It became everyone’s favourite buzzword during the record years of 2006 and 2007. Now with falling earnings, increased competition and subprime losses, it’s time to put ERM to the test, argues Ronald Gift Mullins.

Underwriting earnings of insurers and reinsurers for the first quarter of 2008 have been less bountiful than those of the record-breaking 2007 and 2006 periods. This outcome can be attributable to increasing competitive pressure on rates and catastrophe losses, as well as the thrashing the industry took on sour subprime investments.

Normally such a situation would signal the slithering slide of the industry into its infamous cycle. Yet, a dynamic has appeared, been roundly accepted and widely heralded by the industry during the heady days of 2006 and 2007. Now as underwriting profits begin to erode, will the industry have the tenacity to continue to practice enterprise risk management (ERM)?

Mixed earnings bag

Certainly, overshadowing the modest underwriting results of this first quarter 2008 was the staggering financial and investment losses from some of the most respected and largest insurance and reinsurance companies in the world. While a few claims may result from the gigantic losses from subprime derivatives and other credit defaults, a number of re/insurance companies invested in them directly and now see the losses reflected on their bottom lines. Berkshire Hathaway recorded a loss of about $1.6bn from credit default swaps (CDSs) and long-term equity put options.

Swiss Re had a 53% decline in profits mainly from a major writedown – CHF819m – which was again related to CDSs. Last year, the world’s largest reinsurer, wrote off CHF1.2bn from embarrassing missteps in the subprime market in the US.

Munich Re’s first-quarter profit fell 19.4% compared with the period in 2007, and said it was mostly from a 46% decline in its investment income. It did confirm that its record 2007 results were bloated by nearly $1bn it reaped by disposing of real estate and equities at the time. This windfall was not matched in this year’s quarter. Munich Re reported a combined ratio of 103.8% for its reinsurance group, a two point increase from the same period a year ago.

American International Group (AIG) astounded all with its $7.81bn net loss, mainly from CDSs in the first quarter of this year. This came after it posted a loss of $5.3bn for the last quarter of 2007. AIG president and CEO Martin Sullivan said, “AIG’s results do reflect the extremely adverse external conditions affecting the spectrum of companies exposed to the US residential housing credit and capital markets… However, the underlying fundamentals of our core businesses remain solid and several performed quite well in the quarter despite the challenging environment many faced.”

Travelers reported a 11% decline in profits and a 12% drop in income from investments for the first quarter of 2008. The company reported that net premiums increased 1% to $5.19bn for the quarter. Travelers combined ratio improved to 87.6% from 89.2% for the first quarter of 2008.

Europe’s biggest insurer Allianz reported write-downs from the global financial crisis of $1.4bn in the first quarter of 2008. The markdowns stem from the insurer’s control of Dresdner Bank, which totalled about $3.9bn. Allianz said its property casualty operations turned in a strong performance with a combined ratio of 94.8% compared with 96.8% in the same period in 2007.

Bermuda’s XL Capital reported net income of $211.9m for the first quarter of 2008, compared with $549.7m in 2007. The loss was mainly due to a decrease in net income from investment affiliates of $107.1m, a net realised losses on investments of $102.3m and a decrease in underwriting profit from property and casualty operations of $52.4m.

ACE reported its property and casualty combined ratio for the quarter was 84.6% compared with 87.1% for the prior year quarter. P&C underwriting income increased 14% over the prior year quarter to $439m. “The business climate has grown more difficult globally,” says Evan Greenberg, chairman and CEO of ACE Ltd, “including the broad economy and financial markets. Ironically, the P&C market continues to grow more competitive.”

Subprime not overwhelming

Laline Carvalho, credit analyst, Standard & Poor’s, says the number of losses associated with subprime defaults that could be claimed under D&O and E&O policies is “a moderate amount, because a number of financial institutions that suffered these losses are self insured for D&O and E&O.”

