S&P Shifts Outlook For Personal Lines To Negative, But Sees Re Sector As Stable

Weak operating performance stemming from deteriorating underwriting results and poor investment performance partially explain the individual changes, he added.

On the underwriting front, he said that while the entire p-c industry combined ratio is 105.6, according to a report on industrywide results released by the Insurance Services Office and the Property Casualty Insurers Association of America, the combined ratio for personal lines insurers is likely one or two points worse.

While Mr. Iten listed a string of concerns that prompted the August outlook change for commercial lines, he noted some "good news" on the commercial lines side. Public surveys have shown "a slight moderation in price declines in the third quarter, and there is anecdotal evidence that this has continued in the fourth quarter," he said.

However, "it's still too early to call a turn in the commercial underwriting cycle," he warned, explaining why S&P is maintaining its negative commercial outlook. Prior to the August revision, the outlook for this sector had been stable since June 2005.

Since November, S&P has downgraded seven commercial lines insurers while upgrading four, with three of the downgrades coming in December. "So the ratings trend clearly has been negative," Mr. Iten observed.

The distribution of ratings outlooks–"the best indicator of future ratings actions"–has moved from 7 percent negative in 2007 to 30 percent negative in 2008.

While the sector outlook reflects ongoing concerns about pricing, as well as third-quarter catastrophe losses, lower investment income and a very substantial increase in unrealized capital losses, Mr. Iten said S&P's primary concern has been the rapid deterioration in underwriting profitability.

"The pricing cycle has been unfavorable since 2004, and by August we believed that prices had fallen to the point that we really believed that the sector's underwriting results–which had been favorable for three years–would turn into underwriting losses starting in 2009," he said.

In light of the recent ISO/PCI report, that timetable was accelerated by 2008′s hurricane losses, he said, predicting the industry will report a combined ratio of 103 to 104 for the year.

Underwriting results for some companies could be reduced "to the point that operating performance no longer supports current ratings," Mr. Iten added.

Other factors that could push down ratings for some commercial insurers include:

o Realized and unrealized losses on equities and fixed-income investments, which have reduced capital–in some cases below levels contemplated in current ratings.

o Capital market constraints, making it difficult to raise capital through debt and equity issuance.

On the other hand, positive factors include the capital adequacy for most commercial insurers (which was strong leading into 2008), as well as the strength of their reserve positions (which was adequate or somewhat redundant).

Echoing some of the negative comments he made about commercial lines during his discussion of the personal lines sector, Mr. Iten said weak operating performance and reduced financial flexibility prompted S&P's outlook change for auto and homeowners insurers.

Capital positions of personal lines insurers have been drained away by catastrophe losses (mainly funded by primary insurers rather than reinsurers) and by declines in asset value.

While S&P is seeing signs of a turnaround to higher pricing in personal auto, the economic downturn is having an adverse impact. "Fewer car sales [and] fewer houses being sold mean fewer policies being sold," he said.

The only p-c segment for which S&P maintains a stable outlook is the global reinsurance sector, said Laline Carvalho, who is also a director.

She explained that reinsurers have maintained better pricing discipline, while having better enterprise risk management and limited asset exposure to the subprime crisis due to conservative investment postures.

S&P does not believe the magnitude of price declines in the global reinsurance sector has been as great as primary insurer rate drops, Ms. Carvalho said. "Unlike prior soft markets, this soft market did not start with the reinsurance sector," she noted, adding that the most heated competition was in the primary market.

"We actually do expect the pricing to improve next year for reinsurance risks," she said, describing this expectation as "the cornerstone" of S&P's stable outlook.

If prices and terms and conditions don't improve, however, "we would have to reconsider the outlook [and] potentially change it to negative," she added.

Ms. Carvalho said another positive factor for reinsurers going forward follows from the difficulties of primary carriers. With increased catastrophe and investment losses to contend with, "there will be an increased demand for reinsurance capacity," she predicted. This reverses the situation of the past two years, in which cedents with strong balance sheets were able to retain more business, she noted.

Also separating insurers from reinsurers is the fact that, in S&P's view, global reinsurers have stronger enterprise risk management processes in place. The stronger ERM most likely results from the fact that reinsurers deal with a lot of volatility from catastrophe losses, she said.

"That partially explains why reinsurers are going to be the first ones to push for…improvements in prices and terms…next year," she said, noting that reinsurers are guided by their close adherence to risk and capital models.

While capital is now lower for insurers and reinsurers than at year-end 2007, capital positions of reinsurers are in line with current ratings, she said.

Ms. Carvalho also pointed out that reinsurer exposure to the subprime crisis is limited, reflecting conservative investment strategies on the asset side. She said S&P's expectation is that directors and officers liability losses on the liability side will be contained, for the most part, within the retentions of primary insurance companies.

Negative factors that rating analysts observe for the reinsurers they analyze include:

o Hits to operating performance from Hurricane Ike losses.

o Unrealized and realized losses from investments.

Both have contributed to "a substantial reduction in the excess capital position of the industry," but improved operating earnings next year–assuming moderate cat losses and improved pricing–will help reinsurers rebuild capital, she said.

Ms. Carvalho noted that this is good news, especially given that reinsurers won't be able to tap hedge funds and other past capital providers next year.