Economy Forcing Changes in Carrier Investment Philosophy

Ratings Agencies May Need to Rethink Their Methodologies as Well

The current economic environment has produced several influences that in combination are negatively affecting, or at least stressing, property casualty insurance carriers in unique ways, says one experienced industry analyst.

Investments in financial services providers, such as banks, Fannie Mae preferreds, Fannie Mae issues and debt obligations, have long been thought of as excellent instruments in an insurance company’s investment portfolio, explained Joe Petrelli, CEO of Columbus, Ohio-based actuarial consulting and financial analysis firm, Demotech Inc. Now, uncertain conditions in the financial services sector are causing many carriers to rethink that viewpoint.

“We used to think those were excellent things to have in the portfolio,” Petrelli said. With the instability of equity markets and financial companies, however, insurers no longer “know how to value their quality in their investment portfolio.”

Additionally, the insurance industry traditionally would maintain a high quality portfolio that provided an investment income stream to augment premiums as a revenue source, Petrelli said. With the economic meltdown of 2008 that investment income stream is not as reliable as it has been in the past.

“And the third thing that I think is also interesting is even though we are in an environment where there is relatively low inflation, what is happening to the insurance industry is that that relatively low inflation is impacting their ability to increase premiums, but at the same time losses are increasing markedly,” he explained.

Still, Petrelli said the P/C industry in general remains strong. “The thing that is interesting to me is that from a count perspective, if we look at approximately 3,000 companies in the property and casualty insurance industry, from the perspective of sheer count of companies, the overwhelming majority — probably north of 85 percent of the companies — are absolutely fine, and this meltdown in the equity markets, it really isn’t hurting them,” Petrelli said.

It is the larger, more visible companies that have felt the adverse impact of the meltdown most severely. The smaller companies, regional companies, specialty companies, never invested in exotic investments or got involved in derivatives or any of the types of investments that landed other, larger firms in trouble, he said.

Avoiding Pitfalls

Petrelli says there are reasons why smaller, regional companies have been able to avoid the financial pitfalls that have beleaguered larger insurers.

No. 1 — the overwhelming majority of the smaller companies are not publicly traded, or beyond that they are mutual companies instead of stock companies. So, there was no investor focus whatsoever,” he said.

Petrelli acknowledged that many well-run publicly traded companies have weathered the current economic storm and are doing fine. As for the smaller companies, he said, they remained committed to fundamental insurance concepts, maintained the quality of their investment portfolio, watched liquidity and the adequacy of loss reserves, focused on the quality of reinsurance and kept their eyes on their business models.

Petrelli said in a soft pricing cycle companies traditionally have been able to boost their revenues through investment income and cash flow underwriting. However, in the current investment environment companies are struggling to get a decent cash flow. While expectations are that insurers will need to raise premiums to make up for investment losses, if consumers are unable or unwilling to pay more, carriers may not yet be in the position to raise prices significantly.

Petrelli also doesn’t think premiums are going to rise substantially any time soon. He said it may be the third quarter of 2010 before any significant pricing changes occur. “And it’ll probably be 2011 before things really turn the way the industry would like,” he said.

A Change in Rating Methodology

Petrelli said he hopes one outcome of the crisis in financial services will be a change in the way ratings agencies do their jobs.

“The truth of the matter is, I think one of the dilemmas we have with the downturn in the financial services industry is the sub-prime debt that had been rated triple ‘A’ by many of the rating agencies,” Petrelli said. “We’re now finding that certainly was not triple ‘A’ debt, and there were perhaps some flaws or at least optimistic assumptions in their algorithms and in their financial models. So, I would hope that the rating agencies will recalibrate the way they view debt.”

He would also like to see international insurance rating agencies focus more on fundamentals, which is Demotech’s position.

“We want good liquidity in the balance sheet. We want high quality, verifiable assets. We want loss reserves to be adequate, not just reasonable. We’d like to see high quality reinsurance, and we’d like to see companies sticking to what they know, rather than trying to expand just to make a rating agency happy.”

This story was based on an installment in the podcast series, Agency Management Done Right, hosted by Wells Publishing CEO Mitch Dunford.

Web Resource
The podcast, Agency Management Done Right, Episode 1: The Economy, may be accessed online at www.insurancejournal.tv/videos/2437/.

Topics Carriers Agencies Market