SEE THE STORM BEFORE IT’S COMING
Evaluating the strength of an insurance company
INSURANCE
• Insurers’ do not pose the a systemic risk like some
banking activities do.
• Insurers do not rely on wholesale market funding for
liquidity. They fund themselves through premiums, with
long term capital to support risk taking positions.
• Without insurance, no one could afford to take the risks
necessary to grow a healthy economy.
Cyclical Industry
• Soft Market: where underwriting is less stringent so it's easier
to obtain coverage, there's more competition between
companies so the rates drop and it is easier to obtain the
coverage so overall, the underwriting standards go down.
• Often during periods of soft insurance markets a lot of claims
are filed causing companies to raise underwriting
requirements, causing rates to go up, and that would lead to a
hard insurance market.
U.S. P/C Insolvencies vs. Combined Ratio
1971-2002
54 companies went insolvent in 1985, peaked in 1992 with 63
insolvencies, started to peak again in 2002 with 43 insolvencies.
70
140
Insolvencies
Combined Ratio
60
130
50
120
40
110
30
100
20
90
10
80
0
70
1971
1976
1981
1986
1991
1996
2001
Source: A.M.Best Co. Special Report “P/C Industry – 2001 Insolvencies”, June 18, 2002
Insurance Industry Stats:
• 2001 to 2005 Hard Market - Industry took lots of rate
• 2006 to 2010 Soft Market - Lots of reserve releases
• There have been 550 Property and Casualty Failures since
1970, total paid out – $26.8 billion.
• Combined Ratio of 100 produced an Industry ROE of 1979 =
16% , 2005 = 10% , 2009 = 7%
• PRESSURE = less investment income, more
catastrophic claims, litigious society, stressed
economy, smaller premiums.
Financial Strength Matters
AGENDA
• Key measurements for assessing insurer
financial strength
• Using financial ratings
• Key measurements for assessing the overall
health of the P&C insurance industry
Stressors for Troubled Companies
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Catastrophes
Rapid Expansion
Significant Change
Reinsurance Failure
Alleged Fraud
Inadequate Pricing/Reserve
Affiliate Problems
Investment Problems/Overstatement of Assets
Underlying Cause- Internal
• Management risk
• Internal governance and control risk
• Controller and group risk
Underlying Cause - External
• Economic cycle and condition risk
• Social, technical, demographic, political, legal,
tax, etc. risk
• Market competition risk
• Catastrophe or extreme event risk
Primary Causes of P&C Impairments
(1969 to 2008)
Alleged Fraud
Catastrophe Losses
Reinsurance Failure
Deficient Loss Reserves
Rapid Growth
Investment
Problems/Overstates Assets
Miscellaneous
Impairment of Affiliate
*A.M Best 2009 Guide to Understanding Insurance Ratings
Significant Change in
Business
AIG Has $4.1 Billion Cost on Inadequate
Reserves at Property-Casualty Unit
• February 9, 2010: American International Group Inc. said higherthan-forecast claims costs cut fourth-quarter profit by $4.1 billion,
and $2 billion previously designated to repay its bailout will be used
to bolster the property-casualty unit. The insurer reached an
agreement with the U.S. Treasury Department permitting the
company to keep $2 billion of proceeds from the sale of Star Life
Insurance Co. and Edison Life Insurance Co., New York-based AIG
said today in a statement. Funds will be used by the Chartis
property-casualty unit for losses tied to coverage including workers’
compensation and asbestos liability. AIG is adding to reserves, a
sign that it underestimated the cost of claims, while rivals including
Travelers Cos. have been taking profits after determining they had
set aside more funds than necessary.
• Two types of reserves: Case and IBNR
Primary Causes of Life/Health Impairments
(1976 to 2008)
Significant Change in
Business
Alleged Fraud
Miscellaneous
Investment Problems
Rapid Growth
Reinsurance Failure
Inadequate Pricing
Affiliate Problems
Recent Cases
• Credit Crisis of 2008
– $180 billion in government funding for AIG
• Hurricane Katrina
– Insured losses = 47.4 billion
• Hurricane Ike
– Insured losses = 12.1 billion
*Look for symptoms before it is too late
Measuring the Financial Health of
An Insurance Company
• An insurance policy is only as secure as the
company that issues it
• There are qualitative and quantitative measures
that are important for testing the health of an
insurance company
Profitability Test
• Combined Ratio (after policyholder dividends)
– Loss and LAE Ratio – Loss and Loss Adjustments/Net
premiums earned
– Underwriting Expense Ratio- Commissions and U/W
Expenses/Net premiums earned
– Policyholder Dividend Ratio- policyholder dividend/net
premiums earned
• Reserves are not part the loss ratio until paid.