The credit swaps and subprime losses have little chance of overwhelming insurers and reinsurers, says Steve Ader, director, Standard & Poor’s. “There is another problem,” he said. “Declining profits. We’re not that concerned yet. But if we see another 10% to 15% decline in 2009 we may take a more negative view. We believe insurers and reinsurers should make a profit.”

Rates have been on a slow downward slide since early in 2005. One of the most-watched pricing indexes is the ISO MarketWatch. It records renewal premiums of a composite of various commercial lines policies that have no changes in terms and conditions. The lines include commercial fire insurance, commercial allied lines, commercial auto liability, commercial auto physical damage, premises and operations liability, products liability and business owners.

MarketWatch data showed that premiums on commercial lines renewals began increasing in July 1999, and those increases gained momentum through July 2002, when they peaked at 12.9%. Subsequently, premium increases on these renewals dwindled and in March 2005 premium increases became premium decreases, with premiums on renewals declining 0.4 percent versus year-ago levels. Since then, premium decreases on renewals grew to 3.8% in September and October 2007 and changed little through December 2007, when premiums on renewals were down 3.5% versus year ago levels.

Flicker of cycle

Ader says that a flicker of a developing cycle heading downward makes ERM even more essential as market conditions turn against re/insurers. “They need to be very careful that they don’t cross that line where they are taking on more risk than what ERM allows.”

With top-line revenue hard to realise, reinsurers and insurers are more tempted to buy a greater share of the market by lowering prices. But with ERM, “managements of reinsurers and insurers are better able to access how much to pay for market share,” says Mike Murray, assistant vice president, Insurance Services Office Inc. “Without ERM, you’re flying blind against the competition. It doesn’t mean you can’t compete, but that you have your eyes open to make the right choices, and are not blindsided later. If ERM becomes more universally accepted through the industry there may be less excess of the cycles. It may have an affect on their duration.”

Putting additional emphasis on ERM, S&P intends to start incorporating ERM into its discussions with the companies it rates beginning in the third quarter of 2008, adding commentary in its reports in the fourth quarter. Scoring based on ERM will not come soon. “If we do score companies it will probably not be before the start of the second quarter of 2009,” reveals Steven Dreyer, managing director of corporate ratings for S&P. He adds that S&P will act quickly if it discovers that “something big and important” is amiss in a company’s risk management programme.

Moody’s has been developing a holistic risk management rating methodology through its Enhanced Analysis Initiative. AM Best has stated that ERM will be included as an integral part of its rating process but will not be publicised as a separate rating factor.

In an analysis of the Bermuda insurers, AM Best notes that as much as enterprise risk management is touted, “the coming years will clearly test the execution of this discipline.” It said accident-year loss reserves are deteriorating and that the sizable reserve releases of 2006 and 2007 are unsustainable.

Standard & Poor’s, in a report on P/C commercial lines, said favourable loss trends relative to pricing resulted in $6bn of commercial lines reserves releases in 2006 for the 2005 accident year. There was a similar trend in 2007 for the 2006 accident year. Will 2008 see accelerated releases?

Releasing reserves

S&P’s Carvalho sees insurance and reinsurance companies for the most part “still strong” and believes reserving is not being neglected. Yet she notes that reserves built up in 2006 and 2007 have begun to be released as sound underwriting becomes more difficult to maintain.

As the July renewal season begins, reinsurers will have to confront the problems and opportunities that have been brewing since the high profit days of 2006 and 2007. Now the judicious use of the capabilities of ERM by reinsurers will be really tried. Will companies one by one begin cutting rates to keep premium volume in the house? Will release of reserves increase, shoving some companies into reserving deficit? Will ERM save reinsurers from taking up the worst excesses of past cycles?

Of course, the ultimate test of how rigorous and faithful re/insurance companies have been to ERM standards will come when a thunderous catastrophe sweeps in, leaving billions of dollars of losses in its wake. Already, in the first quarter of 2008, the catastrophe losses hit a decade-record of $3.35bn. And the US hurricane season has only just begun.

Ronald Gift Mullins is an insurance journalist based in New York City.