Trends in the Property Casualty Insurance Industry

1
Trends in the Property Casualty Insurance Industry
Hankamer School of Business Baylor
University October 2, 2003

• Joan Lamm-Tennant, PhD
• Gen Re Capital Consultants

2
Trends In The Property Casualty Insurance
Industry

• Insurance Industry Financial Summary Looking
  Good
• Now Lets Look Beyond The Financial Summary At
  Underlying Trends
• Evolution in Risk Management
• Summary and A Look Into The Future

3
Things are looking goodYou really like me
4
Highlights Property / Casualty 6 Months 2003
2002
Change
2003
182.4
16.7
214.9
Net Written Premium
134.3
11.9
150.3
Loss LAE
(11.9)
-82.3
(2.1)
Net UW Gain (Loss)
17.8
16.3
20.7
Net Inv. Income
4.6
300.4
18.6
Net Income (a.t.)
12.2
285.2
319.7
Surplus
107.2
-7.9 pts.
99.3
Combined Ratio
Comparison with year-end 2002. Comparable 2nd
quarter figure is 282.9 Comparison is with
full year 2002 combined ratio. Comparable
quarter 2002 figure is 105.0
Source Insurance Information Institute
(amounts in billions)
5
U.S. Property / Casualty Industry
Combined Ratio 1955 to June 30, 2003
Average Combined Ratio 1955 - 2002 104.3 1955 -
1979 100.1 1980 - 2002 108.8
116.0
118.0
116.3
115.7
As of June 2003 the industry reported a combined
ratio of 99.3. This is the first time in the
past five years that the industry reported a
combined under 100 mid year.
as of 6/30/03 Source III
6
Property / Casualty Net Income After Taxes
1991 - 2003
As of 6/30/03 Sources A.M. Best, ISO,
Insurance Information Institute.
(amounts in billions)
7
Policyholder Surplus
1975 - 2003
Surplus (capacity) peaked at 336.3 billion in
mid-1999 and then fell 15.2 (51 billion) to
285.2 billion by 2002. In 2003 surplus is
319.7 billion an increase of 34.5 billion or
(12.2) over 2003.
Second Quarter Source A.M. Best, Insurance
Information Institute
(amounts in billions)
8
What Is My Point in this Section?

• Premium is Up
• Underwriting Result is Improved
• Surplus is Growing
• Looks Like the Industry is Doing Well

9
Summary Numbers Dont Tell the Whole Story
Risky Business Are We Exposed or Are We
Protected?
10
Now Lets Look Beyond The Financial Summary

• Economic Value Gap
• Are Rates Holding?
• Loss Trends
• Emerging Exposures
• Reserve Shortfall
• Investment Results
• Credit Quality Insurers and Reinsurer
• Insolvencies

11
Economic Value GapROE vs. Cost of Capital PC
Industry 1991- 2003F
There has been enormous gap between the
industrys cost of capital and its ROE. US P/C
insurers have missed their cost of capital by an
average 6.6 points from 1991 to 2002.
6.8. pts
14.6 pts
If we do end 2003 with 11.6 ROE, we will be
breaking even but not yet creating economic value.
Source The Geneva Association, Ins. Information
Inst.
12
Are Rates Holding?Strength of Recent Hard
Markets by Real NWP Growth
1975-78
1985-87
2001-03
Real NWP Growth During Past 3 Hard
Markets 1975-78 8.6 1985-87 14.5 2001-03
9.1
Note Shaded areas denote hard market periods.
Source A.M. Best, Insurance Information
Institute
13
Loss Trends

• Four Problematic Lines of Business
• Medical Malpractice
• Product Liability
• Workers Compensation
• Homeowners

14
Loss TrendsLine of Business CRs Needed for
Profitability
Source A.M. Best Reflects break-even
accident year results including investment income
on current writings. Break-even figures are
calculated using a 4 interest rate.
15
Loss TrendsAverage Jury Awards 1994 vs. 2001
Figure is for 2000 (latest available) Source
Jury Verdict Research Insurance Information
Institute.
16
Loss TrendsMed Mal Losses Exp Paid vs.
Premiums Earned
Source Computed from A.M. Best data by the
Insurance Information Institute
17
(Re)Emerging Exposures

• Asbestos
• Toxic Mold
• Construction Defects
• Obesity Patron Suits

18
Obesity Patron Suits

• Are the food service manufacturing industrys
  vulnerable to suits over obesity?
• McDonalds sued in late 2002 over allegations
  that their food makes people fat
• Kraft sued earlier this year over trans fats in
  Oreo cookies

