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Commercial Insurance Marketplace: What to Expect in 2009 posted on Wednesday, 03 December 2008

In the fourth quarter, a lot of businesses have been working on their annual budgets for 2009. The purpose of this article is to provide information about the insurance industry from a historical perspective, as well as some educated guesses as to what companies might expect in the coming year.

By Jeffrey W. Cavignac, CPCU, ARM, RPLU, CRIS

Currently, the United States is suffering through what some say is the most challenging economy since the Great Depression. Major financial institutions that many thought were “bullet-proof” have gone out of business, been sold, or gone into partnership with the government.

Who would ever have thought, for example, that AIG would need nearly $125 billion from the government to stay in business? At the same time, the insurance industry is well into a “soft” market cycle, and is starting to feel the effects of substantially reduced pricing. Deteriorating underwriting results and lower investment returns are beginning to take their toll.

So what kind of shape is the insurance industry in? In order to understand what might happen in 2009, it helps to understand a little bit about the insurance business.

Insurance Cycles: Where We Are Now
Like many industries, the insurance industry is cyclical. However, the insurance cycle generally runs independently of other business cycles. Insurance companies make money in one of two ways: 1) underwriting profits; and 2) investment income.

An underwriting profit is achieved when losses plus all expenses are less than premiums. When you divide the former by the latter, you come up with what is called the combined ratio. A combined ratio of less than 100 percent means there is an underwriting profit, and a combined ratio of more than 100 percent means there is an underwriting loss. The industry has generated an underwriting profit in three of the last four years, but it remains to be seen if 2008 will generate an underwriting profit.

Insurance companies collect premiums and set aside reserves to pay future claims. This represents an insurance company’s policyholder surplus. The insurance industry generates investment income from the policyholders' surplus. During periods of substantial investment returns, insurance companies may be willing to underwrite at a loss because they can make up the deficit on the investment side.

Surplus is critical to understanding the economics of the insurance industry. Surplus is set aside to pay future claims, and also determines how much premium an insurance company can safely write. If the ratio of premium to surplus gets too high, the insurance company’s credit rating (as quantified by the A. M. Best Company and other rating agencies) could ultimately impair the insurance company’s ability to operate.

It is important to understand that the insurance industry is supply-driven. While demand for insurance remains relatively constant, supply fluctuates up and down. If surplus or supply goes down, rates tend to go up. Similarly, if surplus goes up, rates tend to go down. The industry’s surplus has increased approximately 85 percent since 2002, which has caused insurance pricing to go down, and in some cases, to go down dramatically.

Finally, it is important to realize that the insurance industry competes with every other industry for capital. In order to attract investment dollars, the insurance industry has to demonstrate an acceptable return on equity. Most investors seek approximately 15 percent. Historically, the insurance industry has underperformed this objective; however, results have improved dramatically in recent years, with 2006 being one of the industry’s best years ever.

The industry’s operating results, however, have begun to deteriorate. Premiums actually decreased in 2007, and are supposed to decrease further in 2008. This rarely happens in the insurance business.

At the same time, combined ratios are climbing. Although 2007 should be a positive year, 2008 may or may not generate an underwriting profit. Preliminary indications put the overall combined ratio for the first half of 2008 at 102.1 percent. This is a result of continued soft pricing, challenging market conditions, unusually high catastrophic losses, and significant underwriting losses.

Pre-tax operating income has also declined. Net income after taxes for the first six months of 2008 fell more than 50 percent from what was reported in 2007. This is attributable to the deteriorating underwriting results as well as declining investment returns.

Finally, return on equity, after peaking in 2006 at 13.9 percent, dropped to 12.1 percent in 2007, and is estimated to drop to 8.7 percent in 2008.

What Effect Will This Have on Rates?
For the last five years, rates have decreased significantly on almost all lines of coverage, with the exception of coverage for coastal properties on the Gulf Coast and in Florida as well as other catastrophic-type lines of coverage, such as earthquake.

Workers compensation rates are a major factor in the recent rate decreases. In California, for example, comp rates peaked in the second half of 2003. The average rate per $100 of payroll was $6.46. Rates hit bottom in the second six months of 2007, dropping nearly 62 percent. Rates flattened out during the first six months of 2008, and will probably increase in 2009.

What Can You Expect in 2009?
In general, the insurance industry remains in good shape. The industry remains profitable and industry surplus is near all-time highs.

The trends, however, are not positive. The ultimate impact of what will happen with AIG remains to be seen. If for some reason AIG were to lose its “A” Best’s rating, billions of dollars of business would be out on the open market, and this alone could dramatically change the insurance marketplace.

Because of this and other factors, Standard & Poor’s Ratings Services revised its outlook on the U.S. commercial lines property & casualty insurance sector to negative from stable. S&P was concerned over two issues: (1) the ongoing decline in pricing for commercial lines; and (2) decreases in investment income.

Fitch Ratings feels the same way. It believes that the market has crossed a tipping point in the underwriting cycle, knowing that industry returns on capital for current accident year business has slipped to inadequate levels. Fitch anticipates that the marketplace will deteriorate further.

Still, 2009 should be a positive year for insurance buyers. Although the industry is trending down, strong market capacity and competitive factors are still decreasing pricing in many areas.

Professional Liability
Rates have trended down significantly for architects, engineers, accountants, attorneys, and other professionals over the last five years. We have now reached a point where underwriters are trying to retain their existing rates. In some cases, they are trying to charge more, often with little success.

Despite the soft market, these programs are carefully underwritten. It is imperative that your annual application for coverage accurately reflects the attributes of your firm, and most importantly, the positive attributes or the steps you take to effectively manage your risk.

Summary
Insurance costs are only one element in your “Total Cost of Risk.” The total cost of risk is what an organization pays to identify risk, figure out ways to manage that risk, as well as the cost to transfer the risk (usually to an insurance company). In the long run, the only way to lower your total cost of risk is to lower the underlying losses that drive those costs. Whether or not we are in a hard or a soft market cycle, a well-run company will continue to look for ways to effectively lower the frequency and severity of their loss exposures. When rates are decreasing, it’s easy to lose focus on your risk management efforts. However, this is not the time to stop investing in risk control programs.

Recognize as well that this article is a general overview of the insurance industry. These projections are based on assumptions that could change. To more accurately estimate your insurance costs in 2009, we strongly recommend that you discuss your specific situation with your insurance broker and insurance underwriters.

Jeff Cavignac, CPCU, ARM, RPLU, CRIS, is President and Principal of Cavignac & Associates, a leading commercial insurance brokerage firm providing a broad range of insurance and expertise to design and construction firms, law firms, real estate-related entities, manufacturing companies and the general business community. The firm employs a staff of 40 at its office headquarters located at 450 B Street, Suite 1800, San Diego, California 92101. More information about the company can be found on the web at www.cavignac.com.

Posted by Jeff Cavignac