Global Reinsurance recently hosted a roundtable lunch at the College of Insurance in New York City on the subject of financial services deregulation in the United States. Our US correspondent Phil Zinkewicz was in conversation with Richard H. Bernero, vice president, Bankers Trust; Dennis R. Connolly, managing director, J&H Marsh & McLennan; Joseph M. Fedor, executive vice president and director, US Re Corporation; Brian S. Murphy, senior vice president, global catastrophe reinsurance manager, Zurich Reinsurance (North America) Inc.; and Donald S. Watson, director, reinsurance ratings, Standard & Poor's.
Phil Zinkewicz: There are some observers of the financial services industry who are concerned that financial services deregulation in the United States will result in a "land of giants," with smaller companies - whether they are in insurance, banking or securities - falling by the wayside. What will be the role of the smaller business entrepreneur in the new financial services scenario?
Dennis Connolly: Speaking for a broker that has just merged twice in the past two years, there will be more merger activity, although there is limited room for further mergers . . . I think we are at the end where the future is rather hard to predict. How things will shake out is difficult to see. The European/Eastern bloc and Asian crises make the future questionable, so I think it is very hard to predict, but I think that there probably will be a period of more mergers.
Brian Murphy: I certainly agree with your comments, Dennis, in that not only is there a potential for further consolidation, but also, when you consider that we are all re-examining the ways that we do business, we may see a situation where many of the current players may well be absorbed by other entities. No one has a crystal ball as to what the future looks like but I think we could all agree that in 5-10 years time the way we conduct our business today will change. I think we are poised for pretty exciting times.
Joseph Fedor: As one of the smaller reinsurance operations represented here, I would say that, in principle, I agree with my colleagues, more particularly with Mr Connolly, in that we probably have seen on the insurance broking side pretty much of what consolidation can take place at least on the very large level. I believe that the smaller brokers will probably start to align themselves on a more regional basis and become much more involved in terms of levels of services provided, not just the ability to be able to lower a price. They have to come up with new products and new ways of dealing with the needs of the client, and I think that we will in the next 5-10 years see a blending of the whole financial services industry bringing together what the buyer of, let's call it, asset protection is looking for. No longer do we have to look at the insurance buyer as only a buyer of insurance at the lowest possible cost.
Donald Watson: We at S&P have a unique perspective in terms of having the opportunity to see a lot of companies, both large and small companies in various industry segments. I think that there is no question that consolidation and globalization is current and this is causing companies to get bigger to serve global needs and we are going to see this trend continuing for some time. I am talking about globalization on the part of the corporations that are looking for global services to be provided by insurance companies and brokers around the world, and that is driving consolidation and we expect to see it continue. But the other side of it though, it is a classic pattern where companies get so big that they lose sight and focus of the details and smaller pieces and their own specialty niches. We are seeing that in 1998, and it is kind of curious, that we have reinsurance markets and property/casualty markets where we see premiums continuing to decline, a very soft market with no end in sight, but we are still seeing a large number of start-up reinsurance companies. Why are these companies being formed in 1998 in the face of this economic outlook?
What is happening is that there are niche strategies that companies can engulf. And certainly, we are seeing increased dollars being committed. It is not unusual for start-up companies to have $200 million to $500 million in capital where five years ago those were very large numbers, and 10 years ago was just unheard of for a start-up company. And also we are seeing this convergence in the financial services investment community that will supply this amount of capital. So I think, going back to your original question, there is room for smaller players, but they are going to have to be very focused on serving particular needs. They are going to have to be very specialized. But clearly the trend for consolidation will continue and the mid-size players will disappear.
Brian Murphy: I would like to amplify one point though, especially for the producer in insurance and reinsurance, there is always going to be room for the smaller guy and each player will specialize in particular areas, perhaps more entrepreneurial than the larger traditional approach, to solve the client's needs.
Joseph Fedor: US Re is specialized primarily in a very focused innovative solutions type of approach toward what the client needs are. Our ability to be able to succeed has usually been driven by the fact that we can come up with quicker solutions mostly because we are a more focused operation, while much larger organizations may have the manpower but not necessarily that quick ability to be focused on a problem and respond to it.
Dennis Connolly: I would have to agree in part and disagree in part. I agree in part that this is still a business of individual imagination and if you can get the right people, whether it is a small or large entity, you are going to score. If you get the wrong people, you are not going to score. One of the things I have found is that our new entity was reorganized for the purpose of targeting smaller groups to try and develop products, and we can throw a lot of resources at it. But this is still a business of people and it is the talent that is important whatever the size of the entity.
