S&P’s: Sophistication is Key to Market Stability

October 28, 2002

Standard & Poor’s said that the growing sophistication of the global insurance industry could potentially lead to a dramatic change away from the historic highs and lows of cyclical underwriting, smoothing the way to a more consistent level of profitability.

“A less cyclical insurance market would be revolutionary for the industry, with such fundamental change promising a more stable underwriting environment,” Standard & Poor’s credit analyst Christian Dinesen said. “Change is by no means certain, however. Reduced cyclicality is the ultimate prize, and it will take a concerted effort on the part of all market participants to attain it.”

Failure to change, however, could result in a downward trend in insurer financial strength ratings. “Almost 50 percent of ratings are now on negative outlook or CreditWatch negative. If the cyclical nature of insurance markets is not addressed, then the next time the market softens, we could see these negative outlooks begin to play out,” Dinesen remarked.

According to Dinesen, the fact that insurers are now beginning to take nonunderwriting risks into account and are using more advanced modeling systems indicates that the market is becoming more sophisticated. Nevertheless, further steps need to be taken, with the market in want of greater sophistication in terms of pricing, its use of risk indicators, and in its relationships both as clients and as risk carriers.

“There is a clear need to move away from the current situation where insurer financial strength ratings of single-‘A’-minus and above are seen as acceptable, and the rest as bad, to one where the insurance markets use the granularity of the rating scale to suit the needs of any given book of business. This could pave the way for more sophisticated pricing, with the cost of risk transfer rising on a sliding scale to reflect the level of security that a cedent is buying,” Dinesen said.

Although there is some evidence that insurers and reinsurers are already placing greater emphasis on the financial aspect of their relationships, there is room for the market to become less relationship-based and more opportunistic in its approach to business.

“The market needs to focus on selective, and therefore opportunistic, profitability. Closer scrutiny of underwriting results in the short and medium term has already begun following the high frequency of nine $1-billion insured catastrophes in 1999, and the September 11 terror attacks in the U.S. last year. Nevertheless, market participants must show greater determination to turn their backs on some long-standing relationships if they cannot make a profit from the business on offer,” Dinesen noted.

Such a change in the management of relationships could help bring about more predictable earnings, a result that shareholders are increasingly calling for. “Continuing shareholder pressure on companies will help the process, as many issues that are key to greater sophistication – such as the better servicing of capital – are high on the agenda of shareholder interest,” Dinesen added.

Clearly, there are many facets that the market must accommodate. It will be a tall order to initiate such fundamental change, but Dinesen believes it will not be impossible: “Other financial services sectors have managed it before, so why not the insurance sector?”

Nevertheless, Dinesen remained skeptical as to whether the market will stay committed to change. “At the moment, market participants are making the right noises, but it is easy to be upbeat when the market is hard. The real test as to whether the market has the desire to carry through change will come as the market starts to soften.”

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