Kaveri Niththyananthan reviews a dramatic year for the US re/insurance market

In recent months, the eyes of the international market have been focused firmly on the US re/insurance industry. With one investigation after another striving to unearth the apparent corruption rife in the industry, while hurricane losses battered profits and asbestos continued to plague balance sheets, the market has become compelling viewing for the financial world. It was therefore somewhat surprising then when Standard & Poor's announced that it had raised its outlook on the US reinsurance market to "stable" from "negative" in December, while a recent AM Best report on the US property/casualty sector reported that the industry had reported its first year of profitable underwriting results in 2004 since 1978. So what is the current state of play in the US?

No stone unturned

October 2004 saw the issue of "bid rigging" come to the fore and witnessed the "demise" of contingency payments, as the behemoths of the US broking industry were put to the sword by Eliot Spitzer. In January 2005, Marsh & McLennan announced it had reached an agreement with the NYAG, including the creation of an £850m fund to compensate clients and the establishment of a new business model, as the broker committed itself to ethical business practices. Since that time, both Aon ($190m) and Willis ($50m) have followed suit by establishing similar compensation funds and adopting new business models. However, despite changing their ways, none of the brokers have admitted any wrong-doing or liability.

Far from ending there, the investigation net has been cast even wider, and is slowly beginning to pull in finite reinsurance. The list of re/insurers in the US currently helping the SEC and NYAG with their enquiries is growing on a daily basis, with AIG and Berkshire Hathaway hogging most of the headlines. Ernie Csiszar, president and CEO of the Property Casualty Insurers Association of America believes that this part of the investigation could continue for another 12 to 18 months. He explains, "I'm less concerned with the viability of the finite reinsurance product as this can be addressed through strengthening of accounting procedures." His real concern is with the allegation of transfer of risk to controlled corporations, which brings back memories of Enron, Arthur Andersen and master partnerships. No doubt there will be interim rules and regulations put in place, but Csiszar believes the issue of how to define a controlled corporation will resurface, along with the 20-20 rule proposal (whereby the reinsurer has at least a 20% likelihood of incurring a loss equivalent to 20% or more of the contract). There are suggestions some state regulators may even look to raise the level to 50-50, which he emphasises would kill capacity as there is a need to balance capital and availability with the tightening of accounting procedures.

Whereas in a number of cases the finger of blame has been pointed at the corporations involved, many industry practitioners have retaliated with the question, "Where were the regulators?" Ernie Csiszar is forthright with his views about the current US regulatory environment, describing regulators as "inefficient, ineffective, costly and fragmented". Going forward, one step he would like to see is uniformity between states with acceptability of one entrance point into the market. The SMART Act (State Modernization and Regulation Transparency Act) is currently being drafted, but with 17 titles, the process may take another three months.

Andrew Barile, reinsurance industry consultant at Andrew Barile Consulting, fears that now we may see regultors become more inolved in the negotiating process of selling reinsurance. "If we do," he says, "this will slow the whole buying and selling process." He adds, "Both transparency and regulatory steps will have a big impact on the negotating and renewal season."

The age old problems

US tort costs reached a high of $246bn in 2003, according to Tillinghast. Compared to 2002, this is an increase of 5.4%, showing a slower growth rate compared to the 13.4% increase in 2002, and to the 14.7% increase in 2001. With class action reforms clogging up the dockets, President Bush signed in the Class Action Fairness Act of 2005. As of 18 February 2005, if a claim is more than $5m and a member of the class is located in a different state to the defendant, then the case immediately goes to a Federal judge. This prevents lawyers filing cases in states with a reputation for being more lenient as has been suggested is the situation in Oklahoma and Mississippi. From the insurance industry's point of view, it will see the cost of doing business decline as the risk of paying out for large claims decreases. Whether the underwriters have already taken this into account when factoring prices remains to be seen.

On the asbestos side, insurance industry support for the proposed $140bn asbestos fund is waning. Senator Arlen Specter, Chairman of the US Senate Judiciary Committee recently announced the introduction of asbestos legislation designed to provide compensation to asbestos victims without litigation. "This legislation provides substantial assurances of acceptable compensation to asbestos victims and substantial assurances to manufacturers and insurers to resolve, with finality, asbestos claims," Mr Specter explained. The bill has received much objection from the industry with the main point of contention being that of claim finality, and a committee vote has been suspended until 12 May. Huhnsik Chung, a partner at law firm Edwards & Angell, explains that this could lead to a continuing trend in pre-packaged bankruptcies. Mr Chung says, "I don't think the asbestos bill will pass and so the insurance industry will need to look at other available schemes to off-load its liabilities. I would expect run-off operations to gain even more popularity, as may be the case with solvent schemes, though these are fairly new here (in the US)." Many would agree that the idea of a parent company, setting up a subsidiary to off-load its asbestos liabilities and then filing for bankruptcy will not bode well for its market reputation.

A mixed bag

In December 2004, Standard & Poor's changed its outlook on the US reinsurance sector to "stable" from "negative" based on "improved market conditions". The rating agency stated that despite rate declines in some property/casualty lines, it still predicted adequate profit margins in 2005, coupled with a drop in adverse reserve strengthening for the market.

