Capital and the Insurance Industry-A Love/Hate Relationship

Capital fuels the insurance industry. It constitutes the reserves, pays the claims and provides the investment funds necessary to make a profit (excepting an aberration like 2001). However, the total amount of capital invested at anytime constantly changes—sometimes there’s too little, frequently there’s too much.

In a classic example of supply and demand, less capital increases the cost for what is available, raising premiums, and allowing tighter control of underwriting risks. This encourages the flow of capital into the industry, which needs to be put to work, depressing premiums and loosening underwriting standards in an effort to attract business.

As previously reported (Insurance Journal-Texas/South Central; Vol. 8, No. 9; May 13, 2002) the first quarter was a very good one, but according to Michael R. Murray, asst. vice president for financial analysis with the Insurance Services Office (ISO), “the rate increases are already slowing down.”

One of the main reasons—the huge influx of capital into the insurance and reinsurance markets. According to reports the ISO has seen, which concern mainly U.S. and Canadian companies, $11.6 billion came into the industry last year. The overall figure worldwide is estimated at around $24 billion, with additional commitments estimated at around $9 billion.

“The new capital that’s come in amounts to more than the losses which have actually been paid out in 2001 on 9/11 [claims],” said Murray. He cautioned, however, that “there may be another $15 billion that will hit the U.S. insurance industry.” The ISO uses a figure of $50 billion as a working estimate of the total worldwide losses that the industry will ultimately pay out.

It will be years before all of the WTC and related claims are fully liquidated. Most of the new capital, however is here right now. Over capacity poses one potential problem; investment returns pose another.

Paul Walther, the head of Reinsurance Directions in Heathrow, Fla., calls it “an accordion,” describing the historic pattern of the reinsurance market to expand and contract. “The cycle always turns,” said Murray. “It goes up, stays flat, then turns down.”

“How will they commit it [the new capacity] and where?” he asked. “If they only keep on writing the usual stuff, it’ll result in over capacity in some areas, and not enough in others.”

The problem concerning the returns insurance companies make on their investments is potentially as serious. Interest rates are at an all time low; the typical yield on a short term Treasury bill is around 1.16 percent. The yield on 10 year T-bills dropped to an all time low of around 4.2 percent in November, and has slowly risen to approximately 5.3 percent. Money market funds pay around 2 percent, and while many debt securities provide greater yields, the higher they go the riskier they get.

As Robert Hartwig, the Insurance Information Institute’s senior vice president and chief economist noted (Insurance Journal-Texas/South Central; Vol. 8, No. 8; April 29, 2002), the insurance industry saw a 58 percent drop in realized capital gains last year, and a 9 percent drop in investment income.

“Overall capital losses in 2001 [which include unrealized gains and losses] were $10.8 billion,” said Murray, “this erased more surplus than the losses actually paid out last year on 9/11.” He went on to indicate that so far this year, despite some rallies, “everything is down, and personally I don’t see any turnaround indications.” As a result a great deal of money, newly invested capital and all those premium payments, needs to be put to work in what is at best a tepid, if not in fact a chilly, investment climate.

As Berkshire Hathaway’s legendary Warren Buffet explained in his latest letter to the company’s shareholders, an insurance company earns money by investing the “float,” the funds it holds against future claims. It’s successful if it earns more money than the cost of that float—the extent to which investment returns exceed underwriting losses. “An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds,” wrote Buffett. “But the business is a lemon if its cost of float is higher than market rates for money.”

Buffet was explaining the huge increase in float cost to Berkshire’s insurance companies, mainly General Re, due to the attacks of Sept. 11, but his reasoning applies across the board, as he himself recognized. “Some years back, float costing say 4 percent was tolerable because government bonds yielded twice as much,” wrote Buffett, “and stocks prospectively offered still loftier returns. Today, fat returns are nowhere to be found (at least we can’t find them) and short-term funds earn less than 2 percent.”

If someone as savvy as Buffett sees a problem making money from investments, then one exists, and the more capital there is, the bigger the problem gets.

One way to combat the problem, and one urged by many companies, including Berkshire, is to stop making underwriting losses. The calls for more careful risk analysis, higher standards, and for refusing to write policies simply to gain market share, do seem to be having some effect, but for how long? Plus, such strategies may look risk free and reasonably priced, but then along comes asbestos or toxic mold or a hundred-year storm and the claims skyrocket.

Prior experience may offer the only guide. “The history of hard markets, for both brokers and insurers,” said Murray, “is that every time it looks poised to make gains, more capital comes in;” with the inevitable results.

Topics Market