European Insurance Summit 2004 Offers Some Words to Live By

By | December 6, 2004

Rating agencies are a reality, and we have to live with them,” Martin Kauer, CFO, Converium AG. “Market share is the enemy of risk management,” Brian O’Hara, president and CEO, XL Capital. “The world is once again opening up,” Sandy Crombie, CEO, Standard Life. “Reinsurers and insurers returns are linked over the cycle,” Patrick Thiele, president and CEO, PartnerRe. “We take our role very seriously; if it’s ever doubted we’re history,” Barry Hancock, European regional practice leader, Standard & Poor’s (S&P).

Those were just a few of the more trenchant observations offered by industry leaders at the European Insurance Summit 2004, held in Vienna, Austria, at the Intercontinental Hotel Oct.13-14. The conference, sponsored jointly by the Wall Street Journal and the German business publisher Handlesblatt GmbH, brought together CEOs, regulators and industry experts in focused presentations on the current insurance market and where it might be headed.

While many of the discussions dwelt on European concerns, insurance is a global business, and some insights are equally relevant in the U.S., Japan and elsewhere.

From that perspective, S&P’s Hancock and Converium’s Kauer offered a revealing look at the symbiotic relationship between insurance/reinsurance companies, their clients and the rating agencies. S&P, with seven offices in Europe, has been rating the industry since 1971, but Hancock admitted that a lot of people are still “staggeringly ill-informed” as to what they actually do. A company’s capital position is just one factor. “Capital models are only a starting point [in calculating ratings], we also consider, management strategy, business plans and where the franchise is going [as well as other factors],” he said.

He also pointed out that “there’s no real difference between ‘A-‘ and ‘BBB+’.’ The big break is between triple-B and double-B. Nonetheless, a ratings downgrade can have serious consequences. Cedents, especially in the U.S., commonly put “triggers” in their reinsurance contracts that allow them to remove business from a company whose ratings fall below S&P’s (or A.M. Best’s) “A” rating levels.

Textbook example
Converium offers a textbook example. Kauer noted that it has now successfully raised $420 million, and had weathered what he called “a perfect summer storm.” While that’s true, Converium’s business position has been diminished, largely because of successive ratings downgrades that followed its announcement of significant reserve strengthening in the U.S. (around $300 million). It’s already lost at least one client, U.K. auto insurer Admiral Plc, and is sure to lose more. Its business could be halved as a result.

Surprisingly, at least to some of those present, neither Kauer nor Hancock felt the system had broken down. Although they both concurred that using ratings as trigger points often causes unfair results, they both accepted the practice as a fact of life.

“An insurer’s financial strength rating is a current [independent] opinion on an insurer’s capacity to pay under insurance policies and contracts in accordance with their terms,” Hancock said. As so many people rely on them, ratings have to be consistent and objective, otherwise, as he noted, “we’re history.”

Ratings–and rating agencies–remain a case apart, however.

Kauer said it’s the only industry he knew of where the “the supplier [the insurance company] pays and the customer gets it for free.” He also stressed, as did Hancock, the differences in capital models and other considerations used by rating agencies, whose main concern is to “advise cedents [on a reinsurer’s] ability to pay claims,” and the models constructed by the companies themselves.

“Our capital model is never finalized,” Kauer said. “It’s always evolving.” However well intentioned, ratings are prone to take on the role of self-fulfilling prophecies. A lower rating means not only less business, but also business with less profitability, which in turn further weakens the company and lessens its chances of regaining a higher rating.

Like ratings, the “cycle” has also come to be seen as a fact of life, although no one expressed much satisfaction about it. O’Hara’s condemnation was perhaps the strongest, but others acknowledged that it continues to haunt the industry.

PartnerRe’s Thiele described the cycle as basically a reflection of the economic law of supply and demand, but “it’s hard to quantify as well, because the [insurance] industry deals in intangibles.” The cycle reflects this, as rates decline when more capital enters the market and tend to rise when there’s a shortfall.

