Insurers Beat Bankers As Risk Managers

Lobbyists for property-casualty carriers must convince Washington lawmakers that insurers are far better at risk management than their banking counterparts to avoid onerous federal regulation, the p-c industry's top spokesman warned.

As Congress contemplates expanded oversight of financial services–including insurance, “insurers can definitely make the case that they're much more stable [than banks] in terms of insolvencies,” said Robert P. Hartwig, president of the Insurance Information Institute, during a speech at the 20th annual Executive Conference for the Property-Casualty Industry, run by The National Underwriter Company, sponsored by Ernst & Young and Dewey & LeBoeuf.

Mr. Hartwig pointed out that few insurers become insolvent, even after major catastrophes, while at least 19 banks have failed in 2008 alone–including the largest in history, Washington Mutual–all undermined by reckless subprime mortgages and unwise securitizations of such loans. “The toxic chickens have come home to roost,” he said.

Although American International Group has become a poster child of sorts for the recent financial meltdown–after the federal government had to bail out the company with commitments of taxpayer funds that now total $150 billion–the underlying problem was not with the company's insurance properties, he pointed out.

“With AIG, it's true that the 'too-big-to-fail' doctrine was applied to an insurance organization for the first time, but insurance was only incidental to the organization's fundamental problem,” which was the trading of risky mortgage-backed credit default swaps by an AIG Financial Products subsidiary, he explained.

However, the fact that AIG figures so prominently in the country's economic problems and subsequent Treasury bailout plan means the insurance industry could face onerous federal oversight as part of the “aftershocks” from the financial crisis, said Mr. Hartwig, who warned that “the regulatory response could be harsh.”

To be spared a federal “overreaction,” he said, “property-casualty insurers will have to make the case that they are different than the rest of these troubled financial entities.” He said this should not be a difficult point to prove, given the industry's superior record of risk management.

“The financial crisis is the result of a failure of risk management [in the banking and securities markets] on a colossal scale,” he said. “We may literally have to tear up the manual of enterprise risk management and start over. How did so many major financial players miss or overlook such huge, systemic exposures?”

The key is to educate a Congress still relatively unfamiliar with the workings of the state-regulated p-c insurance industry that “insurers are better risk managers than banks,” according to Mr. Hartwig, who made the following arguments to back up that assertion:

o “Insurers are more disciplined than banks in underwriting,” he said, especially in managing their overall exposures.

o Insurers have low leverage–especially compared to banks. “Insurers do not rely on borrowed money to underwrite insurance,” he said.

o “Insurers have relatively conservative investment portfolios that are far less volatile and more liquid,” he noted.

o “Insurers maintain a strong relationship between underwriting and risk-bearing,” he said. “Insurers always maintain a stake in the business they underwrite–unlike banks and investment bankers, which package and securitize their risks.” Mr. Hartwig added that by “not having skin in the game” when it came to lending exposures, banks had “created the mother of all moral hazards.”

He also pointed out that while a host of banks and other financial institutions are eagerly seeking cash infusions from Washington under the $700 billion Troubled Asset Relief Program, few p-c insurers will request such help–not even the commercial insurance subsidiaries of AIG.

Indeed, he added, “most p-c insurers say they don't need TARP funds, and argue that it's unfair to use federal dollars as a cheap source of capital.”

These points will be crucial in the debate over federal insurance regulation next year, according to Mr. Hartwig, who said odds are good that Washington will become directly involved in overseeing the industry in some way–although the question is how and when.

“We are likely in the final stages of a state-based regulatory system for insurance,” according to Mr. Hartwig. “Does this mean we'll see the 'O' removed from optional federal charters? Perhaps. But it's unlikely the feds will grab all regulatory authority from the states. In fact, we might end up with some sort of dual regulation, or at least federal preemption [of state authority] in certain areas.”

He cited “a lot of unresolved issues” for the industry and Congress to work through if federal oversight of insurance does become a reality, including:

o Differences, if any, between the regulation of life insurers versus their p-c counterparts.

o The fate of state guaranty funds, with the Federal Deposit Insurance Corp. reportedly exploring the idea of establishing a national insurer insolvency backstop.

o Whether regulatory authority might be split on a functional basis, with Washington handling solvency, while the states continue to oversee forms and pricing–a possibility Mr. Hartwig characterized as “an extraordinary conflict.”

o How to reconcile differences in state workers' compensation laws, including the fate of state funds.

POLITICAL OUTLOOK

Mr. Hartwig also warned that with Democrats in control of both the White House and Congress, p-c insurers could face increasing frequency and severity of casualty claims, given the possibility of “advocacy group representatives running federal agencies,” such as the Environmental Protection Agency.

“Expect the erosion of tort reforms going forward,” he said.

However, insurers should take heart, he added, as studies show that the industry is “just as profitable during Democratic administrations as they are under the Republicans”–noting that the industry's highest profitability was achieved under President Jimmy Carter, with a return on equity of 16.4 percent.

Indeed, between 1950 and 2008, the industry's average ROE has been 8.05 percent under Democrats and 8.02 percent under Republicans, according to Mr. Hartwig–although there was a wide disparity not only among administrations, but between the first and second terms of the same presidency.

In Ronald Reagan's first term, for example, the industry's ROE was 7.7 percent–but it jumped to 15.1 percent in his second term.

Under President George W. Bush, the ROE was just 4.83 percent in his first term, rising to 10.1 percent in his second. (His father's administration produced an ROE for the industry of 8.4 percent.)

“A lot of factors figuring into insurer profitability are beyond the realm of politics,” he said, citing the incidence of catastrophes as just one example.

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