19
Takeaways At This Points

• ROEs might be at breakeven relative to cost of
  capital
• BUT when will the PC industry become Economic
  Generators
• What you want more rate
• Auto, package property, large account property
  look good but
• Homeowners needs work
• Workers compensation still has some problems
• Medical utilization and inflation is a real
  concern
• Then there is Property Liability and Tort

20
What do you mean there is more !!!
21
YES, There Is More

• Economic Value Gap
• Are Rates Holding?
• Loss Trends
• Emerging Exposures
• Reserve Shortfall
• Investment Results
• Credit Quality Insurers and Reinsurer
• Insolvencies

22
Reserve Deficiency, by Line(AY 1992-2001, as of
12/01)
Occurrence and claims made Source Morgan Stanley
23
Reserve DeficienciesAdverse Loss Development

• A number of companies reported reserve increases
  in excess of 1B
• AIG Q4 2002 2.8B increase in excess casualty
  and DO
• Travelers Q4 2002 2B primarily for asbestos
• Employers Re Q4 2002 2.5B in several liability
  segments, workers compensation and asbestos

24
Reserve Deficiencies
Nothing Good Happens When Reserves are Deficient

• Profitability of Current Business Is Misleading
• Continue to Underprice Risk
• Target Rate Increases Are Too Low
• Terms and Conditions Are Likely to Be Too Broad
• Write More Unprofitable Business
• True Adverse Selection
• Losses Compound Across Accident Years Before
  Mistake Is Recognized
• Lose Prestige and Respect in the Marketplace
• Pay Too Much in Taxes
• Very Painful to Fix

25
Investment ResultsInterest Rates Lower Than
Theyve Been in Decades

• While investment income is up in 2003 for the PC
  insurance industry it is due to the reinvestment
  of very strong cash flows from underwriting.
• Rates remain relatively low.

As of April 21, 2003. Source Board of
Governors, Federal Reserve System Insurance
Information Institute
26
Investment ResultsTotal Investment Returns of
U.S. PC Industry
Total Investment Returns (1979 to 2002)
81 billion
17.8 billion
(amounts in billions)
27
Credit QualitySP Downgrades of PC Insurers
Jan 03 to Sept 03

• Of Of the 484 companies rated by SP, 94 were
  downgraded (7 were upgraded)
• For example, of the 94 companies downgraded, 17
  were downgraded from AA to AA 4 were downgraded
  from AA to AA- and 10 went from a AA- to A with
  another 5 going from AA- to A

28
Credit QualitySP Financial Reinsurance
Downgrades
AAA AA AA AA- A A A- ltBBB Outlook General Re
X Stable Swiss Re ------------------
---------------X Stable Chubb Re
---------------------------------X Stable Em
ployers Re -----------------------------------
-----------------------------------X Negative M
unich Re -------------------------------------
---------------------------------X Stable -
American Re ----------------------------------
--------------------------------------------------
---X Stable Hannover Re -------------------
----------------X Negative Transatlantic
Re X Stable XL Re X Stable Partner
Re -----------------X Stable Hartford P/C
Group -----------------X Stable AXA
Re -----------------X Stable Converium
Re --------------------------------------------
--------X Stable Everest Re X Stable SCOR
--------------------------------------------
------------------------X Watch / Dev Gerling
Global Re -----------------------------------
---------------------------------X Withdrawn ACE
Tempest Re X Negative IPC
Holdings X Stable W.R. Berkley X Neg
ative Lloyds -------------X Stable Trenwi
ck Amer Re ---------------------------------
---------------X Withdrawn Renaissance
Re X-------------- Stable PXRE
Reins X Negative Axis Re X Stable En
durance Re X Stable Montpelier
Re X Stable PMA Capital -------------
-----X Negative CNA ------------------X Ne
gative

As of September 2003
29
Credit Risk and Reinsurance Recoverables
30
Credit Risk and Reinsurance Recoverables
31
U.S. P/C Insolvencies vs. Combined Ratio
1971-2002
10-yr failure rate is 0.72 but in 2002 the rate
is 1.33
30 companies went insolvent in 1992,
peaked in 1992 with 63 insolvencies
Source A.M.Best Co. Special Report P/C Industry
2001 Insolvencies, June 18, 2002
32
Causes of Insolvency

• Deficient Loss Reserves
• Inadequate Pricing
• Rising Loss Cost Trends
• Catastrophes
• Cheap Reinsurance Protection
• Cash Flow Underwriting
• Aggressive Growth
• Fraud
• Overstated Assets

