the composite start to fallbelow the long-term average.” At year-end 2010, however, it stoodat 54.

He points out that the line graph of the scores “almost made astraight shot up [from 2002] to 2007,” when the score reached itshigh of more than 65. “That was all the hard-market pricing andredundant reserves starting to develop over time,” whichcontributed to very strong earnings and a buildup of capital.

In 2008, the financial crisis pushed the score down to 55, andit has been trending slightly downward over the past two years,Paul observes. “But nothing right now is indicating that we're atthe point where pricing would necessarily turn,” he concludes,noting that the level is 10 points above the prior tipping point ofthe year 2000.

EARLY WARNINGS

At TMPAA, Paul will review composite scores for meetingattendees eager to hear about industrywide turn signals. But on adaily basis, it is the individual insurance company scores thatclients hire his firm to provide.

A broker might provide a list of hundreds of carriers it workswith, hiring ALIRT to screen those carriers every quarter for earlywarnings of trouble, Paul tells NU. “Traditionally in ourwork, if a score gets into the low 30s or below, some remedialaction is taken,” he says.

“Back 10 years ago, our clients were able tosay, I'm going to get out of Reliance now because scores were inthe teens before A.M. Best would have them at an A-minus,” hereports.

Paul explains that rating agencies can be slow to respondbecause they recognize that their downgrade actions can putcompanies into a death spiral. He also notes that ALIRT's scores,unlike letter ratings assigned by credit rating agencies, are forindividual insurance companies within insurance groups.

Right now, ALIRT scores are showing few signs of trouble in theprogram carrier space. Focusing in on TMPAA members, Paul revealsthat:

• Twenty-six of 38 admitted TMPAA insurers—or roughly 68percent—had scores between 40 and 60 at year-end 2010.

• That's on par with the historical distribution of scoresacross the industry, he says, noting 70 percent of company scorestypically fall in that range year after year.

• TMPAA carriers writing on an excess-and-surplus lines basisfared slightly better, with only one of 27 coming in under 40 andfour above 60.

TMPAA CARRIER SCORES LESS VOLATILE

Paul does not at this point identify the six admitted and oneE&S carrier with scores below 40, reserving that informationfor his clients. But over time, he notes that TMPAA compositecarrier scores have moved up and down in tandem with industrycomposite scores.

Referring to another line graph of historical composites—thisone with TMPAA composite superimposed on top of the commerciallines composite—he reveals that the TMPAA scores move in a tighterband—with lower high scores and higher low scores over time.

While he speculates that one reason for the flatter TMPAA-scoreline graph is the absence of carriers like Legion (a programcarrier that became insolvent during the last turn) from thedatabase, he believes another reason relates to the nature ofspecialty business.

“Specialty business is so price-dependent andso underwriting-specific,” that the scores really reflect “theability of the underwriter” to price well and to select riskscarefully.

Noting that the graphs also reveal slightly higher scores forTMPAA E&S companies than the TMPAA admitted carriers, he saysthe relationship makes sense. “They should be stronger, and thisshows that they generally are because they don't have the cover ofa guaranty fund,” he says. “If you're an E&S writer, you hadbetter have better financials.”

Eyeing those seven scores on the low end of the spectrum,NU asks how many less experienced startup carriers fall inthis range. Paul reports that while 14 of the 64 TMPAA carriers(eight admitted and six E&S insurers) included in his analysishave operating histories of five years or less, only two (bothadmitted) were outsized to the low side with scores of 31 and36.

THEN AND NOW

Tying just a few national carrier names to their scores—both atSeptember 30, 2010 and year-end 2000—Paul provides more support forhis conclusion that a market turn is coming, but not as quickly as some carrier executives are now saying.

• Seven of eight national commercial carriers all had higherscores in 2010 than in 2000, and five are above 60, including ACEAmerican Insurance Company, Federal Insurance Company and TravelersIndemnity.