Phil Zinkewicz: And it should be remembered that your company's merger activity has all been in the same area, as opposed to Citicorp and Travelers, where the merged entities are not in the same area. Let's talk about that for a moment. What are your feelings about the potential impact of that merger?
Richard Bernero: The Citicorp and Travelers situation is really one of two models for consolidation in the financial services industry that we are seeing. One is to grow and enjoy economies of scale. The Citicorp is really more for one-stop shopping. For Travelers there will be more opportunities to grow in other markets. In Asia, for example, Citicorp is quite well known. And Travelers has the products that are desired in those markets, for example, life insurance, asset management, etc. The merger has received approval from the Security and Exchange Commission with the pre-condition that they sell off their underwriting operations over a period of years. That process will depend on developments in Congress regarding H.R. 10, the financial services modernization bill which will lift barriers between financial services firms.
Phil Zinkewicz: What are the prospects regarding H.R. 10? At this time, we have the House version and the Senate version, which are different in some respects. So there has been some headway, but attempts at forging a financial services modernization bill have been going on for the past decade, with relatively little success. Do you think we will eventually have a financial modernization law that will keep Citicorp from having to sell off its underwriting operations?
Donald Watson: I do not think there is any doubt we are going to see some kind of financial services modernization. The problem is the timing of it. Right now Congress is so pre-occupied with current scandals and other problems that they might not want to bother with modernization at this time. I think it is a question of priorities at the moment, but once everything settles down, I think they will get back to the modernization issue.
Dennis Connolly: I agree. I think that right now the calendar is congested. Their interests are elsewhere at the moment, especially with people trying to get re-elected. I believe that changes in the regulatory system regarding financial services are long overdue. But, I believe that some of the concerns that have been raised about H.R. 10 or similar legislation, particularly about how that legislation will deal with the relationship between banking and insurance, some of those concerns are well-founded. You know a lot of this is connected with the Barnett case in Florida. It is not insignificant that the justice who wrote the opinion was extremely knowledgeable on insurance and he even wrote a book on liability insurance. That proves to me, at least, that people who are very knowledgeable in insurance can make very serious mistakes in terms of the transfer of expertise from one area of financial services to another area. Unless those areas are merged properly, there could be some serious difficulties.
Joseph Fedor: I agree with those concerns. But I think you would agree, as has been said earlier, that the merger of financial services is going to happen whether the individual component parts want it to happen or not. The rest of the financial world already operates on a combined basis. We are more in a catch-up situation. I think it is prudent for us to learn from those mistakes that have occurred overseas, and obviously the ones we make over here, to make it work and make it work successfully. I do not think we are going to have one entity that has overall control. I believe that the best solution as to what we agree on who gets what is going to be fragmented in certain specific areas.
Phil Zinkewicz: That brings up a very important point. It is true that, overseas, they already have a combined system of financial services, with banks owning insurers and vice versa, but overseas they do not have to deal with fifty state insurance departments, fifty banking departments, the SEC and various federal banking authorities.
Joseph Fedor: You are correct. But, in reality, we are now looking at Europe trying to deal with the same problem. Yes, they already have the combined system, but now with the European Community situation, they are dealing with some 20 different countries, with different languages and are trying to make it work. Yes, I think we are going to have problems, but I think we have an advantage over Europe in that we are not necessarily dealing with totally different cultures or languages, but more with something where there is a significant amount of similarity. So we start with reasonably common ground - not completely - but reasonably common ground
Phil Zinkewicz: But in terms of supremacy in regulation of the insurance industry, are we going to see the federal government taking jurisdiction over state regulators? Will we see the National Association of Insurance Commissioners become obsolete?
Joseph Fedor: I do not believe so. Not in the short term, definitely not. I do believe that federal regulation is probably good. It is mostly good because we are now dealing with many insureds, let us start with them, forget the insurance companies for the moment, who quite rightly have to cross state boundaries. It is not necessarily country boundaries. So if you are looking at that aspect of it, we need someone who has higher authority, that can sort of superimpose ground rules, and then say to the insurance companies, all right, we will hold you to a higher standard. If you want to operate on a one state basis, then you essentially fall under the control of the state insurance department. If you do not, if you want to practice in more than one state, then you have to go essentially under a higher standard. To the extent that the higher standard becomes the norm, then you may see a release of the state insurance department level of regulation. State regulation is also a depository of history and experience, so I do not think it is ever going to disappear.
