U.S. Insurance Market within
a Global Marketplace
CAS Annual Meeting, San Francisco
November 13, 2006
Todd R. Bault, FCAS
Senior Analyst
Non-Life Insurance
Agenda
 Market update: When will the skeptics be right?
 Pricing down, but what else is new?
 Look at reserves, not pricing
 Does the cycle influence loss trend?
 Thoughts on the global insurance marketplace
 Catastrophe pricing and capital usage: Confusion reigns
 Securitization and capital markets: Baby steps
 Capital flight to tax-advantaged locales: Lloyd’s goes to Hamilton
 M&A: Europe Yea, US Nay
 Q&A
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Warning
 I will not discuss any publicly-traded insurance companies
 I’ll blab all day about non-public companies and the industry
 Please frame questions generically where possible!
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Market update: When will the skeptics be right?
 Currently in the midst of a property cycle
 Driven by increased US Gulf wind frequency in 2004-05
 ALL peak catastrophe exposures have gone up in price (e.g.
Northeast wind, earthquake)
 Abnormally low cats this year likely mark the peak of the cycle
 All other major lines profitable but softening
 This has been happening since 2004—not a new issue
 Loss trends cyclically low and helping to sustain profits
 Loss reserve adequacy continues to improve
 Redundancies on 2003-06 offsetting small deficiencies in late 90s
 Corresponds to early 90s behavior—further improvement likely
but smaller in magnitude
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Market update: When will the skeptics be right?
 May be nearing the point where the market becomes generally soft
 First need most pricing declining (already there)
 Next need loss trends to increase (starting to occur)
 Finally need reserve releases (2-3 years from now)
 This set of conditions corresponds to 1995-97, prior to late 90s
soft market
 Current market discipline not unprecedented (e.g. 1989-94)
 Until trends and reserves deteriorate, results could remain strong
 We call this the “post cycle”: the period after a hard market where
growth is low but profits stay strong
 Coincident with low pricing, low loss trends, and strengthening
loss reserves
 Stock performance tends to be good in the post cycle: stocks are
cheap but grow their book value (but not premium or earnings)
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Pricing down, but what else is new?
Estimated price changes for select commercial lines, 1999-2006
50%
40%
30%
20%
10%
0%
-10%
Property
Casualty
2006-3
2006-2
2006-1
2005-4
2005-3
2005-2
2005-1
2004-4
2004-3
2004-2
2004-1
2003-4
2003-3
2003-2
2003-1
2002-4
2002-3
2002-2
2002-1
2001-4
2001-3
2001-2
2001-1
2000-4
2000-3
2000-2
2000-1
1999-4
-20%
Work Comp
Sources: CIAB, Bernstein analysis
 Pricing is down in most lines but Property, and even this may be fading
 But this has generally been true since 2004 (circled area)
 Ex-catastrophe industry profits are at record levels for 2004-06
 So why the apparent disconnect?
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Loss trends down even more than pricing
Estimated price changes and loss trends, 2000-2006
20001
20002
20003
20004
20011
20012
20013
20014
20021
20022
20023
20024
20031
20032
20033
20034
20041
20042
20043
20044
20051
20052
20053
20054
20061
20062
Estimated price change
Auto
Liability
Property
10%
6%
5%
14%
7%
9%
17%
7%
13%
19%
8%
17%
21%
11%
19%
23%
13%
23%
23%
15%
25%
23%
17%
29%
23%
18%
33%
22%
21%
35%
22%
23%
35%
21%
22%
31%
19%
20%
25%
17%
17%
18%
14%
14%
12%
11%
11%
7%
8%
8%
2%
5%
5%
-2%
3%
2%
-5%
1%
0%
-7%
-1%
-3%
-9%
-3%
-5%
-10%
-5%
-6%
-11%
-5%
-7%
-10%
-5%
-7%
-7%
-5%
-6%
-2%
Sources: CIAB, ISO, Bernstein analysis
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Estimated loss trend
Auto
Liability
Property
2%
2%
8%
5%
1%
17%
8%
4%
10%
8%
6%
-5%
-1%
5%
-4%
-9%
4%
-14%
-6%
1%
-11%
-2%
-2%
-14%
-2%
-6%
-17%
-4%
-9%
-9%
-3%
-11%
-17%
-2%
-14%
-17%
-4%
-12%
-12%
0%
-10%
-21%
2%
-13%
-12%
5%
-15%
-7%
9%
-16%
-7%
10%
-16%
7%
11%
-5%
2%
10%
8%
2%
9%
9%
-1%
10%
10%
-7%
10%
-1%
-3%
11%
-3%
-3%
9%
-3%
-3%
7%
-3%
-1%
The disconnect is loss
trends, which have
been negative since
the 2001-03 cycle
 Most of this is
driven through
frequency
 This appears to
have happened in
the past (e.g.
