Lloyd's Seeks End To Cycle

"Collectively, we no longer have the luxury of a solid financial cushion to ignore changes [in the industry's economic dynamics] and commit financial suicide," Mr. James emphasized. "Hoping that a couple of years of hard market conditions will be our salvation is about as effective as a man lost in the desert trusting a mirage."

A new response is required, he said–one that will "challenge the very notion of the insurance cycle itself."

He said this change is possible if insurers stick to a simple, yet important principle, which should be enshrined on the hearts of every underwriting manager: "Make a sustainable underwriting profit year-on-year. If you can't do that, get out of the game. You're not needed."

Managers who continue to operate with a cycle mentality, he said, are "wrong, utterly wrong, and it is highly dangerous for [the industry's] long-term prospects. These are the managers who are not simply reacting to the insurance cycle, they are creating it."

He pointed to the fact that the U.S. property-casualty industry has collectively lost $439 billion on underwriting since 1980, thereby failing abysmally in its job of managing shareholders' capital. Further, he said, insurance "has managed to under-perform consistently in relation to every single other industry."

"Our industry's cost of capital is 12 percent–in other words, we need to achieve a 12 percent return on investment in order to retain and attract capital," he said, adding that he industry isn't close to meeting that target. "Since 1991, the U.S. industry's rate of return has fallen well short, averaging just 5.3 percent, and with a return of just over 3 percent for the first half of 2002, it isn't even in the ballpark."

As a result of this financial mismanagement, the industry's surpluses are being depleted, he warned. "The surplus for the worldwide property-casualty industry fell by $90 billion in 2001, and it's expected to do the same in 2002," he said. "That means a drop of over a quarter in the industry's global capacity."

Reserves in the U.S. market alone have fallen by $36 billion in 2002, Mr. James said, noting that this had led to rating agency actions. "This year, for the second consecutive year, the number of securely rated companies–that's B-plus and higher–decreased," he noted. "Also, for the second consecutive year, A.M. Best issued more downgrades than upgrades."

Despite these negative factors, people are still prepared to invest in the industry, he said, pointing to the over $40 billion in new capital that poured into the business immediately after Sept. 11, 2001. He said insurance must be full of good salespeople, "because people keep giving us money" despite the industry's obvious shortcomings for investors.

Mr. James suggested that it is the insurance cycle and the prospect of hardening rates and improved fortunes that leads people to continue to invest in an industry with such an "unremittingly dire" performance. Indeed, he added, many in the industry see the rising trend of premium prices "as our salvation."

"The cycle has turned, we say to ourselves. We can look forward to maybe two, three, maybe four good, profitable years of underwriting. Or can we?" he said. Mr. James emphasized that such a notion is fraught with danger for the industry. "If we continue to look at our industry in terms of hard markets followed by soft markets, we are sowing the seeds of our own downfall," he added.

He said the mindset for the industry needs to change because there are a new set of factors affecting the business that have never before been seen, or never seen in this combination. These factors are symptoms of an industry "in the financial intensive care ward," he said, pointing to:

? A volatile investment environment.

Mr. James explained that the insurance industry's exposure to stock prices has grown enormously in recent years, which becomes a very real problem when the stock market is "trapped in a downward spiral, fueled by anxiety and a series of major corporate failures. In fact, insurers have had to realize nearly $1 billion in capital losses during the first quarter of this year."

He also cited the increasing speed with which investment markets react to opportunities, and retreat from poor performers. "We've all witnessed the number of new startups post-9/11," Mr. James said. "Ten years ago, who would have believed you if you predicted that approximately 50 percent of new capital entering our industry post-9/11 would be up and running?in just over two months?"

However, capital could also "check out very, very quickly, if we continue to get it wrong," he warned.

? Escalating claims costs.

"The cost of the U.S. tort system, currently estimated at a staggering $198 billion per annum, is set to rise to $298 billion by 2005," Mr. James said. Further, he noted, medical malpractice awards nearly tripled to $3.5 billion between 1994 and 2000, while for product liability, the growth was even greater, from under $2 million to almost $7 million over the same period.

? The rising cost of catastrophes.

? Dramatic changes to the distribution system.

Information technology "has stripped away the mystique of the value chain," he said. "If you're not adding value now, you're no longer a player."

? Increased customer sophistication.

Customers are now "highly sophisticated people who have grown up in the most consumer-driven society our planet has ever seen," Mr. James said. Customers are using the latest risk modeling techniques "to analyze the price of risk," he noted.

All of these factors should prompt insurers to refocus their management approach away from doing business-as usual, he suggested.