With (re)insurers hit by big investment losses, the pressure is on underwriting profits to save the day, writes Ronald Gift Mullins

Historically it has been the reliable, buttoned-down investment income of Property &Casualty (P & C) insurers and reinsurers that has rescued the free-wheeling, fast-spending underwriting results to produce in most years a net ncome for the companies.

For the second quarter 2008, in a turnabout, it has been thin underwriting profits and a scrapping up of the last of redundant reserves that have cut the staggering losses in investment income and capital gains that have kept the companies from ending the quarter with a net loss.

Surprisingly, the combined ratio for the second quarter 2008 for most insurers and reinsurers remained below 100, even in a market where pricing has continued to soften, and there has been a pull back in premiums written. For example, Swiss Re, the world’s largest reinsurer, for the second quarter 2008 while reporting 23% fewer premiums earned compared with 2007, said its P & C operations combined ratio only edged up to 92.3 from 90.6 in 2007’s period. Yet Swiss Re said that its second quarter net income fell 53% due to on-going problems with its credit default swap portfolio and a decline of 22% in investment income and huge net realised investment losses of $1.714bn, compared with a gain of $1.292bn in 2007.

In its interim report for the second quarter 2008, Swiss Re, provoking a positive future view wrote: “The outlook remains challenging in the short term due to the volatility of capital markets and the softening property and casualty pricing cycle.

Swiss Re maintains its focus on active cycle management and careful risk selection. At the same time, it continues to manage volatility on both sides of the balance sheet through active hedging of both underwriting and investment exposures.”

Surplus drops for US reinsurers

The Reinsurance Association of America’s results for the first half of 2008 show that net income was $2.68bn for a group of 20 reinsurers writing in the US, compared with $2.75bn in the 2007 period for a similar group.

The combined ratio for the first half 2008 was 97.5 compared with 90 for the 2007 period.

Investment income for first half 2008 was $3bn, down slightly from $3.3bn in 2007. Surplus for the group declined from $77.3bn at the end of

first quarter 2008 to $72.8bn at the end of second quarter 2008.

There are ample historical precedents for anomalies in investment income, said Michael R. Murray, assistant vice president, Insurance Services Office, Inc.

He noted that since 1960 there have been a half dozen years – 1992, 1993, 1998, 1999, 2001 and 2002 – when investment income year-to-year declined. “I think the answer for the decline in investment income this time is a combination of things. We have a low interest-rate environment.

Consider the yield for 10-year T-bills was 15.3% in September 1981. The yield is 4% as of July 2008.

Weakness in investment income also reflects poor underwriting results that produce less cash to invest.”

“Yes, investment income is down,” said Peter H. Bickford, independent counsellor and arbitrator, “but this is in large part due to the write off of bad investments resulting from the ‘subprime debacle’.

These write-offs should not be ongoing strains against investment earnings. General interest rates seem to have levelled off and have actually risen a bit. I believe this trend will hold for the foreseeable future as inflationary pressures continue.

Therefore, I do not see a long-term deflation of investment income.”

In a report covering insurers’ and reinsurers’ results for the first half of 2008, Fitch Ratings observed that as one of the largest fixed-income investors in the economy, the turmoil caused by US residential real estate market declines, widening credit spreads across most asset classes, a tight credit environment, declining equity valuations and a crisis in the financial guarantee industry, has significant implications for the P & C insurance industry.

It is due to these adverse trends that the market value of many securities has fallen below their cost, creating unrealised losses for insurers.

When unrealised losses persist, Fitch raised the “other-than-temporary impairment” question: “At what point should the unrealised loss be considered ‘other than temporary’ and treated as a realised loss with a write-down? Unfortunately, there is no single answer to that question.”

Reinsurers post strongest results

Of the various insurance groups Fitch Ratings follows, it singled out the reinsurer group as having the strongest results year-to-date, led by property-focused reinsurers that had the lowest combined ratios and highest profitability levels.

Net income for the entire group of 50 P&C insurance and reinsurance firms declined by 95% in the first six months due largely, Fitch said, to pre-tax realised investment losses totalling more than $17bn.

Of that amount, reinsurers reported almost $1.4bn of pretax unrealised investment losses.

Reserve development for the reinsurers remained favourable in 2007, according to Fitch, and it estimated reserve releases trimmed 2.9 combined ratio points off of this year’s first-half underwriting results. But after two-plus consecutive years of favourable reserve development, Fitch expects that the recent benefits derived from reserve releases could diminish in the near term.

Dave Bradford, executive vice president, Advisen, observed that some insurers and reinsurers are keeping combined ratios in line by releasing loss reserve redundancies. “Of course,” he said, “this is hardly a long-term solution to falling prices and deteriorating investment income.”

He suggested a benchmark he uses to forecast pricing trends is growth of aggregate industry surplus (“supply”) relative to growth of the overall economy (GDP= “demand”). “So long as surplus is growing faster than the overall economy, insurance supply is growing faster than insurance demand,” he said.

“It appears that, after significantly outstripping the growth in demand for the past four years, lower earnings are finally putting the brakes on surplus growth. However, it will take a couple of years to work off the excess capacity that has built up, so rates should continue to fall through 2009.”

Reinsurers emerged largely unscathed in the first half of 2008 by increased frequency of relatively low catastrophe events that impacted the results of primary insurers. Fitch said the reinsurers’ share of the losses was much lower at $336m (2.8 combined ratio points) versus $919m (7.4 combined ratio points) in the first half of 2007.

Bickford predicted that there will be a decline in underwriting income as prices continue to drop, “but this decline has not yet affected underwriting losses, largely because cat losses have been relatively stable. This stability could change significantly as the hurricane season grinds on and there is an acceleration of underwriting losses over the next 12 months. This will in turn begin the tightening of the market in a more normal cyclical process.

In other words, although the situation may seem to be an anomaly at the moment, the normal cycle will eventually win out.”

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

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