Dennis Connolly: Well, if state regulation is a depository for history and experience, I do not think it will disappear any time in the future, unless it is used in a negative way. If it is used to facilitate the needs of a modern market, if it recognizes the difference between the protection that a Fortune 500 company and Fortune 2000 needs involving commercial insurance versus personal lines auto insurance, state regulation will continue. If state regulators do not recognize this difference, then you will start to see a federal overlay to supersede state regulation.
Phil Zinkewicz: What about the supremacy of banking regulators over insurance regulators, either at the state or federal level?
Richard Bernero: We are starting to see some states where some state regulators are realizing that banking and insurance regulation should become more integrated, especially with more banks acquiring insurance agencies. But the disciplines still remain separate. Even at the federal level, the various authorities are being careful not to overstep each other's bounds. Everybody is waiting to see what Congress is going to do, and the NAIC, even though they are state regulators, are working towards some standards of regulation via model bills. But my view is that, especially at the retail level, authority will still rest with the states.
Brian Murphy: I think more people will begin to adopt the philosophy that insurance and reinsurance are nothing more than another form of capital, albeit specialized, and with the mergers and consolidation, you know, the big boys, that regulation should stay at the federal level.
Donald Watson: For commercial lines. Not necessarily personal lines.
Brian Murphy: For commercial lines, right.
Joseph Fedor: I think that part of the responsibility for state regulators is to make sure that economically affordable insurance is available to the general public at the local level, whether we are talking life insurance or homeowners insurance or the like. I think that the state regulatory environment is there for that purpose in the long term, for continuity. Without that, I do not think the federal government will have the time for the oversight to satisfy those local needs.
Dennis Connolly: Well, I think there are a couple of issues that need to be addressed here. One is the extent to which the banking handling of assets and risk is different from the insurance taking of risk, particularly in the commercial and catastrophic loss areas. It would be dangerous to think that banking risk versus insurance risk is very close and very similar. For banking risks, I do not think that there is concern about signs of earthquake or meteorological issues, but those are key ingredients in making insurance decisions. I know that, in one sense, insurance is considered a financial instrument, but it is much more involved than just that. So to see the taking or handling of risk as the same in both banking and insurance is, I think, dangerous.
Brian Murphy: I think there is a striking similarity between financial institutions and insurance and reinsurance, with respect to volatility and with respect to potential losses.
Joseph Fedor: I agree with Brian. Not that I disagree with Dennis in principle. I think it depends on what level you are looking at. If I am looking at buying an individual commercial insurance policy, I have got to be conversant with the physical exposures, the liabilities and the like, but insurance isn't a science. Supposedly, I would try to spread similar type risks and over a very large number and then develop a premium base so that there is a reasonable probability of the insurance company making a profit over the course of time. The more you get into the larger set of numbers, the more it becomes similar to the banking or the securitization type, investment type exposure analysis that needs to take place. One of the benefits of your organization (Dennis Connolly) is that you have a large portfolio of Fortune 500 and 1000 accounts which are very much into analysis of "How do I manage my financial exposures arising from exposure to all different types of lawsuits?" The banking, investment analysis type techniques are only one way of analyzing the exposures of an entity like that whose major concern isn't necessarily a particular workers' compensation loss or a fire in a local warehouse, but rather on what the overall profit picture of the organization will look like if there are losses outside the bearable norm, whatever that bearable norm might be. You move more into looking at the whole thing from a financial analysis type thing, rather than from an individual coverage approach.
Donald Watson: I started out in banking as an underwriter of loans. Now I am with S&P as an insurance analyst covering insurance companies and other financial institutions. One of the differences between insurance company underwriting and financial institutional underwriting is that insurance companies look at the law of large numbers in the sense that you are underwriting an individual client, but you are writing in the expectation as to what the industry is going to do overall and what you expect over a book of business for a certain line. Whereas in banking, they do not look at the law of large numbers, they look at an individual client. I want to know if I am going to get the money back from a large loan. So there is a big difference. An insurer will say, if I write enough of this business, I could make a profit overall. Bankers do that, but not to the extent that insurers do.
Brian Murphy: But don't bankers do that when they look at the portfolio of mortgages?
Richard Bernero: I think more and more, banks are looking at the expertise of actuaries in the conduct of their business, and in so doing are looking more and more at the law of large numbers. But I think that banks tend to look really at the liquidity of a risk, whether it can be traded off, for example. But it also depends on the type of bank, whether it is a commercial lending transaction or equity underwriting or securitization - each of those will have different returns and different levels of risk, some of them will be looked at in the long term and some in the short term.
