Earnings Digest: 5 Lessons From The First Wave

Therein lies a double-edged sword for insurers: returns are generally too low to excite investors while they are too high to act as a catalyst for a broad-based change in pricing. Absent a credible threat from inflationary pressures or other visible cost-of-goods-sold measures, such as rising reinsurance costs, most policyholders seem likely to resist attempts to materially increase insurance rates.

Perhaps, instead of trumpeting their higher, often times double-digit calendar year ROEs, insurer's longer-term interest would be better served with headlines such as "ABC Company Reports a 7 Percent Accident Year 2011 ROE; Company Fails to Earn its Cost of Capital." Headlines like this might cause some industry observers to scratch their heads, but the astute reader would realize that prices in the aggregate cannot remain at current levels forever. (Editor's Note: Accident-year ROEs do not benefit from prior-year reserve releases that push reported calendar-year ROEs to higher levels.)

(2) Reinsurance and primary worlds temporarily disconnect.

Reinsurers had their clocks cleaned in first-quarter 2011, with many expected to report 5-10 percent (or greater) declines in book value from the beginning of the year. With low operating leverage, low interest rates and now massive underwriting losses, the catalyst for change has arrived.  Or, has it?

While declines were substantial and unexpected—since first-quarter catastrophes were highly unusual, particularly in combination—no one event was unimaginable. Moreover, unless or until the string of catastrophes moves from an earnings event to meaningfully affect year-end capital, reinsurers' pricing power may not gain traction.

Importantly, primary insurers are not without options. Retentions can be raised and increasingly liquid alternative reinsurance structures can be tapped (e.g., catastrophe bonds). This is not to say prices shouldn't or won't rise, but the magnitude and the pace of change could disappoint enthusiastic investors.

(3) Audit premiums pass an inflection point. Does it matter?

Early indications suggest that first-quarter 2011 will continue the nascent trend of insurers reporting positive audit premiums. Cautious businesses have learned to report flat-to-down estimated exposures (sales, autos, payrolls, etc.) although the gradual economic recovery is producing, on average, small but positive growth.

Here too investors would be well served to remember the "free lunch" expression (as in, there is no…) because while higher auditable exposures lead to upward revisions to premiums, the revisions also reveal that exposure to loss was higher during the policy period than was initially understood. If the business was properly priced, then more—or positive—audit premium could very well be a negative for insurers.

(4) Share buybacks and the just-in-time capital model.

Score one for the reinsurance executives. Many insurers and reinsurers returned all of their 2010 operating income in the form of dividends and share buybacks, yet so far none have been exposed as being too aggressive in returning "excess" capital ahead of this catastrophe-laden first quarter.  Perhaps the concept of "just-in-time" capital has been appropriately debunked, and managers expect to keep substantial capital cushions on hand for quarters such as this.  But this begs the question: Is the dedicated, corporate form of financing property-catastrophe reinsurance capital-efficient?

Ideally, property-catastrophe reinsurers would behave like accordions, shrinking as pricing declines and growing as opportunities expand. Instead, capital in corporate vehicles is "sticky" as reinsurance executives must placate external constituents including rating agencies, brokers and regulators regardless of the pricing environment.

Investors, slowed only by their manual dexterity, can type sell orders in a softening pricing environment when capital is perceived as being trapped in inefficient corporate vehicles.  Alternative reinsurance vehicles and securities seem poised to get yet another boost during 2011.

(5) Busting the cycle myth.

Were there a Myth Busters team to tackle the general perception that there is one monolithic pricing cycle in which all participants are price-takers, Travelers would likely present itself as "Exhibit A" to the contrary. The company's first-quarter statistics highlighted positive renewal rate changes on two-thirds of its guaranteed cost, commercial accounts.

With most companies still grumbling about the soft primary market, this begs the question: Can scale and superior analytical tools be combined with massive amounts of internal data and an active pricing and segmentation strategy to create a sustainable competitive advantage?

It seems clear how Travelers would respond, but the Myth-Busters team might require further evidence before declaring the cycle myth busted. Nevertheless, the competitive challenges facing insurers lacking either scale or true underwriting specialties are only going in one direction—higher!