Specialists Rule In Cycle Management

The rating analyst and casualty actuaries in the audience stressed, however, that it's an oversimplification to say diversification isn't valuable. Ms. Marshall distinguished "more successful strategies [of] diversifying intentionally and with a comprehensive plan for getting into a new state or a new line," from ad-hoc, soft market strategies to grab bigger pieces of the premium pie.

For example, companies that have traditionally focused on a certain niche and then tried to diversify often end up running into difficulties, one actuary said, stressing that expertise in a diversifying line is critical. Ms. Marshall agreed that the rating agency had seen this particular phenomenon play out in the late 1990s.

"A classic example is a standard company moving into surplus lines" during a soft part of a cycle, another actuary suggested, and Ms. Marshall took note of a number of startup companies that have tried to position themselves to take advantage of the hard market by setting up surplus lines subsidiaries over the past few years.

"It's going to be interesting to see what happens" to those companies, she said.

Referring to the late 1990s expansions, another panelist–Jay Votta, a principal and actuarial practice leader for Ernst & Young in New York–noted that many companies "bought underwriting teams that supposedly had…expertise. But I'm not sure that's what happened," he said, referring to their subsequent poor performance.

Explaining what probably happened, two actuaries in the audience agreed that the acquired teams, in spite of their expertise, simply followed the market down, failing to exercise underwriting discipline. "You don't bring in a new team and say wait two years, one actuary said.

Another audience participant questioned whether longer-term rating agency stress tests might reveal that more diversity does produce better results, noting that the A.M. Best study Ms. Marshall described looked at only 10 years of information.

"For companies diversifying geographically or diversifying from catastrophe-exposed property into other lines, you would hope that over the long term that would be true," Ms. Marshall said. "If you're a Florida homeowners writer, [expanding] into Montana might help, but only if you understand the Montana market, you have an agency force there, and you don't have to overpay for that book."

She also confirmed that finding out whether the 10-year period is representative of longer-term trends will be one of the topics Best will investigate in subsequent studies now being planned.

Introducing the basic methodology of the A.M. Best research, Ms. Marshall distinguished this particular study from others published by the rating agency, noting that this one was not called a "statistical study" because it was not done with the kind of statistical rigor that would allow for that description.

Instead, she said, it was an attempt to help Best analysts identify the behaviors that are fairly consistent among companies that "do a good job managing through cycles."

The intent was to inform the rating process going forward–"to get a sense of what we look for in a good cycle manager," she noted.

To do this, analysts ran four tests on just over 1,000 North American rating units (groups rated by A.M. Best other than mortgage and financial guaranty insurers) for which 10 years of statutory filings were available (1997-2006). The tests were:

o Is the 10-year average combined ratio better than the median for the industry composite in which the rating unit falls?

o Is the standard deviation of combined ratios less than the standard deviation for the industry composite? (A standard deviation is a measure of volatility which looks at the year-to-year divergence of results from the average combined ratio.)

o Did the company combined ratio outperform the industry composite in eight of the 10 years?

o Did the company report an underwriting profit–a combined ratio under 100–in eight out of 10 years?

Examples of industry composites as defined by A.M. Best are categories such as commercial casualty, commercial property and personal lines. The study compared each rated entity's long-term average combined ratios to the composite combined ratios to give a sense of how each company fared throughout a cycle in comparison to its direct competitors.

The first surprise was that only 6 percent–60 rating units–passed all four tests. On the other hand, over 600 rating units–more than half of all rated insurance groups studied–failed at least three tests, and 38 percent failed all four, Ms. Marshall reported.

That proves "it's extraordinarily difficult for companies in this industry to outperform their direct competitors," she said.

Another somewhat surprising result was that good cycle managers–those doing better on the four tests–tended to increase premiums during soft markets.

The rating agency analysts had gone into the study with several preconceived ideas–namely that:

o Good cycle managers reduce premiums in soft markets and increase them dramatically in hard markets.

o Good underwriting companies have good operating results.

o Cash-flow underwriting and "managing reserves to drive income" were strategies of poor cycle managers.

These three expectations were borne out by the study results, Ms. Marshall confirmed.

Another unusual result was that small companies tended to do better on the four tests, Ms. Marshall said.

Rationalizing this particular finding, she said that very large companies probably don't outperform their rating composite because they are big enough to actually set the average for the entire composite in which their results are included. She offered this as another reason for the result showing that large national multiline writers tended to have a poorer showing than niche writers in the study.

Ms. Marshall's presentation was part of a session–"In Focus: The Underwriting Cycle"–that was initially intended to explore the impact rating agencies and auditors have on underwriting cycles.

An early working title for the session was "Auditors and Rating Agencies: Do They Help or Hurt?" noted the panel's moderator, Patricia Teufel, principal for KPMG in Hartford.

"For well-managed companies, auditors and rating agencies shouldn't make a difference," she said, noting that the theme of the session was changed based on this consensus view of the panelists.

After Ms. Marshall's presentation, Ms. Teufel and Mr. Votta ran through a series of case studies, asking audience members to put themselves in the role of auditor or rating analyst when faced with some problematic facts and circumstances about insurance company financial results, such as company management that had traditionally booked reserves at the midpoint of an actuary's range of estimates, suddenly changing its approach to book the low end in a year when unrealized investment losses had made a significant dent in the surplus of the company.

Throughout the session, and the remainder of the conference, actuaries and auditors stressed the improved levels of required documentation of decisions by company managers to deviate from actuarial estimates, better transparency and data quality as factors limiting the possibility of companies "managing cycles" in the sense of manipulating reserve levels to improve results.

Still, there were intermittent concerns raised throughout the two-day conference about actuaries either being overly conservative because of bad experiences of adverse reserve development in the past, or the reverse situation.

In the latter camp, Ms. Marshall and Stefan Holzenberger, an assistant vice president for A.M. Best, at separate sessions, each noted they have witnessed insurers taking down liability reserves for recent prior accident years at a faster pace than they might expect.

Among the examples of actuarial conservatism that emerged during the conference was a reference to umbrella business Ms. Teufel made during the presentation of one of the case studies.

Referring to loss ratio picks used for recent years in the reserve process, she said that "many companies are experiencing unbelievably good results in umbrella"–results that would support initial loss ratio picks of 20.

"But most company actuaries are saying, 'There's no way I'm going to reserve umbrella at less than 60,'" she said, referring to a longer-term result with which most actuaries are more comfortable.

"That is an instance where an auditor might want more documentation of why you believe it's appropriate to continue to reserve at a 60 when the losses just haven't been there," she said.

"It goes both ways from an auditor's perspective," she said, referring to the fact that she and other auditors are more typically asking why selections are overly optimistic rather than conservative.