Analysts: U.S. Insurers Sitting with Excess Capital Face Rocky Road

June 5, 2008

U.S. insurers, in an industry awash in excess capital, face a stretch of turbulence that won’t soon abate, according to analysts at a Standard & Poor’s Ratings Services conference this week.

“We’re sitting in an environment where we have way too much capital,” said V.J. Dowling, managing partner at Dowling & Partners Securities LLC. Predicting that the industry might see as many as three bad calendar years, Dowling added that because of the excess cash floating around, “we’re going to see more and more price competition.”

Speaking during the panel session titled “The Insurance Industry: Varying Perspectives from the Street,” Robert Glanville, managing director at Pine Brook Road Partners LLC, suggested that the industry slowdown could be slightly shorter than Dowling predicts.

Nonetheless, companies face a rocky road ahead and will have to be more careful, according to Glanvile.

“What we’re looking for now is management teams to be a lot more disciplined to reduce their exposures,” Glanville said.

Edward Spehar, managing director at Merrill Lynch & Co., said enterprise risk management has become increasingly important, and that companies “have certainly made great strides in hedging.”

At the same time, he said it might be “naive to assume companies are doing as well as they say they are doing hedging exposures.”

Standard & Poor’s has kept its stable outlooks on the life, managed care, property/casualty, and reinsurance sectors–reflecting its opinion that upgrades and downgrades will be almost equal in the next six months.

However, S&P said it believes the tables could be turning, especially given weakening economic trends and industry-specific factors that depress earnings.

In any event, the potential speed and depth of an industry slump should come as no surprise, analysts said.

Standard & Poor’s said it believes the insurance sector is well-positioned to navigate through the accounting volatility inherent in investment portfolios, given the generally manageable levels of exposure to the more volatile asset classes, healthy liquidity, and strong capitalization levels.

Also, with limited prospects for organic growth, S&P expects to see prudent debt-financed share-repurchasing programs as an integral part of capital management, as raising new capital has been difficult until recently.

Dowling said the key to effective buyback programs is timing in the markets.

“We’re big proponents of share repurchases, but we’re very price-sensitive,” he said. “It makes all the difference in the world (at what price) you buy back shares.”

Glanville said repurchases are “an important part of demonstrating to your investor base that you care about rightsizing your capital base to your business.”

At the same time, “relying on the capital markets to be there when you want them constrains your options,” he added.

In any case, companies will need to find places to park excess capital. Under current guidelines, “it is just as wrong to have excess reserves as it is to have inadequate reserves,” Dowling said. This could mean that drawdowns of reserves might be faster than in the past, perhaps accelerating the industry cycle.

Meanwhile, the weak U.S. dollar could spawn merger and acquisition activity–with U.S.-based targets–as companies look to broaden of their core product lines.

“We do think (M&A) will pick up, and I would not underestimate what might happen from overseas,” especially for property-casualty insurers, where U.S. companies are “pup-sized” compared with their European counterparts, Dowling said.

Life insurers might also see an increase in consolidation, Spehar said, adding that these companies seem to be well-positioned, given that they have emerged relatively unscathed from similar economic downturns.

“I am fundamentally more optimistic about life companies than about other financial companies,” he said. “The competitive environment in the life industry is not something I’m overly concerned about” because companies will innovate on products and figure out a way to make pricing more profitable.

Source: Standard & Poor’s

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