Improved Reserve Adequacy and ERM Critical for P&C Insurers

For the U.S. P&C industry, reserve adequacy and enterprise risk management are increasingly critical to the health of the industry, as are pricing discipline and risk management, which are putting pressure on corporate earnings.

After heavy catastrophe losses in 2011, the P&C industry appeared to be on the mend in 2012 before Superstorm Sandy, the second costliest U.S. catastrophe, hit the east coast.

“We had significant catastrophe losses, a very sluggish U.S. economy that curtailed demand for insurance products, and the low-interest rate environment continued to be at historical lows, which could not provide an offset if there were underwriting losses,” explained Anthony Diodato, A.M. Best Group VP in the “First Monday: Review and Preview 2013.”

“There was a bright spot. We still continue to see companies take that incremental rate increase that will help bring that risk and that rate to the same level, which will add value when the company’s financial strength is evaluated.”

Concerns about ratings have not much changed on a year-to-year basis, Diodato said, and pricing discipline is very important, Diodato explained, emphasizing the importance of managing to the cycle and not chasing rates down below the point of making a profit.

Reserve adequacy remains a concern for the rating company.

“From our default studies, insolvencies over the past 30, 40 years, the no. one reason for insolvencies is loss reserves. But the concern is, if there is a sudden change in inflation, that could have a significant impact on reserve development. And the reason would be is that the pricing and reserves that were set now don’t contemplate inflation. So if there is a small, mild uptick in inflation, that could have a ripple effect on the reserve development and the reserve adequacy of companies. ”

Enterprise risk management also is of increasing concern, as catastrophe losses in the United States have been higher for the past two years, attributable to Hurricane Irene and Superstorm Sandy.

“How are you treating these two significant years? Are they aberrations? Are you downplaying them or are they something you are building into your ERM process, and saying ‘this is the new norm’?” Diodato said.

Further, regulatory and political interventions also are increasingly possible. In the case of Sandy, politicians and state insurance regulators said they would prohibit the application of hurricane deductibles, which insurers must consider for the future, Diodato said.

“If you are pricing for it, and then you have to pay for something much larger because it’s being taken away from you, that’s an unforeseen risk. How are you contemplating that in your ERM practices?” Diodato said.

A.M. Best’s outlook for the P&C industry is split. For personal lines, the company has a stable outlook, as it is well capitalized, and rates are steadily increasing. In the homeowners’ space, Diodato said pricing is becoming more sophisticated, as the application of credit scoring, segmentation and other models are adapted from auto insurance for that space.

For commercial lines, however, Diodato said the story is different, as capital adequacy is not as strong and competition is driving prices below the break-even point.

“Commercial lines is more dependent on the U.S. economy. The demand for products, if its commercial auto or worker comp, is greater and we don’t see the U.S. economy changing in the near term.”

Pricing improvements in the United States’ and Bermuda reinsurance markets are not enough to offset interest rate pressures, leaving managements challenged to keep investors happy, said John Andre, Group Vice President.

“Capital management strategies are in play,” Andre said. “it’s not just about having the most capital. It’s about having the most efficient capital.”

The financial crisis since 2008, the euro zone economic crisis, the U.S. debt down grade and catastrophe events of 2011, drought and the Superstorm Sandy were effectively earnings event, Andre said and yet rating upgrades have, on the whole, improved. “This year we expect reinsurers to have an ROE of about 9 percent, that excludes capital gains or losses, and assumes a normal catastrophe year.”

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