The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Warren Buffett in 2001 famously said: "You only find out who is swimming naked when the tide goes out"

The sage-like wisdom was penned in a Berkshire Hathaway's annual report following 9/11.

Then, of course, the financial health of the (re)insurance industry was under serious threat.
After wallowing for several years in the depths of the soft market, the double whammy of a large cat loss and falling investment markets left the capital bases of many (re)insurers increasingly vulnerable.

And in the years that followed, the billions of dollars pumped back into the industry's reserve pot - not to mention company failures and a slew of ratings downgrades - exposed just how naked some had been swimming through the dire underwriting years of 1998-2002.

With the soft market tide once again threatening to leave underwriters high and dry, IQ wondered what signs might point to naked swimmers in the (re)insurance sector this time around.

History lesson
History tells us that the relationship between reserve deficiencies, company failures and the transition from a soft market to a hard market holds true.

In its annual survey of 2009 insurer financial impairments in the US property and casualty (P&C) insurance sector, ratings agency AM Best notes that the majority resulted from "under-reserving, under-pricing and too-rapid growth".

That was in a year when the number of impairments hit 18 - a figure expected to rise as state regulators exhaust other avenues to rescue insurers teetering on the brink in 2009 - compared to an all-time low of five in 2007.

The agency suggests that insurance failures peak "at, or close to, declines in operating income that typica lly force the end of soft markets".

AM Best notes that deficient loss reserve s "persist as the main cause of impairments", leading to significant increases in company failures shortly after soft markets end.

Health check
So what is the health of P&C reserves in 2010?

At face value, the evidence suggests (re)insurers are continuing to mine a rich seam of redundant reserves.

Since the short sharp uplift in pricing that drew the Class of 2005 to Bermuda following Hurricane Katrina, property casualty (re)insurers have enjoyed four relatively benign years for claims, theoretically allowing accident year reserves to steadily build up.

A glut of capacity chasing limited underwriting opportunities had its inevitable effect, sending pricing across all lines back on a downward trajectory.

Through that period natural catastrophe events such as Hurricane Ike and the Chile earthquake have tipped the balance in directly affected sectors, but even the asset damage inflicted by the financial crisis could not correct the overall softening trend.

However, despite the falling prices and heavy cat losses in the first half of 2010, (re)insurers' combined ratios have broadly held up - with a large helping hand from reserve releases.

Research by The Insurance Insider reveals the extent to which Bermudian (re)insurers have relied upon reserves to support their underwriting results.

Second quarter figures suggested that, in a period of significant claims activity, 26.2 percent of operating profits were attributable to prior-year reserve releases - up from 21.1 percent in Q2 2009 (see figure 1).

Click to enlarge Industry commentator V J Dowling describes the phenomenon as the "cheating phase" of the pricing cycle - but it looks as if the cheating opportunities may soon run-out.

Atlantic Equities analyst Alan Devlin warned in a research note that reserve releases in the current cycle peaked in 2009.

"We expect underperformance over the next two years as the reserve releases decline, and lower EPS [earnings per share], RoE [return on equity] and book value growth," he predicted.

Devlin tracked reserve development across the peaks and troughs of the pricing cycle, observing that at the start of the last true soft market, reserve releases peaked in 1997 and began to decline in 1998-1999 (see figure 2).

The P&C sector then underperformed the S&P500 by 35 percent and 46 percent in 1998 and 1999 respectively.

Click to enlarge Our research on the Bermudian market suggests that, for the second quarter of 2010 at least, reserve releases were down on the prior-year period. But is there any evidence that reported reserve redundancies are about to tip towards reserve deficiencies as the soft market continues to drag on?

The latest health check from Guy Carpenter on the development of reserves in the US P&C market picks up clear symptoms of possible rating and reserving inadequacy.

The research tracks the progress of reserves from the past 10 accident underwriting years in relation to their initial loss picks.

It reveals that when an accident year's initial loss ratio moves up into the 70-75 percent range, the underlying result tends to deteriorate by a further 5-10 points as it matures.

Years with a lower initial loss pick - in the 60-65 percent bracket - tend to actually improve further over time, with a 5-10 point swing in the other direction.

The data appears to suggest that looser reserving in the soft market squeeze is eventually compensated for as (re)insurers salt away more reserves when the market turns hard.

1999-2001 eventually caused billions in reserve charges in the first half of the 2000s, for example, experienced significantly higher initial loss picks than those years that eventually yielded reserve releases.

