Connect the Dots in 2005 and it Spells Government

Center stage will belong to Government in 2005. While it lacks the sizzle of themes from prior years–consolidation, convergence, digitization and hard market–it will have a more immediate and profound impact.

The industry’s business practices and competitive landscape have long been shaped by the government’s hand. Rate regulation, RBC levels, residual market mechanisms and class action jurisdictions, to name a few, play key roles in defining the rules by which we operate. While government is important to our industry, 2005 will be pivotal due to possible changes in some key rules.

Center stage clearly belongs to New York Attorney General Eliot Spitzer. He is challenging a mix of long-standing business practices. It is too early to speculate on how things will eventually shake out.

Stage right features the Terrorism Risk Insurance Act (TRIA), namely its potential extension. In broad terms, TRIA serves as a safety net to a key safety net in our economy. Our bet is that it will be extended.

Stage left features asbestos. This area is crowded, but two issues stand out: Will a federal solution be established and will insurers retain a voice in bankruptcy proceedings? We are optimistic that compromises will be achieved on related issues.

In the wings: a federal regulatory charter, tort reform, new rules of engagement in hard to serve markets–Florida wind and Massachusetts auto–and the use of credit in personal lines underwriting. These four issues are too early to call but we expect significant progress on each during 2005.

While the outcome of these issues is uncertain, there are two takeaways. First, distribution will become more expensive, driven by a greater need for transparency. Second, claims will improve. Whether it is the passage of reform or mere threat thereof, expect all stakeholders to be on their best behavior.

Focusing on lines of business
Personal lines outlook. Auto pricing is softening and key competitors are escalating advertising spending, (the Olympics were a great example of this). These two levers will pressure profit margins. At the risk of sounding like a broken record, Progressive and GEICO will define the competitive game in the short term. Their need to fuel growth flies in the face of the conventional one-stop shopping personal lines paradigm. One caution: there are signs that the long-term frequency decline may be ending. If so, insurer loss ratios will face the double jeopardy they have not experienced in more than a decade–sinking premiums and quickly rising costs.

Homeowners results, excluding catastrophes, should remain favorable with prices stabilizing in most areas. Longer-term issues involve the balance between the deductible feature of policies and escalating claim costs. This will play out in Florida where deductibles and Q3 2004 catastrophes are being evaluated. The lesson is that the “science” of predicting such extreme events is still in its infancy.

Commercial lines outlook. With the exception of certain niche areas (D&O, medical malpractice, workers’ compensation in troubled states) we expect softening prices. The key question is the magnitude of the softening. During 2005, we expect the softening to be diluted by two issues. First, while there is ample capital, there are fewer established brands playing in the market relative to the late 1980s. Second, the interest rate environment leaves little room for imagination with regards to cashflow underwriting. Of course, the benefits of these factors will be diluted as one’s target market moves from the mainstream, i.e., excess and surplus line markets.

Last, here are a few lessons from prior softening markets:

You can’t make it up on volume. Soft markets are not a naturally occurring phenomenon. They are the results of management actions. Growth through volume is a lose-lose, as each price reduction increases the number of new units needed to grow premium.

Watch out for “expense ratio whiplash.” While ratios continue to drift downward for a short time, be prepared for a controlled rebound.

Hard markets are tough for customers to swallow.They are especially hard on your best customers. Differentiate with superior customer service.

Win the ease of use race or, at minimum, don’t finish last. Adopt a “make life easy for the CSR” mantra.

Watch out for adverse selection and be mindful of different risk appetites. The proliferation of predictive modeling applications on the underwriting side and advances in the risk and capital management space have personalized risk-related decision making, changing the way many companies pursue the market. Be sure your organization is on equal or better footing than its competition.

While the theme of 2005 will be government, this is not necessarily bad news. There is more long-term upside than downside on the table right now. A trifecta of an asbestos solution, a TRIA extension and the emergence of a federal regulatory charter would be epic.

Chris McShea (chris.mcshea@ey.com) is national property casualty director for Ernst & Young’s insurance and actuarial advisory services.

Topics Legislation