Capital, Capital, or Where Did All the Money Go?

At least the global depression has focused people’s minds on some important issues. The Group of 20 (G20) meeting in London acknowledged the need for more capital to shore-up the world’s financial system — essentially the U.S./UK view — as well as the need for stronger regulation of the financial sector, to try and reign in the excesses that caused the problem — the European view.

Across the Irish Sea in Dublin the European Insurance Forum (EIF), which concluded its proceedings the day before the G20, got underway, focused on the same issues, albeit from an insurance industry perspective.

This article focuses on what the world’s, and the insurance industry’s, leaders consider the most pressing problem — shoring-up the global financial sector.

How the Credit Crisis Affects Insurance

Somewhat ironically, and with some notable exceptions, the industry has by and large escaped the worst consequences of the financial meltdown. American International Group, the monoline mortgage insurers, and many life and pension groups have suffered severe losses. But the property/casualty industry — in the United States, Europe, Asia and elsewhere — has so far avoided the most dire consequences of the meltdown.

At the EIF, James Vickers, chairman of Willis Re International, pointed out that “all the clever people” who saw the insurance industry as “not very exciting,” are now wondering how it managed to survive the current crisis, while they are floundering. He said that the industry “had continued to “focus on what it’s good at, while the others went ‘off piste.'” He didn’t need to mention that strong regulation and reserve requirements played a major role in preventing the industry from following the bankers’ excesses. That’s understood.

The more immediate concern is how the industry can continue to avoid being sucked into the financial maelstrom, which over time could threaten its continued access to capital. “We’re not capitalized enough,” was the way Michael O’Halleran, executive chairman of Aon Benfield, put it. In other words, if the industry needs more capital, where will it go to find it?

In normal circumstances, the industry would be in relatively good shape. The reinsurance industry was able to handle $52.5 billion in property claims (according to Swiss Re) in 2008, the third worst year for natural catastrophes in history. However, these are not normal times. What would happen if 2009 or 2010 were to produce similar figures? The capital markets are in a coma. If a costly disaster results in further losses — a major hurricane for instance — the industry could find that it very difficult to replace the capital it needs to continue to function.

“This is the first time that the [insurance] market has been affected by the asset side of the balance sheet,” said AXIS Capital CEO and President John Charman. As a result, he believes the industry, more than ever before, will have to “get back to basics.” Not only can it no longer rely on investments to make up for underwriting losses, but it may not even be able to rely on the capital markets to supply capital.

Charman said the industry needs to do more to modernize “from a number of different points.” It will have to “get back to basics, because its investments are negative; to set higher risk [evaluation] standards, more discipline and higher underwriting standards.” His prescriptions aren’t new. Many industry leaders, particularly at Lloyd’s, have been telling their colleagues that the industry needed to change for years. However, the current capital crisis makes the message a lot more urgent.

Charman puts the blame for inaction on the industry itself. In his opinion, the problem isn’t with the reinsurers, but is due to primary insurers “commoditizing pricing.” As a result, premiums are too low, and “customers refuse to pay, even when the price is right.”

As a consequence, if insurance companies cannot offer the prospect of decent investment returns for potential investors, how are they going to attract capital? If the primary insurers don’t “adequately price products, it discourages investors, as they can’t make any money,” Charman said. That’s the heart of the problem, but there may be some solutions.

Insurers have a ‘Window of Opportunity’

The insurance industry doesn’t operate in a vacuum. Companies and brokers have a reciprocal relationship with the economies in which they do business. If enterprises and individuals spend less, less coverage is written and income drops. Therefore anything international governments can do to ameliorate the current crisis ultimately helps the industry.

At the G20, world leaders pledged $1.1 trillion to the International Monetary Fund, the World Bank and to support trade in order to help developing economies. True, much of that money had already been allocated and a significant portion may never materialize. Nevertheless, it should help developing countries, and to some extent the more developed ones, to avoid a total collapse. Insurers and brokers doing business in those countries should benefit.

Spanish Prime Minister José Luis Zapatero said — as reported by Reuters and perhaps somewhat exuberantly — that the G20’s decision “contributes to confidence … and will facilitate recovery. We have set in motion the greatest concerted plan of fiscal expansion in history. It is unprecedented. It reaches $5 trillion … This amount will contribute in a decisive way to facilitate a recovery of the world economy and to preserve millions of jobs.”

While that will help the insurance industry over the long term, it isn’t really a solution that will provide the capital it may need sooner.

Hubert Brandts, a partner in the London-based corporate financial advisory firm Hines & Associates, suggested insurers look closer to home. “How do you get them [investors] to invest?” he asked. “The biggest group of potential investors are the company’s shareholders,” as they are already investors. In that case, the industry may soon see more rights offerings.

Charman added that insurers “need to develop a greater sense of ‘communality’ with their investor base.” This would group together greater transparency, a cap on excessive executive compensation, the previously mentioned focus on improving earnings, and an adherence to sound regulatory principles. “The industry needs better management and government,” he said.

Implementing such initiatives would also highlight the fact that most insurance companies are not managed like banks or hedge funds. It would encourage a “flight to quality” that hopefully would make the insurance industry look like a good and a safe investment. “We have an opportunity to reset the rules of the game,” O’Halleran said. He explained that the biggest mistake Wall Street made was to look only to short-term considerations, thereby ignoring the long-term consequences. “We know risk, and what we’re seeing now is a classic reinsurance market turn,” he added. A change the industry must be prepared to deal with, because, as O’Halleran put it, “the role of the insurer is to survive.”

In Charman’s opinion that’s not enough “to just survive; companies must also evolve.” In addition to tighter underwriting standards, this also requires “greater intellectual capital, more diversification, more efficiency and a focus on better management control.” Costas Miranthis, chief executive of PartnerRe Global, added that the companies “who adapt better are the ones who will survive” and bigger companies may have an advantage in that respect.

Although assuring access to adequate capital is the most pressing problem, there aren’t any magic solutions. Better risk management in the form of higher quality information and spreading the risks along the lines of a subscription market like Lloyd’s may help. Adequate reinsurance rates that reflect the real nature of risks are another vital component. These are things the P/C industry has been implementing. Now, however, the industry’s very survival may depend on getting them done right in order to attract capital.

O’Halleran warned, “if the reinsurers can’t cover the risks, the government will.” That could happen if the risks are really too large, or if there isn’t sufficient capital. It’s a solution that would fundamentally alter the insurance industry, perhaps forever.

It’s not a solution that anybody in the industry would welcome, and until last October it might have been almost unthinkable. However, after AIG and the bank bailouts, it’s a possibility. The insurance industry may have escaped the worst of the financial crisis so far, but it will need to marshal every resource it has in order to continue to do so.

Topics Carriers Legislation Europe Reinsurance Market