Evolving Criteria - Reinsurance Thought Leadership | Aon Benfield

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Evolving Criteria Profitability Trends Rating agencies have become increasingly focused on companies’ ability to underwrite profitably. P&C insurers are facing several impediments to earnings, including an extended soft market cycle, weak economic conditions, inadequate rates due to government restrictions, and catastrophe frequency losses. Exhibit 12: Percentage of Companies Reporting Combined Ratios Greater Than 110 Percent and Below 100 Percent 70% 60% 50% 40% 30% 20% 10% 0% 12 less than 100% CR greater than 110% CR 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 The gray line on the graph above depicts the percentage of companies that reported a combined ratio below 100 percent. For example, in 2006 64.5 percent of companies within the U.S. P&C industry reported a combined ratio below 100 percent. At year-end 2009, this percentage dropped to 46.1 percent. Conversely, the green line shows the percentage of companies that reported a combined ratio above 110 percent. This inherently has a negative correlation to the percentage reporting a combined ratio below 100 percent (gray line), but we chose a 10 point buffer to segment the percentage of poor performers versus companies that reported results only slightly above a 100 percent combined ratio. As expected, over the last ten years, the trough was 2006 when only 20.7 percent of companies reported a combined ratio above 110 percent, but this percentage increased to 30.6 percent in 2009. Whereas profitability trends are often the catalyst to rating actions, this graph depicts a weakening trend on a by company basis that is sometimes masked when looking at industry aggregate results. This concern is evidenced in several negative rating actions taken against well-capitalized companies that have performed poorly in comparison to their peers. In fact, 11 of 26 downgrades by A.M. Best in 2010 showed more than a 10 percent improvement in BCAR yearover-year. Further, shrinking premium bases are placing pressure on expense ratios and thus profitability. The median net expense ratio for the U.S. P&C industry in 2009 was 30.7 percent, which is 3.5 points higher than 2006 and 7.0 points higher than five years ago. Lastly, given these profitability trends, we have seen an increased focus on companies’ ability to achieve projections presented to rating agencies. The detailed pricing, reserving and profitability analyses are based on U.S. data due to general availability and accessibility of information. However, the underlying trends are applicable globally as many other markets are facing the same pricing pressures as in the U.S., and the rating agencies have the same concerns globally. S&P issued a report about the U.K. non-life market, noting declining profitability has largely been masked by reserve releases overall. Further, investment returns have been limited by the current low interest rates and the conservative investment strategies that insurers have maintained over the course of the financial turmoil of the past two or three years. A.M. Best noted that European multi-line insurers are relying on life business to help offset a struggling soft market. However, this is not the case in Asia as capacity and demand remains sufficient due to expansion, though not to the same levels as in the prior years. Further, many global companies reiterated in recent earnings calls these prevailing issues impacting overall profitability, with little hope on the horizon. The global reinsurance industry is experiencing similar trends, and we expect continued pressure on downward rates will be evident throughout all property catastrophe segments (even beyond the U.S.) as supply continues to exceed demand. Further, across most non-catastrophe lines globally, pricing is flat to slightly down with the exception of a few lines.
ERM Expectations ERM continues to play a significant role in how the insurance industry manages its operations broadly, and in understanding the risks associated with those operations specifically. Rating agencies elevated the awareness of ERM with specific ratings criteria introduced as far back as 2005. Regulatory influences have also been in play particularly with the pending Solvency II regime. External forces aside, some industry practitioners have benefited from their ERM frameworks for several years now. Many organizations have full-time chief risk officers or equivalent ERM leadership in their firm, with some industry surveys suggesting more than half of insurers with such roles in place. Moreover, economic capital modeling still plays a prominent role with insurers to understand risks, optimize reinsurance and make capital allocation decisions. All signs indicate that expectations for ERM are rising, along with related resources and technology. Rating Agency and Regulatory Influences S&P continues to be active in clarifying their criteria for ERM and capital during the past 12 months. One of the more prominent updates was the criteria draft for formal ECM reviews (or Level III ERM reviews) noted previously. Refinement to Level III criteria is expected in the coming months, followed by formal ECM reviews beginning later in 2010 or early 2011. This update by S&P is viewed as a logical progression in the review of ERM, an enhanced understanding of insurer’s capital needs and ultimately improved ratings decisions. Early indications suggest that ECM reviews that are not deemed credible will be a limiting factor to ERM scores. Yet S&P has indicated that in some cases a credible ECM may warrant capital relief in their view, and ultimately positive ratings traction. Additional clarity is needed before any definitive statements in that regard can be made; however, what is clear is ERM will remain a driving force for pending ratings evaluations. Thus far, A.M. Best has not updated their ERM criteria since their paper Risk Management and the Ratings Process for Insurance Companies was released in January 2008, nor have we seen any recent and significant updates or clarifications on ERM from other major rating agencies. A.M. Best has stated plans to release a criteria paper that discusses their approach for evaluating ERM capabilities for small and medium-sized Aon Benfield companies with varying levels of complexity. Overall, we expect ERM to remain a key factor in the ratings review processes among all rating agencies, particularly in understanding how ERM supports management’s strategic objectives, risk tolerances and risk preferences. The Solvency II regime and particularly Pillar II has ERM underpinnings to it. Further tweaking is expected to Solvency II requirements prior to companies going live in 2013. However, most of that tweaking is currently focused on Pillar I (capital requirements and related calculations). Less debated, but arguably of similar importance is Pillar II (governance and risk management). Pillar II’s focus is on such topics as risk control and self assessment, supervisory review, risk governance, and general risk management effectiveness. These topics all relate to the ERM ideal, and those organizations viewed to have relatively weak ERM constructs run the risk of regulators requiring additional capital and oversight; a precarious and costly situation that most insurers would like to avoid. External stakeholders continue to influence and elevate expectations of ERM. However, the industry is well-positioned to be at the forefront and raising the bar of what constitutes robust ERM. Indeed, best practices from today will become standard practices tomorrow. Those insurers who embrace this concept and push innovative risk intelligence will create their own competitive advantages, and as a by-product appease external influencers such as rating agencies and regulators. Key Trends in ERM Aon Benfield has identified three areas of ERM that seem to garner more attention on a consistent basis across the industry: risk appetite refinement, understanding emerging risks and risk modeling. Risk Appetite Refinement A key element of risk governance and risk oversight is to prescribe the extent of risk an organization is willing to take. This risk tolerance is predicated on understanding the firm’s capacity or ability to assume various risks. One part of risk bearing capacity is from a quantitative perspective such as available capital or surplus. The second is from a qualitative perspective and comes 13
Page 1 and 2: Evolving Criteria Keeping Pace with
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