New York - While to date there exists no standard economic capital methodology in the U.S., it is becoming increasingly clear that the insurance industry needs to move in this direction. This is the conclusion of the 2006 Industry Outlook report issued by the Insurance and Actuarial Advisory Services (IAAS) practice of Ernst & Young LLP, New York. The report, released this week, addresses key life and property/casualty sector issues, including economic capital, catastrophe modeling and risk recalibration, and mergers and acquisition (M&A) activity.

The report notes European regulations, and their establishment of more common standards, as driving global insurers toward economic capital. Another key driver is competitive regulatory and rating agency developments in the U.S., including S&P's new enterprise risk management criteria.

Insurance companies that do not begin taking economic capital seriously in 2006 will pay the price in years to come, says the report.

"It is no longer a question of if, but when U.S. companies will be expected to have economic capital measurement capabilities... those who wait for U.S. standards to be set will wake up one day to find themselves behind the competition," explains Michael Hughes, principal with Ernst & Young's IAAS practice. "U.S. companies should begin planning and piloting economic capital so they are prepared for the new market reality which is getting closer and closer."

For the P/C industry, 2005 will be remembered as the year doubt was cast upon catastrophe models. However, the true fallout will occur in 2006 when the industry will be forced to determine next steps. It will be a crucial period as P/C insurers decide if they will continue to retain and manage catastrophe risk or if they will turn to capital markets which could create a significant chain reaction, notes the report.

History can offer valuable lessons as P/C insurers make their next move. In 1985/1986 commercial writers, driven by anemic results, withdrew liability capacity from the market. Unfortunately, this move trigged an unwanted market response as numerous companies chose to self insure rather than pay rising premiums, the report continues.

"In an effort to eliminate high-end liability, insurers lost attractive business," explains Chris McShea, national director for the property casualty division of Ernst & Young's IAAS practice. "If the industry is not thoughtful in its response to recent catastrophe issues, it could set off a series of events leading to premium leaving the market. Now is the time to carefully weigh the options and examine the risk/reward of potential next steps."

Although 2006 may not be a stellar year for mega-deal M&A activity, consolidation will continue to be a part of the industry landscape, predicts Ernst & Young. Less activity is expected on the P/C side, but some interesting deals are already taking shape in the life sector.

While the P/C sector has sustained considerable hurricane related losses, there are few insurers and reinsurers that will be forced to sell. Anticipated rate increases have resonated with the capital markets, leaving many companies, particularly start ups, well capitalized.

On the life side, Ernst & Young predicts a few mid to large-sized transactions; however, the real M&A action will take place around small and mid-sized deals strategically targeting closed blocks, distribution channels or specific product lines. In addition to traditional M&A activity, the report says the industry should expect to see much more capital market activity through securitizations.

"While we don't expect 2006 to be a standout year for M&A activity, consolidation will continue to be a part of the industry landscape," explains Rich DeHaan, Senior Actuarial Advisor, of Ernst & Young's IAAS practice.

Source: Business Wire

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