S&P Upgrades Outlook For Commercial Sector

After several years of significant rating downgrades, theres been a marked decline in the number of downgrades so far this year, according to S&P. We are expecting a continuation of that trend, said Robert Partridge, managing director, during S&Ps annual insurance seminar in New York last week, explaining the outlook change.

Revising the outlook from negative to stable means we believe that the ratings for the industry over the next 12-month period will be relatively stablethat the number of upgrades versus the number of downgrades will be relatively in balance, he said. We should not see the wholesale downgrade of the commercial side that we have seen in recent years, he added.

The rating downgrades that have occurred in the last few years have been caused primarily by three factors: the competitive position of the company, profitability and capitalization, Mr. Partridge said. Noting that the latter two are very quantitative in nature, he said the most qualitative factorcompetitive positioninghas actually been the driver of many of the rating downgrades.

Observing that the commercial sector outlook change comes at a time when many industry analysts are saying that the industry has reached its peak and is now going on the downslide, Mr. Partridge went on to explain the key reasons that prompted S&P to take a seemingly contrary view.

For one, he said, there is strong embedded profitability due to the large number of rate increases imposed. The industry also has strong levels of capital, and S&P believes there will be a slowdown in large reserve hits this year, he added.

With respect to loss reserves, Mr. Partridge said a major expectation supporting the stable outlook is that, during the hard market, insurers built up a significant bank of conservative reserve levels in the most recent accident years that can buffer any additional needed boosts for older years.

During his presentation, he displayed a slide showing changes in reserves in recent years. Bars on the slide indicated reserve additions made in the last three calendar periods for accident years 1998-2001, demonstrating that the reserve additions were greatest during the 2002 calendar period. While companies still boosted reserves for these accident years during the 2003 calendar period (by $10.6 billion), collectively they took down reserves for the 2002 accident year by $4.9 billion.

Are companies releasing money out of the bank? he asked, referring to the $4.9 billion takedown. However, evidence he presented to respond to the question suggested that the bank has not been disturbed. In particular, he showed that the reserve release was largely related to personal auto insurance (about $2.6 billion of it), with another chunk (just over $200 million) relating to a transfer of reserves of a U.S. subsidiary of Hannover Re to its German parent company.

In terms of the overall outlook, he said, what we have is a point of inflection, conceding that there are a host of negative factors impacting the industry, as well. What happens from here really depends on whether the industry maintains pricing discipline going forward," he concluded.

In addition to the pressure to ease up on pricing discipline, a report summarizing the outlook change published a few days before the conference listed other potential negative impacts on future earnings and financial strength. The report, titled "U.S. Commercial-Lines Insurance Midyear Outlook 2004: Market Finds a Wary Equilibrium," listed construction defect claims, terrorism and silica litigation, among other factors.

"The thing to watch out for is legal expenses," Mr. Partridge said, referring to silica. Drawing a comparison to asbestos, he said, "for the first decade, about 90 percent of all payments were defense costs. That's where the issue with silica may arise."

The actual timeframe over which S&P had maintained a "negative" outlook on the commercial lines sector before last weeks change is not clear. In the late 1990s, S&P placed a negative outlook on the property-casualty industry as a whole, moving to individual outlooks for the commercial lines, personal lines and reinsurance sectors within the past three years.

In separate announcements, S&P said that the outlook for personal lines remains stable, while the outlook for reinsurance remains negative. S&P noted that U.S. reinsurers would continue their downward ratings slide were it not for the reticent support of overseas parent companies," explaining why the sector outlook is still negative.

Reproduced from National Underwriter Edition, June 18, 2004. Copyright 2004 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.