33
Bringing It All Together

• Industry Results are Much, Much Better
• We might breaking even in 2003 no longer an
  economic detractor
• Remember, not all lines are producing profits so
  we have work yet to do
• Rates are still hardening
• But can we hold them
• Adverse reserve development continues to be a
  drag
• Investments cannot support underwriting
• (Re)emerging exposureswe must keep a watch on
  these!
• Keep an eye on credit quality when placing your
  business
• Focus and discipline are key

34
Trends In The Property Casualty Insurance
Industry

• Insurance Industry Financial Summary Looking
  Good
• Now Lets Look Beyond The Financial Summary At
  Underlying Trends
• Evolution in Risk Management
• Summary and A Look Into The Future

35
Evolution In Risk Management - New Disciplines
36
Evolving Disciplines in Risk Management

• Managing for Profitability versus Growth
• Advance Risk Metrics
• Delaying Claims Payments Market Consequences

37
Lets Do the Math
Managing Profitability versus Growth
Still looking for photo
38
Managing Profitability versus Growth

• What combined ratio is needed to provide a fair
  risk-adjusted return on capital given leverage
  and given investment income?

39
Underwriting Profitability Is Critical
Source Dowling Partners, Underwriting Profit
is Essential
40
OK So How Do We Change The Culture To Manage
Profitability as Opposed To Growth

• Reward profitability not growth through
  compensation schemes
• Build skills
• Advance risk metrics
• Improve both the quality and quantity of data

41
Evolving Disciplines in Risk Management

• Managing for Profitability versus Growth
• Advance Risk Metrics
• Delaying Claims Payments Market Consequences

42
Realistic Risk Choices Depend On Our Ability To
See The Complete Range of Outcomes
Stress testing may give you a false sense of
confidence that you are seeing the complete
range. Simulation may appear complex but it can
be very insightful.
Mean
-70
-30
25 (Mean)
50
Change in Underwriting Profit
43
Simulation Gives Us A New Measure Of Risk

• The probability of a decline in underwriting
  profits (Value-at-Risk) is a useful risk measure.
  

Mean
20 probability of a 30 or greater decline in
underwriting profit
-70
-30
25 (Mean)
50
Change in Underwriting Profit
44
Simulation - An Insightful Way To Understand
The Drivers of Unacceptable Results

• Bottom up modeling allows us to explore in
  detail the root causes of risks.

Interest Rate Spike
Probability
East Coast Storm
Adverse Reserve Development
Equity Market Declines
-70
-30
Change in Underwriting Profit
45
Taking It Even Further Portfolio Analytics
Return on Surplus Percentile Distribution
Combined Ratio Percentile Distribution

• This company did an in-depth simulation analysis
  the impact of 3 options for growth on the
  combined ratio and ROE of their company.
• They were able to make a better-informed decision
  about the trade-offs presented to them.

46
So what is the point

• Know more than your expected outcome
• A 25 increase in underwriting profit
• Know the range around the expected
• A 70 decline in underwriting profit to an 50
  increase in underwriting profit
• Focus on the tail the strike zone
• Know the probability of the downside
• Be aware of the economics underlying the strike
  zone
• Think about hedging the unthinkable

47
Evolving Disciplines in Risk Management

• Managing for Profitability versus Growth
• Advance Risk Metrics
• Delaying Claims Payments Market Consequences

48
Delaying Claims Payment

• What are the cause for the increase in unsettled
  claims?
• Greater Fear
• Greater Pressures on Profitability
• Trading Reputation for Short-term Profitability
• Willingness to Game Information Asymmetries
• Imbalance in Risk Psychology Fearing Losses
  More Than Loving Gains
• More Litigious Society
• More Uncertain World
• Simply unclear because the contract was never
  written with these claims in mind

49
Delaying Claims Payment Market Consequences and
Solutions

• What might be the market consequences?
• Loss of confidence in the insurance markets
• Will have downward bias on price
• What might be a solution?
• More disclosure of data
• Is this even reasonable?
• Does the data even exist?
• Re-thinking the economics of contracts
• Recognize that incomplete contracts may be
  optimal
• Therefore, how might we design contracts on
  verifiable losses, given that non-verifiable
  losses will exist?

50
Summary An A Look Into The Future

• Industry Results are Much, Much Better
• We might breaking even in 2003 no longer an
  economic detractor
• Remember, not all lines are producing profits so
  we have work yet to do
• Do we have the discipline to hold rates
• Will adverse reserve development continue to be
  a drag
• (Re)emerging exposureswe must keep a watch on
  these!
• Keep an eye on credit quality
• Evolving risk management disciplines are key

51

• The future ain't what it used to be.

Yogi Berra