“Reinsurers’ and insurers’ returns are all linked over the cycle,” Thiele continued. “As loss costs [claims] increase, supply [capital] declines. Prices respond to this with a lag [they increase eventually], and profits respond to prices with a lag as well. Both industries are cyclical with the same drivers,” he concluded.

He also observed that “reinsurance is a tool to principally manage volatility and capital, not returns.” Ideally, both insurers and reinsurers should therefore realize adequate returns over the cycle. It sounds deceptively simple, but it requires a great deal of hands on management and expert knowledge of the market.

For one thing, different market sectors have different cycles. “Insurer demand varies,” Thiele said. At any given point in the pricing cycle some lines may be depressed or in decline, while others are becoming scarcer with a consequent rise in rates. As an example, as of January 2004, U.S. professional liability, credit and surety and European casualty rates were all on the increase, while industrial property, energy and airline risks, which had risen sharply, were declining.

The secret of profitability is to try and align all these variables to smooth out the cyclical influence to the extent possible. “Which,” Thiele said, “requires that a company be diversified–both in terms of risk and geographically.” He knows what he’s talking about. PartnerRe just celebrated its 10th anniversary, but it’s already one of the 10 largest reinsurers with net written premiums in 2003 of $3.5896 billion.

XL hasn’t done badly either. Starting with one employee–Brian O’Hara–in 1986, it now employs more than 3,200 people in 30 different countries with total assets close to $40 billion. O’Hara and Thiele expressed similar convictions on the necessity of managing risks, and the attention to detail that has worked well for both their companies.

O’Hara reviewed the “Large Risk Market Landscape since 1975,” a sobering presentation when compared to 2004. Out of some 35 companies 20 years ago, there are now just 12. Having the people with the dedication and the expertise in place to manage change and adapt to new conditions rapidly and well is the most important aspect of survival. O’Hara called it XL’s strongest asset.

A poignant reminder of just how drastic changes in society can be, and what the consequences are for those who insure it, came from Standard Life CEO Sandie Crombie. He mainly addressed the seismic shift in Europe since the collapse of the collectivist regimes of the eastern bloc countries and the Soviet Union, which began in 1989. As a result, parts of Europe that had been essentially closed, were opened, or rather reopened. That closure began 90 years ago in July 1914, when The Austro-Hungarian Empire, Capital Vienna, declared war on Serbia. What the French call “the Great War” that ensued unleashed economic, social and political forces that have yet to reach their conclusion.

By 1910 Scotland’s Standard Life was selling its policies around the world. In the aftermath of World War I it considerably reduced its scope. Now, as Crombie noted, Europe and large portions of the rest of the world are open for business again. Of course times have changed. While the European Union’s enlargement to 25 members, many of them in the east, could eventually unite the continent, “the political and economic challenge ahead for member states, the [European] Commission and the European parliament is enormous,” Crombie observed.

Nor is Europe itself united on fundamental issues, such as how to deal with declining birth rates, rising life expectancies and what form, if any, an eventual European government might take. While many see great benefit in harmonizing taxes and regulations, an equal number decry the stifling of diversity and free competition. The current debate over the “Solvency II” rules, which would require greater transparency and would add risk management criteria into financial service regulations, including insurance, are seen by many as much needed reforms, by others as an additional regulatory burden.

No one is quite certain what form the European, and by extension the global, insurance industry may take in the end, but the general tone of the European Insurance Summit seemed to be that the industry and its European members were at least heading in the right direction. The drive towards stricter accounting rules and greater transparency will probably receive a boost from the current Spitzer investigations in the U.S., as they have put into stark relief the kinds of abuses which need to be addressed.

Professor Andreas Gr├╝nbichler, the executive director of the Austrian Financial Market Authority, which regulates the country’s insurance industry, called the reforms “neither a curse nor a blessing.” But he reminded the participants: “The insurance industry affects the way companies think about business lines, new markets and risk management.” The industry therefore bears an obligation to the society it insures to set a proper example. While everyone probably agrees on that, the devil remains in the details.

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