Donald Watson: Just a little thought on Brian's question, I think there is the increasing consolidation of some banks that is allowing them to look at the law of large numbers. I think mortgages is a perfect example. If you are writing mortgages in one state or in one region of the country, you are much more vulnerable to the economic cycle. But you can do it if you are writing over a larger area. But insurers, especially the smaller ones can write in smaller, more regional areas because they have the statistics from Insurance Services Office (ISO) which they can draw upon to price the risk properly with industry-wide statistics.
Dennis Connolly: I think you are correct in this respect and that is large companies tend to look at losses, particularly property/casualty losses in terms of how they will affect a company's stock prices. And, then they ask if they can get insurance coverages to protect against these losses and protect their stock prices. The problem is that sometimes the data is simply not available. For example, Lloyd's, the Home, Crum & Foster and to a certain extent CIGNA and many others - all of these companies have experienced financial difficulty for two particular exposures. One was asbestos and the other was environmental liability. Now I know a good deal about environmental liability. The fact is, if you asked an actuary for the loss picture regarding environmental liability back in December of 1980, the actuary would have told you there is no potential for loss, because there had never been any. Of course, that was the same year that Superfund was passed, so the industry took a considerable bath. It was the same thing with asbestos. Go back to 1972, when asbestos was known as the greatest life saver discovered by man. In that year, a court decision came down that affected insurance companies writing asbestos. It showed that there was a great deal of expertise needed in this type of underwriting. There are some types of risks that demand an awareness and an expertise and I do not think that banking people are trained to think this way.
Joseph Fedor: I do not think we are arguing whether there should be knowledge of different disciplines in light of what is taking place in financial services. This may be simplistic, but I think that in the near future, we will see the banking side utilizing their people to sell insurance products, but they may be, hopefully should be, falling under the disciplines of the insurance side of the business rather than the financial side. What we are looking at here, eventually, is a blending of different disciplines for the purpose of aiding and abetting an entity that houses those different disciplines.
Dennis Connolly: I agree 100%. But playing a "Cassandra" again, I can foresee a scenario in which banks will use their distribution system to move into the smaller personal lines and that will cause traditional capacity in the insurance industry to seek a home elsewhere. Then banks might look at where the insurers are going and say, "what do the insurers know that we do not know?" and then begin moving into those more esoteric lines where they might not have the expertise. That I think is one danger.
Brian Murphy: I do not think that we are saying that there will not be a need for expertise. I think we will always need underwriters.
Joseph Fedor: I agree, I think and I would hope that banks, when they merge with an insurance company will take on the sales function and allow the insurance company to continue on with the underwriting function. I think that for a bank to take on insurance underwriting without the expertise would be a disaster.
Donald Watson: I think the key element is the quantification of the risk and risk assumption. Financial institutions, when it comes to insurance-type issues, do not want to assume the risk. They are going to be transformer or conduit by which they distribute and sell it. Insurance companies, I suspect, always will be risk takers. I think that will be the fundamental distinction between what a bank is likely to do and an insurer is likely to do. The bank is more likely to be a transformer of risk rather than a taker of risk.
Brian Murphy: I would just like to go back to an earlier point that was made about there being several black holes in the insurance business that banks should be concerned about, with asbestos and environmental liability being given as examples. I am sure that there are plenty of black holes in the banking end as well.
Dennis Connolly: Yes, we have seen several, the savings and loan crisis, for example.
Donald Watson: I think there is a distinction. If an insurance company is willing to take on a pollution liability risk they will try to quantify the risk, but at some point they will say that they cannot quantify it, but they can protect themselves within a certain range by spreading it. A bank would have a hard time taking on a pollution liability risk because it is not something that makes sense to them. They can spread it, but that is not the way financial institutions think. Could they flip that, transform it into a financial product or something, yes, that makes sense, they could do that because they are not taking on the risk. They are turning it into a financial transaction.
Phil Zinkewicz: What about the role of the capital markets in the insurance industry today. When capital markets first started getting involved in insurance there was a lot of criticism. The insurance industry saying that they are not here for the long term. As soon as we get the big hit, an earthquake or something like that, capital markets will lose their interest in insurance.
Brian Murphy: Capital markets have always been involved in insurance. A perfect example. In 1993, a few hundred million dollars was raised for the formation of Mid Ocean and that whole concept was pretty quickly validated by an additional $4 billion in capital pouring into the island of Bermuda. What are we, all of us here, but capital markets? I think the whole notion that capital markets right now coming into the reinsurance industry
is something new is not true.
Phil Zinkewicz: Well, would you say, then, that the roles of capital markets are changing in terms of what they were?
