I have been analyzing the insurance industry and individual insurers and agencies for a long time now. When I started analyzing the industry, I never imagined, and I have not met any industry veterans who could imagine, this industry having so much surplus. No one could have imagined 15-plus years without a hard market.
Think about what has happened since the last hard market: Katrina, Sandy, and the credit crisis, to name just a few. Katrina and Sandy were two of the nation’s largest natural catastrophes ever and the credit crisis caused a huge, world-wide financial disruption, yet the insurance market didn’t turn. Surplus at the end of 2017, according to A.M. Best, was roughly 280 percent higher than in 1999.
The property/casualty industry has so much capital, it is not all being used. Keep in mind, this capital is not equally distributed. Some companies have more than they know what to do with and others are short a competitive perspective. Maybe, or maybe not, their shortage leaves them without the capital required to be profitable while simultaneously maintaining rate competitiveness with companies that have surplus and/or are more profitable.
Not All Capital is Created Equal
A critical point is not all capital is created equal. Most I talk to in the industry at the carrier and agency level don’t understand that all capital is not created equal relative to surplus. A quantity of surplus is obvious, but the quality of capital is not. There is the obvious equity vs. debt capital. There is also a thing called surplus notes that some companies use to boost the quantity of capital. If you do not know what surplus notes are, I strongly encourage you to research this lower form of capital. The smartest companies have high quality equity capital that also serves as a large investment portfolio upon which they earn outsized investment income.
Insurers have not historically made money through underwriting. That is a well-known fact. Less well-known is that the industry has made money in underwriting more often during the past 10 or so years. The industry cannot stand making money through underwriting, so it has reverted to losing money underwriting. Therefore, investment income is critical and with low yields, the size of the investment portfolio is critical to profitability, rate flexibility and organic surplus growth.
Operational vs. Competitive Perspectives
I recently completed an analysis of 50 large P/C companies. Some, from an operational perspective and competitive perspective, are absolutely at a competitive disadvantage because the quality of their surplus/capital is so much less than stronger competitors. Their strategy is defined by their constraints. In some cases, this will determine who sells, who buys, who continues to build strong relationships with clients and who does not.
Historically when insurance companies had too much money, they found ways to waste it convincingly. This usually involved massively underpricing resulting in latent under reserving issues, which ultimately was a driving factor in the market cycle. The surplus that appeared to exist, therefore, did not really exist once the under reserving was addressed. These points were usually addressed by the next C-suite and/or hidden in an acquisition. Bad acquisitions are always a great way to waste capital too.
The past 10 years, with a couple of notable exceptions, carriers have been far more disciplined with maintaining their pricing and resolve to avoid bad acquisitions. To some degree, they have also greatly benefited from a safer environment the actuaries seem to have failed to predict resulting in premiums increasing faster than claims. The result is the carriers are collectively averaging a $37 billion profit annually. So if your company is not profitable in this environment, it truly may be a personal problem.
Two new models have developed that will take much longer, maybe, for the negative effects to develop versus the speed with which poor discipline became evident in the past. One model is the use of alternative capital. One reason the industry has so much capital is the development of alternative capital. Most commonly known sources are catastrophe bonds, captive insurance companies and other creative financial structures. When these models are built well, all parties involved benefit.
Other forms of capital, however, are being employed differently that may catch people unaware. One issue is the captive that may not be legitimately organized. Another may be a captive where the parties involved truly are not adequately finance/insurance educated or wealthy enough to participate on an adequately informed basis. These captives can be made to sound sexy, and the dangerous aspects are overlooked.
RRGs and Reciprocals
Another method involves RRGs and Reciprocals. Both have been around forever and play a constructive role in the marketplace. However, it looks as though some consumers being sold these vehicles do not really understand them. The agents selling these often do not know what they are selling. I have interviewed many agents as to whether they understand the financial mechanisms involved when these entities run short of capital, their call abilities, and few have had any understanding. If the agent does not understand, I doubt the insured understands that the policyholder is the bank, depending on the situation, for capital calls.
At one time, these financing entities were modeled differently when capital would accumulate over time and thereby decrease the probability of a capital call. Many RRGs and reciprocals still are. But we now have multiple entities where owners and C-suites are paid de facto dividends off the top, based on revenue and not profit, like private equity is paid. This makes high quality capital more difficult to accumulate, at least organically. The alignment of interests in this model does not exist at the “rubber meets the road” level. The owners benefit most, upfront.
Not Growing or Staying Even
In the more traditional carrier capitalization world, a related but different model seems to have been adapted. This is where a company has determined it cannot grow or maybe doesn’t want to grow. A mid-size carrier finally quit going backwards after 10 years of going backwards, becoming approximately half the company it was. That seems purposeful. If a company is not growing, its stockholders are not usually happy unless dividends and stock buybacks are strong.
If a company begins distributing its surplus in this manner, then depending on what its surplus ratio was initially, it either has to reduce its writings accordingly if its ratio was limited or if it had extra surplus to burn, then it simply gives up its cushion but does not use its surplus to grow.
In the former, I am sure some companies plan some miraculous reversal at the appropriate time and others plan to sell themselves at a tipping point. From a C-suite/shareholder perspective, this camouflaged wasting asset strategy makes sense if the execution is quality. Their agents and policyholders may still have a different perspective even if execution is good because they both face disruption. If it goes bad, everyone will be unhappy.
In the other instance where the company just does not grow but started with extra surplus, regaining growth momentum after not really trying to grow is easier said than done.
One factor quite frustrating for agents is how specific companies talk as if they desire to grow but their real strategy is to stay even. How many times can a company say they want to grow but will not write what is being submitted when the submissions are quality and on the carrier’s hit list? Or they will write them at a 10 percent to 30 percent premium over the competition? They are not seriously planning to grow.
A few companies may be playing a longer game and appear patient. My guess is they see the follies of some of the capital strategies being used and have decided to slowly (or not) take advantage of their short-term thinking competitors because they are achieving far more growth while remaining profitable and/or waiting to buy competitors when the time is right. In many ways, the short-term strategies are arguably often about enriching a certain class of insiders and the long-term strategies are about building a long-term business that benefits the carrier, their shareholders, agencies, and policyholders over a long period.
For agents, understanding your carriers in depth, whether they are part of the short-term or long-term game, is well worth your time and energy. While it is not every day you can use this information to benefit your clients, when that opportunity exists the value can be large.
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