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By STEVE TUCKEY, who has written on insurance issues for a decade for several national media outlets

If you mark the start of the Great Financial Crisis of 2008 with the federal government-assisted delivery of Bear Stearns into the hands of J.P. Morgan Chase for pennies on the dollar, then we have now passed the one-year mark. The time has come for a serious look at how the world as we know it has changed.

But no half a trillion dollar industry with its pulse at the center of American commerce can ever be so lightly dismissed. And so the question of just how this once-in-a-lifetime asset side of the balance sheet crisis will take its toll on commercial insurance pricing and the overall health of the property/casualty industry will have to take into account unprecedented factors and calculations.

Earlier this year Brian Duperreault, president and CEO of Marsh & McLennan Cos. Inc., created a bit of buzz with his declaration that the industry may soon experience what he termed an "invisible hard market," in which the traditional pricing increases will push up against staggering losses in the financial markets and declining underlying exposures.

"Without a meaningful change in the top line, you may not get a dramatic change in the absolute level of underwriting income," Duperreault told the annual joint luncheon of the APIW/NY Chapter of the Chartered Property Casualty Underwriting Society in January. "The countervailing forces of rising rates and declining exposures producing the same top line may not translate immediately into an improved bottom line."

Duperreault himself recently marked his first anniversary at the helm of Marsh. But his 10 years as CEO of ACE Ltd., along with his more than 35 years of insurance experience, makes him as qualified as anyone to make sense of the 2008 meltdown.

The declining exposure side of the equation stems from companies' improving performance that does not right away show up in improved earnings, with true value taking longer than normal to surface.

"And the typical corollaries of a hardening market--stock appreciation, greater access to capital--are unlikely to be in evidence at first," he says.

The hard market may become visible to the naked eye when any number of factors take place, such as an improving economy with a result in rising exposures, an increase in investment income and, of course, a major insurable event.

"If we have a major event, it could be very dramatic in terms of rate change," he says. "We are very vulnerable to event risk right now."

Many analysts see any sort of real hard market, visible or otherwise, as not taking place until the end of this year, while the most current numbers tell the story of a soft market at least winding down. According to Dallas-based Market Scout, the composite rate for property/casualty insurance declined 8 percent in February, compared with 14 percent in the same year-ago period.

"A slow moderation in rate decreases continues as insurers evaluate their 2008 results and the impact of a slowing economy in 2009," says company CEO Richard Kerr.

He adds that four large insurance companies, which he declined to name, are "drawing a line in the sand and demanding rate stabilization."

"If it sticks, we will see a further flattening of reductions very soon," he says.

The more severe and enduring the recession and credit crunch turn out to be, the less visible any inevitable hard market will be, and so property/casualty executives are grasping eagerly for hints of a recovery, no matter how slender they may seem now.

As for a general economic rebound, Federal Reserve Chairman Ben Bernanke moved any such possibility from happening late this summer or early fall into sometime next year. The first hint of such a rebound usually can be seen in the Dow Jones Industrial Average, which by early April had edged back past 8,000. This can be seen as a cause for rejoicing in some corners, or warnings of a so-called "bear trap" in other quarters.

While the Dow may dominate the headlines, Adam Klauber, director of U.S. equity research for Fox-Pitt Kelton Cochran Caronia Waller, says the key property/casualty industry factor will be the extent of the deterioration of the bond market, which in turn could put pressure on capital.

"It is not a direct correlation because statutory accounting does not mark to market necessarily, and A.M. Best does not have big capital charges on unrealized losses. So it is not one-to-one direct, but if your bond portfolio is down 20 percent, that is all going to come out of your capital base," he says.

An early look at 2008 property/casualty Generally Accepted Accounting Principles results showed a combined ratio rising to 97.2 from 88.7 in the previous year and operating earnings declining 34 percent to $29.8 billion for the year, according to a Fitch Ratings study of 49 publicly traded companies. (When the $52.1 billion AIG 2008 operating loss is included, the operating earnings figure declines to a $22.3 billion overall loss compared with $54.4 billion profit for 2007.) GAAP shareholder's equity for the group fell by about 16 percent, excluding AIG numbers.

"The market's ability to rebound in 2009 remains questionable as a broad market pricing turn is not materializing from the losses of 2008," says Fitch analyst Jim Auden. Meanwhile, deteriorating underwriting results, along with unrealized investment losses from 2008 and additional credit- and recession-related turbulence, will paint a gloomy picture for the industry this year, he adds.

And so the question now comes like it did in other game-changing moments such as 2001 with its double-whammy of the Sept. 11, 2001, attacks and subsequent downturn: Will carriers really walk the walk of true underwriting discipline, or just talk the talk?

Steven Weisbart, chief economist for the Insurance Information Institute, says the asset-side crisis could be the key factor that makes underwriting profitability reign supreme in property/casualty executive suites.

"It is clear that investment results are not going to be available either to provide a cushion beyond underwriting experience, or indeed it may turn out to be a negative," he says.

The same kind of analysis is taking place at the reinsurance level, where companies face fewer regulatory constraints.

"Everyone has fewer margins for error because of the capital market values being beaten down, and so the reinsurers are looking at this and saying, 'We better raise our prices and draw boundaries around what we are willing to offer.' "

At the Jan. 1 renewals, while some peak property-catastrophe reinsurance rates rose as much as 15 percent or more, most other rates stayed fairly flat, but did not suffer the kind of modest declines showed by the primary companies in February.

Some carriers may just decide to give up some exposure, with the most prominent example being State Farm, attempting to exit the personal homeowners' lines in Florida.

Liability risks may face more challenging pricing issues because of their longer tail, which could make a tempting target to push up top-line revenue.

"I think the focus will not be so much on levels of revenue, but rather combined ratios and profitability measures," he says.