Joseph Fedor: Well, I do not feel that the capital roles have changed, necessarily. I think that in the past the role of the capital markets was purely as an investor, and I think the equity type of investor today in capital markets is taking on an additional interest role, if you want to say it that way. With catastrophic exposures, for example, to the extent that you can have an investor who can get comfortable with measuring the probability of a loss versus the return on the investment, he is likely to be more comfortable, he is going to be a more active player. Long term I believe strongly that capital markets are going to continue this type of role, not only in terms of supplying CAT bonds, but will also be competing with similar types of instruments dealing with portfolio exposures, with casualty or whatever, where the insurance companies are looking for more stability in the marketplace.
Dennis Connolly: Also, in terms of capital markets being long term players, I have found that once people start putting money into risks in different ways, even if there is a loss, it is sort of like gambling, people always come back. For example, in the insurance industry some would think that nobody would write pollution insurance, particularly after the early eighties. In fact, it is a highly popular line of insurance. What you do is you take your loss experience and you tweak it around until you become comfortable with the risk and then bang, you are back into the game. So I think capital markets, even after they have their first big loss, will tweak things a bit, change their rates and be right back.
Brian Murphy: Even beyond that, investors understand that they will have losses. They will accept that, if they believe the investment lowers their overall exposures loss. Hedge funds, catastrophe bonds offer non-correlated risk. They are not tied to the economy and thus can provide investors with a way to truly diversify. The economy can be doing poorly, and it will not affect investors.
Richard Bernero: I agree. This can help quantify and mitigate investor exposure to loss. However, time will tell just how much diversification of risk from the insurance portfolio investors will accept. There was an evolution on the catastrophe side. Catastrophe bonds became attractive. But today, there is a flight to quality following the economic turmoil. Capital markets will decide and where funds are allocated depends in part on how liquid the investment proves to be.
Brian Murphy: There is a great potential for reinsurance companies to develop new products by aggregating insurance liabilities for capital consumption.
Donald Watson: That is really what reinsurance companies do, put together portfolios of risk. That is why you will see the reinsurance industry performing at different levels than the primary insurance industry. Writing excess of loss type arrangements and treaty arrangements, you will continue to see excellent performance on the part of reinsurance companies even as you see the primary industry decline. A lot of primary companies are seeking to avoid volatility, but with a lot of the acquisitions in the reinsurance industry announced earlier this summer, for example the Berkshire Hathaway merger with General Re, with that acquisition General Re is now capable of accepting more volatility as long as it produces a decent return, year after year on the average, Berkshire Hathaway will be comfortable with it. The thing is, if you underwrite well, you can accept that volatility. And that is why, I think we are seeing some trend towards consolidation.
Dennis Connolly: It was exactly the same with Munich and American Re.
Donald Watson: It is an interesting market out there. For example, despite the soft market, captives continue to grow. That is intriguing because insurance and reinsurance rates are very low, at historical levels. And yet, captives continue to form and that is partly because companies are continuing to consolidate and their ability to withstand larger losses increases as they grow.
Richard Bernero: They do not use the captive for every situation, they use it basically for the potential low level losses and then they go to the primary or reinsurance industries to protect themselves against the more volatile exposures. They are assessing what hits they can take and then going outside for the rest.
Phil Zinkewicz: If we can go back, for a moment to the potential blurring of boundary lines under H.R. 10, what would financial services modernization mean specifically to the reinsurance business?
Richard Bernero: From my perspective, as an observer of the reinsurance industry, I think it is an incredibly exciting time. There is a lot of change going on in the reinsurance industry. Reinsurers are in an excellent position to securitize risk. They are also staffed well enough and they do not have the overhead problem so that they can efficiently put together packages and price them properly. As a matter of fact, in terms of financial products, I think that reinsurers, if they play their cards right are even in a better position than commercial banks are to put together packages. A lot of reinsurers are moving in this direction, but some are not and that is providing the opportunity for banks to become involved in securitization. The banks are getting the expertise to securitize. Some of the major brokerage firms are setting up their own reinsurance operations to get into securitization.
Brian Murphy: We are very excited about the developments at Zurich Re. We look upon it as a great opportunity for us to exercise our expertise to originate the products, properly price them, underwrite them and then properly aggregate them because that is what we do best. You know ultimately what we are all trying to do, and I think reinsurers are well positioned to provide greater value to the ultimate client.
Donald Watson: I think that financial guarantee reinsurance is a growing area and I think that this is something that banks, with the proper expertise can provide albeit with different underwriting techniques.
Dennis Connolly: What I find at our company is that people are increasingly looking to insure things that were not traditionally the province of insurance, such as currency fluctuations. And that, I think is the reason we are seeing a blurring of boundary lines between banking and insurance.
Phil Zinkewicz: Thank you, gentlemen.