If the rule holds true, then the evidence of the last two accident years points to a shift from reserve releases to reserve deficiencies in the near future.

As Figure 3 demonstrates, the initial accident year loss ratio picked up noticeably in 2008 on US P&C business. That continued into last year, with the initial loss pick coming in at between 70 and 75 percent - much higher than the decade low of 60 percent in 2007.

Click to enlarge If the pattern repeats, then we would expect 2009 to deteriorate by a further 5 percentage points from its 70 percent-plus starting point.

Although Guy Carpenter observed the uptick in the 2008 loss ratio doesn't necessarily point to a deficiency in industry reserves, "it may suggest that more recent accident years may be less generously reserved".

The view was supported by industry veteran Tony Markel, speaking at The Insurance Insider's InsiderScope New York event earlier this year.

The Markel Corp vice chairman said there is a "real reserve deficiency" industry-wide that is not being recognised. "The difference between the combined ratio that the industry is posting and the reality in rate reductions over the last five-year period is hard to rationalise." The industry had been "robbing Peter in the older years without paying Paul in the current years."

If that signals a tipping point in reserve adequacy, is there actually solid proof of under-reserving in the industry that could presage a spate of corporate collapses and a long-awaited turn in the cycle?

With the industry's capital base still looking in rude health - share buyback activity accelerated in the second quarter to record levels - it is difficult to foresee a near-term change in the market.

The run down of reserves could turn to a torrent if underwriting margins continue to be pressed by rates falls as the bottom line is deprived of healthy investment returns.

Sector-specific examples already demonstrate the paucity of reserves in some areas.

The tough trading environment for UK motor was neon-highlighted this summer with dramatically deteriorating losses on Australian insurer IAG's Equity Red Star business.

The Lloyd's motor underwriter warned that losses could hit £330mn on the 2008 and 2009 years of account - just three months after strengthening reserves by £210mn to protect itself against the mounting deficit.

Rival Lloyd's motor syndicate KGM also warned of a significant deterioration in forecast losses on the same underwriting years.

Meanwhile, the long-tail liability losses reared their head as US insurer Hartford upped its asbestos reserves by $169mn before tax, after an annual survey into the exposure revealed "increases in claim severity and expense".

Allianz's US P&C subsidiary Fireman's Fund also increased its asbestos and environmental risk reserves with a $301mn charge.

A recent UK study by the Asbestos Working Party more than doubled its estimates for asbestos-related claims in the 2009-2050 period to $11bn.

It is a moot point whether the timing of recent reserve strengthening is linked with the erosion of the buffer across other lines that would otherwise absorb deterioration.

Uncomfortable
But it is clear that the cushion that had offered (re)insurers wriggle room around the setting of reserves across their business is not as comfy as it once was.

There are also examples of prudent reserving. Axis Capital, for instance, was able to put an end to speculation over its lumpy trade credit and political risk exposure to Blue City as it settled for up to $399mn within its previously established loss reserves.

A bullish sign of (re)insurance loss ratio health could be read from research by Oriel Securities. Analyst Tom Dorner noted that four out of five Lloyd's (re)insurers that had reported by mid-August posted attritional loss ratios that had fallen by more than 10 percent compared to the first half of 2009.

"On average attritional loss ratios improved from 53.0 percent to 47.5 percent in H1 2010, suggesting that the underlying profitability remains robust (although future price declines will put pressure on this in time)."

However, a more pessimistic counter-argument might support the theory that reported attritional loss ratios are only lower because (re)insurers are putting aside less for current accident year exposures.

As dipping into prior-year "redundant" reserves can boost combined ratios, under-reserving on an accident year basis in the knowledge that a turn in the market could refill the well may also prove tempting in difficult underwriting and investment conditions.

By the same token, in hard markets (re)insurers may over-reserve on attritional losses knowing that the buffer will come in handy when pricing softens and margins are squeezed.

It is difficult to establish whether under-reserving and over-releasing in the P&C sector is generic in the current soft market.

But it is clear that the conflicting dynamics of combined ratios continuing to hold up while underlying underwriting profitability is strangled by falling rates and heavy cat losses cannot be sustained.

And with the added pressure on profits exerted by sluggish investment returns, the tide might be going out quicker this time.

At this stage of the cycle, everything points to reserve releases drying up. They haven't yet but when they do, the turning tide could leave red faces and naked butts on the sand.