Volatile Capital Markets Keep Prices Hard

He added that the environment has changed significantly over the past year, influenced by several factors including record-high insured losses in 2001, a new and unprecedented level of terrorism threat, a stock market collapse, recession, and credit concerns as well as continued low interest rates.

Furthermore, the economic downturn is probably lasting longer than many expected, impacting the level of credit defaults and balance sheets.

"Several of these factors have led to the depletion of capital base of the industry. It's a worldwide phenomenon," he observed.

After noting that the consensus estimate of industrywide Sept. 11 losses published by the N.Y.-based Insurance Information Institute is around $40 billion, Mr. Holzheu said that the problem of credit default also poses a significant threat to insurers. Just the default of now-bankrupt Enron Corp. alone created losses for the p-c market in the neighborhood of $3 billion, he said.

But the most important capital absorber has been the stock market, Mr. Holzheu argued.

"We see that it had already started in 2000," he said, noting that U.S. companies had $20 billion of capital losses that year. "The figure just kept growing"to $24 billion in 2001, and for year-to-date in 2002, it's around $35 billion, he said.

And although U.S. companies faced heavy losses from the volatile stock market, European p-c insurers have actually suffered more, he said, adding that "this impact on the capital base is not across the board but [is] concentrated particularly on commercial lines and reinsurance companies."

To illustrate some of the challenges the U.S. insurance industry must tackle, Mr. Holzheu also discussed how far its commercial lines and reinsurance surplus have been stretched in the past year.

"Starting with the year-end surplus of about $157 billion in the year 2001 for commercial lines companies and reinsurers, they have lost, year-to-date, $17 billion in capital losses. They may still recover. But right now, the surplus has shrunk to about $140 billion," he said.

There are also a couple of other potential problems, one of which is the reserve shortfall, which Mr. Holzheu estimated to be around $25 billion for the core reserve, excluding asbestos and environmental losses. "Then we have this big chunk of $55 billion which is an estimate for asbestos and environmental," he added.

Mr. Holzheu noted that the reserve shortfall will not be realized right away. "There is no solvency threat. But potentially, over the years, there will be some earnings impairment further down the road," he said.

The other major factor currently driving the industry's behavior is the declining investment income.

Mr. Holzheu explained that as long as insurers invest long term and interest rates continue to come down, companies can make higher yields compared to the market rate. Thats because insurers can realize capital gains.

But now they are at a phase where interest rates have very likely bottomed out and will soon go up.

"Then we will have the opposite effect. Yields will lag behind and interest rates will only come up and recover very slowly," Mr. Holzheu said.

What that means for insurers is that there is now clear pressure to have profitable underwriting businesses because there won't be strong support from the investment side for the next couple of years.

"Without realized capital gains, the current average return on bonds is 5.2 percent. If you ask for just an average return on equity of 10 percent–and that's what the U.S. p-c industry was returning over the last 30 years–then, on a lowered investment yield of 5.2 percent, you need a combined ratio of about 100," he said.

Andreas Beerli, chief executive of Swiss Re Americas Division, said that combined ratio figure "can be reached [by] better identifying perils, restricting covers, and assessing the correlation among lines of businesses, assets and liabilities."

Additionally, Mr. Beerli advised that insurers must manage terrorism exposure carefully through fundamentally sound underwriting following the passage of the new terrorism insurance law.

He also suggested that an industry-wide reorganization and reorientation of internal control and steering processes would be helpful in combating corporate governance failures that can affect the industry's credit exposure.

Looking forward to 2003, Mr. Holzheu offered an optimistic forecast.

"After two years of turbulence, things are lining up for a positive outlook for the underwriting core business of the insurance industry," he said.

"We expect a strong recovery in underwriting results. But on the other hand, we see only a moderate recovery in investment results. So when these are added up, there will be a steady improvement of net income."

Since last year, acceleration of the hardening of the market has marked the industry's reaction to the declining investment yields, Mr. Holzheu said.

"We have seen the hardening now reaching all regions and all lines of business."

The hardening of the market, he noted, is expected to last longer than previous cycles, due to the global shortage of quality capital, along with increased risk exposures.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 16, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.