• The only one of the eight national commercial carriers with alower score in 2010 than 2000 was National Union Fire, a member ofthe Chartis/AIG group—43 in 2010 vs. 64 in 2000.

• In an analysis of nine specialty carriers, Chartis' Lexingtonalso had a lower score in 2010 than in 2000—58 vs. 65.

• Seven of nine specialty carrier scores came in higher than in2000, with five over 60 in 2010 and only two scores below 40(Markel and Argo).

The scores reveal little evidence of market-turning pain, Paulsuggests, also comparing the carrier combined ratios for 2000 and2010—an important financial metric behind the scores. He notes, forexample, that ACE American's nine-month 2010 combined ratio was 87vs. 119 in 2000. On the specialty side, Houston Casualty reportedan 84 combined ratio in 2010 vs. 109 in 2000.

And for the commercial composite overall, thenine-month 2010 combined ratio was 99 vs. 109 in 2010.

“Does a market turn on break even? It's hard to imagine,” Paulconcludes.

CANARY IN A COAL MINE?

“We're constantly going over these companies quarter afterquarter, and we are now seeing the deterioration in the individualresults quite clearly,” Paul says, suggesting that the year-end2010 and first-quarter 2011 scores and combined will show a bleakerpicture.

In a March research report, he reveals that the year-end ALIRTP&C industry combined ratio was 102.6 for the full yearcompared to 100.2 in 2009. In addition, industry surplus levelsrose more slowly last year—increasing only 2.5 percent in 2010compared to a 8-20 percent jumps in the last seven years (with theexception of the drop in 2008 tied to the global financial crisis),the report reveals.

“At some point, especially if financial deterioration continues,some catalyst could move carriers to dial back their appetite toplace business. This would lead to harder pricing and a marketturn,” he writes.

What might be the catalyst that lowers the willingness to writebusiness?

In addition to large global catastrophes or a markeddeterioration in economic conditions, he suggests “continueddramatic increases in prior-year reserves” might fit the bill.

While Chartis was the only insurance group to announce a majorboost in reserves last year—$5.2 billion—Paul notes that 28 percentof the total related to recent accident years (2007-2009).

“It could be argued that Chartis is a proverbial 'canary in thecoal mine,'” taking necessary steps to strengthen near-termaccident years before most of its peers,” he writes.

“If they're taking big charges on some of this stuff, you've gotto believe some of the other folks, potentially, will have them,too,” Paul tells NU. If that's the case, then subsequentreserve hikes by additional carriers could mark the beginning of apain cycle that drives pricing higher, he says.

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Understanding The ALIRT Scores

• ALIRT produces a two-page analysis for roughly 1,600 P&Ccompanies every quarter.

• The top page is a scorecard that can range from 0-100, withthe higher score being the stronger relative strength of thecompany.

• The bottom page provides raw financial ratios used by theanalysts to develop the scores.

• The 10-year median score for P&C companies is 50, and 70percent of the carrier scores fall in the 40-60 range.

• Traditionally, scores below 30 indicate that a carrier isheaded for some type of near-term remedial action.

• Unlike letter ratings assigned by credit rating agencies,ALIRT scores are recalculated each quarter based on statutoryfinancial information

• ALIRT scores are calculated for individual insurance companieswith insurance groups—the names behind the policy paper—rather thanparent companies.

• The ALIRT analysis looks at four tiers of risk, with the firsttwo tiers—operational risk and investment risk—accounting to 75percent of the score.

• The remaining tiers look at the financial flexibility at theholding company level as well as the impact of credit ratings(assigned by Moody's, S&P, Fitch and A.M. Best)

• The biggest components of the operation risk score areunderwriting profitability, capitalization and reserves.

Related articles:

• Will Next Market Turn Be Traumatic For ProgramAdministrators?

• MGAs Uncork Multiple New Program Niches

• Events: Program Administrators To Gather At TMPAA Midyear