Nevertheless, for the first time since 1978, the US property/casualty sector recorded an underwriting profit in 2004 with a combined ratio of 97.9%, according to AM Best's recent sector report. While the study highlighted the continued growth in earned premiums due to "peak pricing" in 2003, the rating agency warned that with a marked decline in premium growth in 2004, particularly on reinsurance and commercial lines, coupled with increased price competition, 2005 growth looks set to slow "beyond the paltry 4.7% recorded in 2004". The sector recorded a $2.7bn rise in underwriting gain for the fourth quarter to $2.9bn compared to the same quarter in 2003, which the agency attributed to a drop in reserve charges year-on-year.

Loss reserve deficiencies however remain a concern, with AM Best estimating overall reserve deficiencies of $59bn for asbestos and environmental (A&E) liabilities. Karen Horvath, vice president, Property and Casualty, at AM Best, explains, "This number, however, is significantly lower than that of two to three years ago. For example, CNA Insurance Companies had a loss ratio of 115.3% in 2003 because they took a large charge to increase their reserve and eliminate its loss reserve deficiencies." While 2004 did see a number of large reserve charges, including St Paul Travelers ($2.4bn) Zurich/Farmers Group ($2.6bn), AIG ($1.9bn), ACE ($691m) and Liberty Mutual Insurance ($363m), those companies which had announced significant charges in 2003, such as CNA, Hartford and XL Capital, were relatively stable in 2004.

The rating game

While most market commentaries suggest 2005 will see fewer company downgrades, 2004 saw a number of US re/insurer ratings slide, while in the last few months AIG, Transamerica Re and GE Insurance Solutions have all experienced rating downgrades.

AIG's problems continue to mount, following the recent announcement that Eliot Spitzer and Howard Mills plan to appoint a consultant to audit years of alleged improper booking of workers' compensation premiums by the US giant. The group is still to file its 2004 Form 10-K (now set for 31 May), after requesting an extension on its 31 March deadline. However, the current accounting review is set to wipe $2.7bn off the group's shareholder equity, with $1.2bn attributable to adjustments relating to "risk transfer matters". Standard & Poor's, AM Best, Moody's and Fitch have all lowered the group's rating, with S&P, AM Best and Moody's keeping the rating on negative watch. AM Best held out on its rating change, believing the filing may "alleviate some, although not all of these concerns" but has since announced that the extent of the restatement changes have exceeded expectations. AM Best had also warned that, "management's time and attention has been diverted from the focus necessary to manage the current softening market pricing cycle at a time when customers and competitors may look to leverage the situation."

Converium Reinsurance North America's rating fell following the announcement by its parent Converium AG that the subsidiary had effectively stopped writing business, despite an original proposal that it would provide additional capital to bolster the company's balance sheet. Transatlantic Re and Putnam Re, reinsurance subsidiaries of Transatlantic Holdings, also saw their ratings drop. AM Best, who lowered their financial strength ratings to "A+" (Superior) from "A " (Superior) cited a decline in the group's risk-adjusted capital, due to continued growth in premium volume, plus $100m in hurricane losses. The rating on American Re was also lowered in February, with AM Best saying the rating action followed recent announcements that it has taken additional reserve strengthening of $180m in the fourth quarter related to asbestos exposure, culminating in $482.3m pre-tax of prior-year adverse reserve development in 2004. Ms Horvath adds, "American Re's downgrade resulted from the quality of American Re's risk-adjusted capitalisation and underwriting performance. Furthermore, its earnings trend over the past five years, having been negatively affected by significant and repeated adverse development charges covering the 1997-2001 accident years, asbestos charges and catastrophe-related exposure."

S&P in early April lowered its counterparty credit rating on GE Insurance Solutions to "BBB+" from "A-", reflecting a poor operating performance over the last five years, primarily due to substantial reserve strengthening during that period. The rating agency also believed its medium term operating performance remained exposed to potential reserve development for prior years. Ultimately, S&P's opinion was that the firm's operating results are likely to under-perform in comparison to its industry peers over the next two to three years. Speaking to Ron Pressman, GE Insurance Solution's chairman and CEO, he said the firm was looking at disciplined underwriting in a softening market with competition being faced at primary levels. "We are looking for real pockets of growth, where clients search for value-added services, which tends to translate to portfolios, where we can write reasonably sized insurance programmes into a big pool. We thus ensure that there is not one risk that is 50% of the pool." The firm is a low property catastrophe risk underwriter and plans to remain so. The reinsurance part of the group amounts to two-thirds of its business, which Mr Pressman does not foresee changing in the near future.

Going forward, the US is facing a shrinking market, while competition continues to stiffen from Bermuda-based reinsurers, with some suggesting the allure of Bermuda is growing in the current regulatory and investigatory environment. As the cycle shows clear signs of softening on a number of lines, calls for underwriting discipline go head-to-head with the ever present push for market share. These are difficult times for the US market.

- Kaveri Niththyananthan, Global Reinsurance.