Some property/casualty insurers might be in for a rude awakening with respect to their reserve practices, according to industry experts.
The property/casualty insurance sector’s ability to properly estimate its loss and loss-adjustment expense reserves directly affects its financial strength, noted actuaries and analysts at a recent Standard & Poor’s Ratings Services insurance conference.
Several panelists, however, expressed concern that broad expectations for a coming positive turn in the business cycle could be overdone and that reserve releases might be premature, leaving insurers exposed to unforeseen future liabilities.
“While at this time we are rightfully mired in discussions about investments, the recession, and cyclical pricing, we don’t want to lose focus that prudent reserving is the bedrock of the property/casualty industry’s financial strength,” said moderator Michael Gross, a Standard & Poor’s credit analyst. “We believe that everyone must be on guard for the potential that loss reserve inadequacy could emerge as a possible ratings mover in the years ahead.”
The discussion centered on the potential return of the so-called hard market, the stage of the property/casualty industry’s business cycle known for higher rates relative to insurance exposure underwritten. The industry last experienced a hard market following the intense price competition of the late 1990s and the terrorist attacks on Sept. 11, 2001.
Although most panelists agreed that a hard market is on the way, they also said it could look very different than in the past. And if insurers underestimate prospective loss experience, a reserve deficiency will arise, which means they’ll need to cover the difference.
Raji Bhagavatul, a principal at Milliman Inc., noted that the conditions are in place for a hard market. However, “while you have all the necessary ingredients to herald a hard market, you have other forces at play that could counteract that, and you may see a very anemic hard market,” she said.
“The investment income is going to be so down in 2009 and 2010 that you have to have underwriting discipline in order to make a profit.”
Discipline might be tested in other ways as well on this go around, according to John Iten, a Standard & Poor’s credit analyst. He stressed that insurers will likely face “temptation to help earnings by underreserving,” particularly if there isn’t a strong recovery. “And we’re not expecting that either,” he said. “We think that any hardening of the cycle will be fairly modest over the next couple years.”
The trend in the industry of releasing reserves possibly prematurely raises questions on reserve adequacy for the future.
“Currently, we are witnessing a healthy amount of reserve releases for recent accident years, with a particular focus on longer-tail, commercial product lines,” Gross said. In 2008, prior-year commercial line reserve releases nearly doubled to approximately $11 billion in 2008 from $5.7 billion in 2007.” Long-tail liabilities refer to types of coverage where an injury or other harm can take a long time to be known (such as asbestos) or the payout of the claims occurs over a long period (such as workers’ compensation).
In 2007, Standard & Poor’s was concerned about the industry’s release of just under $2 billion for accident-year 2006 for workers’ compensation. “Just given how long a tail that line of business has, that certainly raises some questions,” Iten added.
Michael Angelina, chief risk officer and chief actuary at Endurance Specialty Holdings Ltd., also signaled that the industry might be getting ahead of itself. “Now is not the time to be releasing reserves,” he said. “It’s a little premature to be taking good news on that business.”
At the same time, he said insurers are celebrating that rate decreases have declined, which is not a sign of a hard market. Also, in the 2007-2008 period, given the credit crisis and the associated exposure to directors’ and officers’ (D&O) liability for financial institutions of a number of commercial lines writers, he said it’s unclear whether insurers have underreserved. Many market observers expect a $6 billion to $10 billion reserve need for the D&O product line.
Regardless of whether the next hard market mimics the last, Angelina is convinced that the industry has learned lessons and has the tools to help it along. He noted insurers now have better data and analytics tools for price monitoring, better management of exposures, and better understanding of loss-cost trends.
Although panelists agreed that asbestos remains a prospective reserve issue, all agreed that it isn’t expected to be the shock that it once was. When asked about specific prospective reserving issues, a variety of responses surfaced. Angelina noted that few products today are as ubiquitous as asbestos, but potential problem areas include food, genetically modified crops, nanotechnology, and pharmaceuticals.
“The bigger problem is something that affects all lines of business,” added Bhagavatul. “If tort reform is put on hold, I think liability costs will rise substantially, much more than inflation–that to me is the biggest threat.”
She’s also concerned about what’s happening in 2009-2010. “There’s not going to be the underwriting that’s needed in a low interest rate environment, which won’t allow the industry to build up the capital that’s needed for any major catastrophe,” she said. “I think the capital building might not happen, as it happened after Katrina or anything like that, so that’s a scary thought.”
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