September 24th, 2009

Casualty Specialty Update: The Credit Crunch and Reinsurance

Posted at 1:00 AM ET

casualtyDavid Lewin, Managing Director
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When problems in the subprime mortgage market erupted into a full financial catastrophe last year, conventional wisdom suggested that property and casualty (P&C) insurance companies would suffer. The culprit, many believed, would not be investments in mortgage-backed securities (MBS) like the life insurers. Rather, it would be the possibility of slipped bond ratings because of problems with bond insurers, ultimately lowering the value of the bonds held in P&C investment portfolios. The increase in insured losses as a direct result of subprime and the ensuing credit crunch would certainly drive P&C companies to have poor returns, the thinking continued. Even at the mid-point of 2008, talk of a turn in the market began to percolate.

Today, however, we can see that the worst-case scenarios imagined in 2008 did not transpire. (Re)insurers did lose a considerable amount of capital — 18 percent to 20 percent, as measured by the Guy Carpenter Global Reinsurance Composite — but, aside from a few casualties, the stability of the industry was never truly threatened.

We’ve seen double digit rate increases in Financial Institution (FI), Professional Indemnity (PI), Directors & Officers (D&O), Surety/Trade Credit, and Political Risk, but rates have remained relatively stable in other lines of business. The rate increases occurred mainly because of poor loss experiences in specific lines, though a reinsurance capacity crunch may also be a contributing factor.

In Europe, we’ve seen several major reinsurers withdraw or cut back significantly on financial lines (D&O and PI) liability treaties. The timing of this is surprising in some cases, as most of these treaties are on a risks-attaching basis — i.e., these reinsurers are left with paying the claims of 2007 and 2008 but receiving none of the upside of rate increases and tightening of terms seen in this year (and probably in 2010). Granted, most of the relationships abandoned had been long-standing, and reinsurers and insurers alike had benefited from years of profitable results. Nonetheless, the withdrawal of these major reinsurers has had an impact on the amount of capacity available. This “reinsurance capacity crunch” has led to insurers finding themselves with larger net retained lines which, in turn, should result in smaller overall lines offered by insurers on given risks compared to recent years.

Countering this “downsizing” is the emergence of new carriers looking to take advantage of the anticipated sellers’ market. Underwriters from established market leaders who have been weakened financially due to their involvement with mortgage-backed securities, have sought greener pastures and are now employed by these new carriers. Once again, the reinsurance capacity crunch has kept available line sizes in check. However, the emergence of these new markets may also be slowing the market’s turn through the simple economic principle of supply and demand.

The lack of claims outside FI and Trade lines has delayed a substantial increase in pricing for European carriers. Average incurred loss ratios for Commercial D&O, Commercial PI, and General Liability (GL) has been far below expectations in Europe since 2002. But, will this trend of relatively benign claims activity in these lines of business continue?

Some economic indicators seem to point toward an increase in claims frequency. Foremost among these are the increase in expected corporate insolvencies. Traditionally, insolvencies have driven D&O claims. So the indication is that the insurance industry should experience an increase in D&O claims in 2009 and 2010. Additionally, we expect that many of these insolvencies would be in the small-to medium-sized enterprises segment of the business, which has historically been profitable. On the PI side, advisors are often brought into lawsuits when the companies they were advising become insolvent.

european-corp-insolv

Insolvencies are just one economic indicator that more claims are on the horizon. It is commonly thought that people are more likely to sue in poor economic times. As unemployment rates rise, people may try to use recent changes in employment law to sue their former employers for wrongful termination. In certain situations, indemnity may not result from the claims, but significant legal expenses will still need to be paid.

Reinsurers have cited the potential for increased claims notices given the economic climate during the 2009 renewals, and concerns have arisen for January 1, 2010, as well. Pushes for significant rate increases and tighter terms have been delayed, though, as profitability in recent years and a clear lack of claims activity made it difficult for reinsurers to justify what they sought. As we approach the next renewal, both insurers and reinsurers are wondering if the claims lag has finally caught up. If so, the reinsurers will want their due.

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