Beneath a prosperous surface, the effects of underlying problems have begun to emerge, say Ted Collins and Sarah Hibler.

Despite a prolonged downturn in premium rates, US property/casualty insurers entering 1999 can reflect, with some satisfaction, on their good fortune in recent years. A long-lived bull market for bonds and stocks, moderation in medical cost trends and advances in loss control have all helped to support capital formation and earnings growth. But just beneath the surface, the effects of underlying problems have begun to emerge.

Competitive pressures have many insurance managers running just to stand still and have others reviewing their options, restructuring operations, or retreating from the business altogether. Investors find that, in addition to interest rate risk, they may also own a good chunk of event risk too, with natural catastrophes, unseen liability aggregations and other negative surprises always ready to ruin an otherwise good day at the office.

Against this backdrop, Moody's sees a number of key issues, challenges and inescapable realities that will affect the actions and fortunes of US property/casualty insurers in 1999 and beyond.

• Weak industry fundamentals continue to drive consolidation. With limited opportunity for growth in the mature US market and margins shrinking on the in-force business, insurers continue to seek out mergers and acquisitions for their potential to add volume and reduce expense loads.

Although consolidation has eliminated some of the weaker players, it has done little to change prevailing market dynamics - growth rates are still declining and rates continue to be soft. We believe the industry will continue to restructure itself, and insurers with marginal economic scale and/or undifferentiated product and service offerings will be hard-pressed to maintain their independence.

• A difficult operating environment has pressured the quality of reported results. In recent years, publicly held property/casualty insurers have seen their market capitalisation grow at impressive rates, in a broad show of support by the equity markets for this, among other, industries. An unpleasant sub-text to this message, however, has begun to emerge: “The market will brutally punish even slight earnings disappointments.”

With this in mind, insurers have generally sought to maintain reported earnings at acceptable levels, in many cases by harvesting reserve redundancies on prior accident years. Of course, this tactic has a limited useful life, especially when margins on recent underwriting years provide little cushion and paid claims begin to mount. Entering 1999, it is clear that the time has come for accounting to catch up with economic reality.

• Commercial lines insurers are locked in a race to the bottom. Slogging along in the second decade of a market cycle trough, fear has begun to replace frustration as the communal emotion of the commercial lines marketplace. With new money investment rates at historic lows, reserve cushions eaten away and underwriting cash flows at anaemic levels, commercial insurance prices continue their drive toward burning cost and beyond.

Although commodity-like standard coverages have been hit hard, even specialty lines such as medical malpractice and professional liability have seen substantial price deterioration too. Tough talk by industry leaders in recent months has offered some hope of a return to underwriting sanity, but negative operating cash flows and red ink over a number of years are more likely to force discipline on the market as a whole.

• Personal lines insurers are rewriting the rules of distribution. Pressed to meet the challenge presented by low-cost direct writers, personal insurers have responded by chiselling away at their cost structures, even to the point of questioning the efficiency of their respective distribution channels, a distinction that has long defined this segment of the market.

Insurers have also concluded that owning the customer is paramount, and unwavering commitment to a single channel of distribution threatens to exclude a growing segment of customers who are demanding non-traditional - or even multiple - points of access. In a turnabout, many personal lines companies are finding that multiple distribution channels may co-exist peacefully, although managing the process takes a great deal of diplomacy.

• If not a friend, technology will certainly be a foe. Improvements in the application of technology are being used to improve the speed and quality of decision-making and service within the industry - in many areas to a degree not otherwise possible. Those companies that can use technology to gain competitive advantage while managing the cost effectively will be successful. Those who fail to integrate technological advances cost-effectively into their business paradigm will be left behind.

• Year 2000 risk represents an historic uncertainty.

Despite heavy investment to remediate internal systems, however, property/casualty insurers could find themselves called on to pay for possibly substantial losses incurred by their policyholders. Insurers generally assert that coverage under standard policy forms is not available, but coverage litigation could become extremely expensive. Exposure to year 2000 liability risk is a dice roll that few property/casualty insurers have been able to avoid.

Ted Collins is managing director and Sarah Hibler is vice president and senior analyst at Moody's. Tel: 212 553 0376;