Weisbart's colleague, III President Robert Hartwig, says the new economic conditions imply the need for an underwriting discipline not seen in more than 30 years, and says analysts would be wise to look at the period of 1920 through 1975 for guidance.

But just how that age-old alchemy of fear and greed will play out in these conditions is anybody's guess.

"I know it has been said before, and doesn't always materialize, because you have to remember that these are human beings doing the work," says Hartwig.

"When you know the company next door is growing faster than you are, and you have a less than marginally priced risk in front of you, do you accept it, or get your revenue to top line up to prevent the guy next door from grabbing all the glory? Or do you hope your underwriting decisions are the right ones a year and half from now, and when the profitability numbers come out you will beat him?"

So has everything changed now in a different sort of way than it was supposed to have changed after Sept. 11?

"The quick answer to that is we have never had business conditions like this that anyone has really experienced or learned any lessons from. There are just so many questions that one can say we have no idea," Weisbart says. "I hate to run back and hide from a question like this, but it is true."

With all this talk of a soft market that has prevailed for the past few years, it is easy to forget that the property/casualty industry is coming off its second straight year of underwriting profitability after a nearly three-decade losing streak. But Klauber sees factors such as diminishing reserve redundancies that covered up a multitude of sins in the past coming to an end, which could threaten the inevitability of a new hard market and underwriting profits coming into play.

"You just won't be able to keep your combineds low based on reserve releases, the way you could in '07 and '08," he says.

Earlier this spring, Moody's issued a report estimating that, of the $5 billion to $12 billion in excess loss reserves the industry had at the start of 2008, about $9 billion had been depleted in the first nine months, with estimates rising to $14 billion for the entire year. Moody's Vice President Paul Bauer says he believes the industry has exhausted its cushion, portending dipping profits for 2009.

"In addition, the decline in reserve adequacy implies a further weakening of balance sheet strength in what is already a difficult market environment," he says.

Meanwhile, anecdotal evidence seems to indicate that frequency may be on the rise. "It is hard to tell whether it was the good economy that kept frequency low or the terms and conditions," Klauber says. Severity could also rise from a new Democratic era in Washington, D.C., depending on how deeply it is influenced by the trial bar in terms of judicial appointments and philosophy, other analysts say. Any severe rise in claims costs on the back of 30 percent price reductions over the past three years could firm up and even harden the market.

The wildest card of them all remains what kind of catastrophe losses Mother Nature has in store for us this year. With the capacity shortage in the Florida Hurricane Catastrophe Fund and the unwillingness of state regulators to let primary companies pass on increased private reinsurance costs, primary carriers may enter the hurricane season starting June 1 with more risk than normal.

"So if you have a big hurricane, you may see more destruction of capital than you saw in Katrina-Rita-Wilma (in 2005) at the primary level," Klauber says.

Any serious decline in exposure units, whether it is employees, fleet vehicles or buildings, will make raising prices more difficult because more capacity is chasing fewer such units. And it will also make year-over-year numbers less than impressive even if prices do rise, analysts say.

Kerr expects a hard pricing market to be with us by early next year and does not put much stock in any recession-induced decline in the exposure units the industry is looking to insure.

"In my view it is immaterial. You may have more premium dollars chasing fewer accounts, but with three gas stations versus five, the price should be less, but you will have a better price for each station net on than you did a year ago," he says.

And in the end, the rules have not really changed. "If you have a book of business where the combined is 120, the rates are going up, and if the combined is 50, the rate is going down," Kerr says. "Sometimes we get too carried away with the outside financial world and market conditions. At the end of the day, actuarially, the deal has to dance."

Ken Crerar, president of the Council of Insurance Agents & Brokers, sees a "custard-like" market, firming by the end of the year with spikes in some lines such as directors' and officers' taking place now as a result of the fallout from the economic distress.

As for the impact of the financial crisis on the overall health of the industry, Crerar says evidence so far has remained anecdotal. "We are hearing from some of our members that we are seeing levels of coverage drop for a number of reasons including expense," he says.

So aside from declining exposures, companies can drop some lines of coverage. "Or if you cover something for $50 million, then you can cover it for $30 million," Crerar says. That decrease in coverage could stem from either a recession-related decrease in value, or a conscious risk management calculation to reduce limits to reduce expenses, or a combination of both factors.

While coverages such as kidnap-and-ransom may fall by the wayside due to less travel, Crerar sees levels of coverage in certain lines reduced, rather than eliminated entirely. "People do all sorts of things in this kind of economy, and so people are trying to maintain levels of coverage, while at the same time surviving the down cycle."

Different segments of the market may see varying degrees of price hardening. Crerar says that in the middle market, prices will level or rise slightly. Because middle market companies have less ability to analyze their owns risks compared with the analytical abilities of a Fortune 1000 company, they may have fewer alternatives than to just grin and bear the pricing increase.

In addition, the truly global nature of this financial crisis and ensuing recession means insurance companies don't have what Crerar terms "pockets of strength" around the world to cushion any reluctance to raise prices to maintain market share, and thus may have to bite the bullet of market discipline once and for all.

Duperreault says the story of this hardening market will be difficult to get across "because one has to divine the declining exposure side of the equation." And for that you have to look at the numbers of this recession, and what they mean in terms of the overall health of the property/casualty industry.

With an unemployment rate averaging 5 percent for the first eight years of the new century, Hartwig says the current rate of well over 8 percent represents a job loss approximating the loss that took place at the end of World War II in 1945. In addition, a projected net annual decline of 1.35 million home starts through 2009 could result in a net exposure to homeowner's line loss of $1.2 billion.

But while declining auto sales will take their toll on the requisite line, the effect will be less pronounced than the impact in the homeowner realm, Hartwig says.

May 1, 2009

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