U.S. Casualty: Storm Clouds on the Horizon

August 31, 2009

Higher capital costs, low interest rates, the looming threat of inflation and the potential rolling back of U.S. tort reforms are starting to look like a potential re/insurance version of “the perfect storm”. We examine the implications for long-tailed casualty lines.

Higher capital costs, low interest rates, the looming threat of inflation and the potential rolling back of U.S. tort reforms can be individually problematic for long-tailed casualty lines of business. Collectively their occurrence can be market changing – and not for the better. Indeed, the potential confluence of these factors looks like they’re building up into a potential re/insurance version of “the perfect storm”.

The current situation and outlook is a dramatic shift from recent years, particularly between 2002 and 2006 when many key indicators including legislative initiatives, pro-business court decisions and a strong economy led to a lower than expected frequency and severity of claims. At the same time, industry practices such as prudent limits management, adequate rate levels, careful underwriting and tight terms and conditions contributed to profitable years for the U.S. casualty market.

Now we’re seeing signs that the risk drivers for casualty maybe tuing. In this article we explore these drivers and their implications, and offer observations on maintaining a strong portfolio within such a dynamic risk environment.

Higher cost of capital

Access to capital has reduced dramatically since the financial crisis. Risk margins and credit spreads have also risen. While there are some signs that the credit and capital markets may be recovering, it is clear that the cost of new capital for insurers and reinsurers has increased. This is an issue for casualty business. As we slide into a continually declining market environment, casualty loss ratios are not only going up, but the volatility around them is also increasing. This means that more capital is required to support that business; additional capital that the market does not have access to, or at the very least, will need to pay more for.

Interest rate environment

Meanwhile, the low interest rate environment is also impacting total retus. Profits are generated from a combination of underwriting and investment income. Until recently, interest rates when coupled with a long-tail casualty portfolio produced investment income that offset any underwriting profit shortfalls. However, today’s low interest rates mean that investment income is no longer sufficient to produce adequate margins. Primary insurance and reinsurance companies need to look for significant underwriting profitability in order to generate the necessary risk-adjusted retus.

Social inflation

In addition to economic cycles, history shows that the U.S. is susceptible to legislative, judicial and political cycles. Taken together, these social policy mechanisms have a significant impact particularly on casualty insurance claims and their costs. The good news is that over the past few years, a number of tort reforms were enacted that reduced the number and cost of general liability, medical malpractice and workers’ compensation claims. The bad news is that the social cycle now appears poised to swing back, aided in part by the results of the recent 2008 congressional and presidential elections. If not properly identified and priced for now, the future profitability of insurers and reinsurers will suffer.

Could recovery policies overshoot?

While cost of capital and low interest rates are issues facing the business today, the threat of future inflation, not just social but also economic, looms on the horizon. “The U.S. Govement policy responses to the current financial and economic crises really amount to pumping more money into the system to stimulate consumer and business spending. The risk is that the policy could overshoot and cause higher inflation at some point in the future,” says Wayne Hommes, EVP, Risk and Capital Management, PartnerRe U.S.

“This is particularly challenging from an underwriting and pricing standpoint, when considering a long-tail business like casualty,” adds Wayne. “We are currently in a virtually zero inflationary environment today, and so the marketplace isn’t focusing on inflation as a driver of the business. But they should be. The risk is that inflation needs to be considered when pricing the business now; otherwise companies will have adverse development in the reserves later.”

Setting appropriate rate levels

As these negative effects compound, insurance and reinsurance companies need to charge an adequate price for their product, so that the market can honor its commitment to pay claims. Unfortunately, in any soft pricing cycle, companies do not want to give up their top line, and so compete for market share on price. “We get into these pricing cycles where the market will, for a protracted period of time, charge less for our product year over year,” says Dick Sanford, EVP and Head of Specialty Casualty at PartnerRe U.S. “With so much uncertainty about the future, it’s easy to take a myopic point of view. But this is a long-tail business; we need to keep in mind that we can’t re-price mid-stream to respond to a shifting environment. All players in the industry need to take a long-term view.”

Riding the perfect storm

Active cycle management in the context of long-term commitments and client relationships is now more critical than ever. In the current climate this means actively monitoring and managing the duration of all liabilities within an established risk management framework. A defining characteristic of casualty business is that events only unfold over time and can simultaneously impact several underwriting years. Prudent risk management therefore calls for keeping the casualty risk profile in balance with the overall risk portfolio and risk appetite.

Limits management is also critical. Exceeding established limits when there is much uncertainty about the future will lead to problems when it is time to pay the loss. “If you can’t envision or cope with a full limit loss, then don’t sell to those limits,” says Dick Sanford. “Live within your established guidelines. Problems often arise when companies have strayed from what they said they were going to do.”

At PartnerRe, we continually review, anticipate and actively manage these issues. While there is no obvious or easy short-term solution, by consistently working within our established guidelines and risk management framework, we will be ready for whatever this changing and challenging environment brings, with continuity of offer for our clients.

Story Highlights

  • Risk drivers of U.S. long-tail casualty business indicate negative results outlook
  • Inflation – an important driver – may be low now but will increase
  • Long-term pricing view needed by all players to avoid adverse reserve development
  • Active cycle management and strict adherence to established limits essential for a healthy casualty portfolio

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