early 90s)
 Loss trends are
much less
carefully
monitored outside
the industry, thus
the disconnect
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Look at reserves, not pricing
20%
100%
10%
80%
Reserve adequacy
0%
60%
-10%
40%
-20%
20%
-30%
0%
-40%
-20%
-50%
Adequacy/surplus excl. old years
2007E
2006E
2005E
2004E
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
-60%
1983
-70%
1982
-40%
1981
-60%
Cumulative relative stock performance
Industry reserve adequacy vs. insurance stock outperformance, 1981-2007E
Relative performance
Sources: Best’s, ISO, Highline Data via NAIC filings, Bernstein analysis
 Changes in reserve adequacy a much better leading indicator for cycle
 Reserve strengthening coincident with market improvements
 Reserve releases leads soft market by 2-3 years
 Verified in academic work examining balance sheet accruals and stock
performance
 Favorable accruals (e.g. reserve releases) signal underperformance
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Does the cycle influence loss trend?
Relationship of price increases to future frequency changes, property (left) and liability (right)
40%
25%
35%
20%
25%
Price C h an g e
P ric e C h a n g e
30%
20%
15%
10%
5%
y = - 1 .5 1 x - 0 .0 3
R 2 = 0 .8 9
15%
10%
5%
0%
-5%
-10%
-30%
-20%
-10%
0%
Fr e q u e n c y C h a n g e ( 1 Y r L a g )
10%
0%
-25%
y = - 1.04 x + 0.00
R 2 = 0.89
-20%
-15%
-10%
-5%
0%
Fr e q u e n cy C h an g e (1 Yr L ag )
Sources: CIAB, ISO, Bernstein analysis
 Past losses influence future pricing, but does past pricing influence future losses?
 It seems to, through claims frequency: frequency declines after price increases (data above
1999-2005)
 Theory: Exposure cuts after a hard market (“terms & conditions”) reduces claim counts but is
not captured fully in exposure bases
 Phenomenon exists in every line we can measure (from personal auto to D&O), and appears
global (comment from an Australian CEO)
 This result needs more testing, with better data than I have!
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Global issues
 Catastrophe pricing and capital usage
 When US property reinsurance pricing hardened, many predicted
Europe to follow
 Reasons: 1) inadequate price 2) capital rationing
 Argument for 2): reinsurers will deploy capital towards betterpriced risks and pull it away from worse-price risks
 Capital rationing has not come to pass this cycle
 Theory: insurance market doesn’t ration capital, it prices risk
 Regulators ration capital, but market is used to this
 Capital “allocations” are contingent and notional
 No hard money is flowing anywhere, unlike the stock market
 Market needs either an event or balance sheet shock to begin
rationing capital
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Global issues
Capital inflows vs. industry premium growth, 1985-2005
Hard
Post-cycle
Hard
Post
Soft
Hard
Post
3.5%
25%
3.0%
20%
Inflows/surplus
2.0%
1.5%
15%
Northridge
earthquake
Hurricane
Andrew
1.0%
9/11
attacks
0.5%
10%
0.0%
-0.5%
Premium growth
2.5%
5%
-1.0%
Smoothed capital inflows
2004
2003
2003
2002
2001
2000
2000
1999
1998
1997
1997
1996
1995
1994
1994
1993
1992
1991
1991
1990
1989
1988
1988
1987
1986
1985
0%
1985
-1.5%
Premium growth
Sources: ISO, Bernstein analysis
 In fact, capital inflows signal price increases in insurance
 Chart is total US industry, where premium is a reasonable pricing proxy
 This surprises many investors, who assume capital flowing in dampens
prices
 But insurers only ask for capital in the face of potential pricing strength
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Global issues
 Securitization and capital markets: Baby steps
 Securitization in insurance still disappointing despite hype
For example, cat bond market on its way to its biggest year
ever, yet is still less than 2% of world reinsurance capacity
Compare to credit derivatives (which started about the same
time as cat bonds in the mid-90s), which are now many times
the size of the global reinsurance market (by limit)
 Why the failure? Basis risk is shunned by capital markets
No way to hedge except with true reinsurance
Parametric bonds simply push basis risk onto end user
 Contingent capital may be the better way forward
Design products to provide lump of dollars when most needed
ILWs do this, as do sidecars (private reinsurers)—these and
other product may replace the traditional retro market
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Global issues
 Capital flight to tax-advantaged locales: Lloyd’s goes to Hamilton
 Despite vast improvement in Lloyd’s underwriting, syndicates
continue to move to tax-advantaged locales
 Function of the global marketplace more than Lloyd’s
 Prediction: Bermuda will lose future influence simply because other
regions will offer comparable advantages
For example, Lloyd’s lobbying FSA for tax exemption
 M&A: Europe Yea, US Nay
 Discussions of insurance M&A all over Europe, but with no followthrough in the US
 Seems driven by standard arguments of scale economies, etc.
 Ignores US state regulation, which conspires to keep industry
fragmented
 Need Federal regulation or a much softer market for US M&A
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