• HO are short tailed so need to run a low 86% c/r.
• Auto have long tails and can run at 95% c/r.
Profitability Test
**From a profit perspective, the industry experienced an underwriting profit in
three of the last 10 years (2004, 2006, and 2007). Prior to 2004, the property and
casualty market did not produce a combined ratio below 100% since 1978.
Leverage Test
• Underwriting Leverage
– Current premium writings
– Reliance on reinsurance
– Reserves
• Financial Leverage
• Asset Leverage
– Asset quality
– Diversification
– Liquidity
Operational Performance Test
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Underwriting performance
Investment income
Capital gains/losses
Total operating earnings
Qualitative Test
• Internal company risk management
• Business profile
• Quality of management
Simulation Gives Us A New Measure Of Risk
The probability of a decline in underwriting profits (Value-at-Risk) is
a useful risk measure.
Mean
20% probability of a
30% or greater
decline in
underwriting profit
-70%
-30%
+25% (Mean)
% Change in Underwriting Profit
+50%
Using Financial Ratings
• Financial strength ratings:
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A.M. Best
Standard & Poor’s
Moody’s Investor Services
Fitch Ratings
A.M. Best
• Financial strength ratings
– An independent opinion of an insurer’s financial
strength and ability to meet its ongoing insurance
policy and contract obligations
• Based on a comprehensive quantitative and
qualitative evaluation of a company’s:
– Balance sheet strength
– Operating performance; and,
– Business profile
Best’s Financial Strength Ratings
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A++, A+
A, AB++, B+
B, BC++, C+
D
E
F
Superior
Excellent
Good
Fair
Marginal
Poor
Regulatory Supervision
In Liquidation
Secure
Vulnerable
(3% of Insurance Co’s are A++, 25% A+, 50% A or A-)
(Independent agents do not represent anything less than B+)
Standard & Poor’s
• S&P Insurer Financial Strength Rating is a
current opinion of the financial security
characteristics of an insurance organization with
respect to its ability to pay under its insurance
policies and contracts in accordance with their
terms.
S&P Financial Strength Ratings
Highly Likely to Meet Financial Commitments
Extremely Strong
AAA
Very Strong
AA
Strong
A
Good
BBB
Vulnerable
Marginal
BB
Weak
B
Regulation and Oversight
• Credit rating agencies
– SEC
– IOSCO
– NAIC
• Insurance Companies
– State insurance departments
– State guaranty association
– Federal Insurance Office (FIO):
• Lack of information source or knowledge base (evident after 9/11
and Katrina)
The Property & Casualty Industry
2008 Results
• $450 billion in net premiums
written
• $1.5 trillion in assets
• $480 billion in policyholders’
surplus
Source: A.M. Best “U.S. Property/Casualty – 2008 Financial Review (4/13/2009)
1994-2007 U.S. Combined Ratio –
Home and Auto, Industry
120%
110%
100%
109.9%
104.5% 103.5%
104.9%
102.7%
110.9%
104.5%
105.3%
96.4%
97.6%
99.8%
98.4%
90%
94.3%
92.0%
80%
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
70%
Industry
1994-2006 U.S. Net W.P. Growth –
Home and Auto, Industry
Industry
CAGR
1994-2006
CPI: 10.3%
PL Industry: 5.1%
15 .0 %
10.1%
10 .0 %
5.7% 5.5%
5.7%
5.6%
5 .0 %
7.3%
4.1%
6.6%
2.0%
1.8%
0 .0 %
19 9 4
19 9 5
19 9 6
19 9 7
19 9 8
19 9 9
9.5%
2000
2001
Industry
2.6%
2002
2003
2004
2005
2.0%
2006
Strength of Recent Hard Markets by Real
NWP Growth
25%
20%
1975-78
1985-87
2001-03
Real NWP Growth During
Past 3 Hard Markets
1975-78: 8.6%
15%
1985-87: 14.5%
10%
2001-03: 9.1%
5%
0%
-5%
Current $
Real $
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
-10%
Note: Shaded areas denote hard market periods. Source: A.M. Best, Insurance Information Institute
Too Big to Fail?
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Stick to what you know
Insurance ratings can be misleading
Don’t chase extraordinary results
Risk Management and U/W Profit is key
When things go badly, they do so quickly
Some risks cannot be avoided
Affiliated businesses and distribution channels
Expect more Federal regulation of insurance
Avoid the “cheating phase” by posting adequate
reserves which in turn supports accurate rates.
2011 Fitch Outlook
• .9% Growth
• Flat Investment Income
• 103 Combined
• Net Income fall by 30%
• Key to Success is Risk Selection – Underwriting
profit is a must.
What Writing Company are you in?