Over $2B In Reserve Hikes Spark Concerns

"Still, this is the first time a major company has added to environmental reserves in at least five years," William Wilt, a Morgan Stanley analyst, told National Underwriter last week. (In addition to the $1.625 billion charge, St. Paul Travelers said second-quarter earnings will recognize a $60 million net benefit from prior-year developments on Travelers? business, including a $190 million takedown of 9/11 reserves, favorable development of personal and commercial lines, and a $205 million charge for environmental reserves.)

"But I can't help but wonder if it was a placeholder to get them through this year-end," he said, noting that absent any environmental strengthening, the survival ratio (ratio of reserves-to-average annual payments) would have fallen to just a little over 1.0?a level that would sooner or later catch the attention of rating agencies.

Mr. Wilt, whose firm has produced several in-depth studies on environmental liability this year (see page 9), believes rating agency attention to low survival ratios, a likely reversal of inactivity at the federal environmental regulatory level and a new wave of natural resource damage claims will soon reignite environmental reserves as an industry issue. "If they're not going to be the sleeper story of 2004, I absolutely think they will be in 2005," he said.

While environmental got an honorable mention in St. Paul Travelers' announcement, asbestos was totally missing in the charge breakdown. The company said an annual asbestos study will be completed by year-end. And Jay Fishman, chief executive officer, assured: "We're not anticipating anything of an outsized nature" in the way of an asbestos charge.

"How do you define outsized?" an analyst asked during an investor conference call.

"I don't know how to define it, but I know it when I see it," Mr. Fishman said.

Like the St. Paul Travelers charge, and unlike reserve actions by insurers and reinsurers in recent years, Converium's reserve boost of nearly $400 million had nothing to do with asbestos. But the Converium news did share at least one common element with St. Paul Travelers?a provision for construction defect exposures.

For St. Paul Travelers, both construction and surety were center stage, with the two lines accounting for more than $1 billion of the total charge. At Converium, construction defect was simply part of a larger problem of liability losses in excess and surplus lines and other specialty areas for policies written between 1997 and 2001.

The analysts said they didn't have a good read on whether the construction developments at both companies, and surety at St. Paul Travelers, signaled more to come at other companies. Mr. Karaoglan took note of discussions by St. Paul Travelers' CFO Jay Benet describing the adjustments in these lines simply as a move toward a much more conservative posture at Travelers than had existed at St. Paul.

Compounding Converium's problem in recognizing the extent of its liability in the construction area sooner was the structure of underlying insurance policies and reinsurance contracts, CEO Dirk Lohmann said during a conference call last week.

He explained that some underlying policies attached over aggregate deductibles, and that mass tort construction defect losses came into the excess liability policies after deductibles eroded. With the same sort of structure in reinsurance contracts, Converium would start paying only after a certain amount of incurred losses impacted the contracts.

Overall, the $384.7 million reserve boost and balance sheet impairments at the North American operation meant an overall net loss of $660 million for Converium's second-quarter bottom line. Coming on the heels of a $43.0 million reserve hike in the first quarter, and reserve additions of $148.5 million in 2002 and $123.6 million in 2001, the latest addition brought adverse development in recent years on U.S. casualty reinsurance to a $668.5 million grand total, Converium said.

All the major rating agencies announced downgrades or warnings on the news, with A.M. Best and Standard & Poor's taking the ratings down to "A-minus" from "A." Converium said it is exploring options to maintain strong capitalization, including capital raising activities targeting an increase of $250 million to $400 million. The reinsurer will also reduce writings in capital-intensive areas such as reinsurance for national account writers of lead umbrella and E&S lines.

"Better underwriting, coupled with better pricing, are the first two steps toward insuring that the risk of negative surprises is reduced," Mr. Lohmann said. Detailing more reasons that charges won't happen again, he listed a move to a diversified risk portfolio with more shorter-tailed business, a complete overhaul of the underwriting staff since 2001, new price-monitoring tools and underwriting sign-off procedures.

Mr. Fishman was also on the hot seat to guarantee no more bad news at his company. "We can basically hold your feet to the fire and say this is it," an analyst prodded during a conference call, prompting a quick "yes" from Mr. Fishman.

"Only with [a] caveat on the asbestos," Mr. Fishman added after a brief pause, referring to a re-evaluation of asbestos survival ratios for smaller claims that is part of the annual asbestos study.

Later, he insisted: "There are no other reserve adjustments. There are no other shoes to drop. This is as broad a look as we know how to put to it." His remarks followed an analyst's question about the recent departure of St. Paul's head of claims and a suggestion that this signaled the existence of more reserve issues.

Analysts' concerns were likely prompted by a string of charges at The St. Paul in recent years, perhaps most notably a $1.0 billion pre-tax charge to settle a single asbestos claim in second-quarter 2002 and $900 million in pre-tax charges in fourth-quarter 2001 when The St. Paul exited its medical malpractice business.

According to Mr. Karaoglan, since the merger was announced, The St. Paul alone has taken $2.3 billion in pre-tax charges. Adjusting the purchase price for the charges, Travelers paid 2.1 times book value instead of the advertised 1.5, he noted, adding that "with the benefit of hindsight, the original St. Paul shareholders made out exceedingly well." Original Travelers shareholders didn't do as well, but with potential cost savings figured in, the deal is still slightly economically accretive to earnings, he said.

"We always knew that due diligence wasn't extensive, but thought there was a trust relationship between the management teams given that [Mr. Fishman] had worked at Travelers. So the likelihood of having such a big charge, in my mind, was little. But then it happened," said Mr. Karaoglan.

As to the question of whether The St. Paul could have weathered the reserve storm on its own, Mr. Karaoglan pointed out that the charge might not have been as big absent a merger. While a $250 million surety charge related to the financial difficulty of a contractor was likely, a $155 million charge related to a reinsurance commutation was discretionary. And on its own, The St. Paul might not have recognized another $375 million on the surety business and might have postponed the $500 million on construction defect, he said.

Indeed, Mr. Benet described these as "conforming adjustments," explaining that $1.17 billion of the total amount was taken so that the accounting and actuarial methods of The St. Paul conform to the methods of acquirer Travelers. During the conference call, Mr. Fishman and Mr. Benet alternately described the Travelers methods for surety and construction as "conservative" and "decidedly pessimistic."

"Had St. Paul been acquiring Travelers, would they have had reserve releases on the Travelers book?" Mr. Karaoglan commented to NU.

Morgan Stanley's Mr. Wilt said: "It's interesting to observe that you had legacy Travelers go from a position of very robust financial flexibility to suddenly being in a position where I don't think they have much of a cushion from a ratings perspective." He noted that Travelers is now "solidly out of the double-A category."

"You never know what can happen," he said, noting that a catastrophe or an asbestos charge bigger than rating agencies expect could force St. Paul Travelers to raise capital from a position of weakness.

Mr. Fishman said that the ability to absorb the current charge without raising capital speaks to the financial strength of the merged companies.

"The merger is really going very, very well," he reported. "I'm not sure it could actually be any better," he said, referring to the field office environment. He also said expense savings will likely exceed a previous estimate of $350 million, and that "headcount will be down 10 percent on a combined basis" once the integration is complete.

The company has yet to finalize second-quarter results as it awaits guidance requested from the Securities and Exchange Commission on the correct accounting treatment for the reserve charge. If the charge is treated as an adjustment to the opening balance sheet of the merged companies, with no hit to second-quarter income, income will fall in the range of $775 million-to-$800 million. If the adjustment flows through the income statement, a second-quarter net loss will be reported in the $275 million-to-$300 million range.

Reproduced from National Underwriter Edition, July 29, 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.