2011 Insurance Outlook: More of Same With Potential Pitfalls

by: Gloria Vogel, CFA

We ended 2010 on a high note: investment markets and insurance stocks were up for the year. And, there are now plenty of bulls on the airwaves seeing signs of economic recovery. So, based on 2010 performance, 2011 should be a great year, right?

If the economy continues to recover in 2011, then surely insurers will benefit. But, let’s check again at some areas that might make it difficult for insurers to repeat their 2010 performance in 2011.

Pricing: According to Guy Carpenter, its Global Property Rate on Line Index fell for a second year by 7.5% for January 2011 reinsurance renewals. Similarly, Willis Re noted that the reinsurance market saw price cuts of 5-10% on January renewals. Both firms attribute the continued price competitiveness to excess capacity. Insurers currently have plenty of cash on their balance sheets to repurchase shares, raise dividends, make acquisitions, or to compete more aggressively on price in order to sustain growth in a weak economy.

Capital and Surplus: Insurance pricing cycles typically turn only when losses significantly hit capital. In 2010, despite $36 billion of insured catastrophe losses from several earthquakes, floods, and windstorms, plus man-made disasters like Deepwater Horizon, companies were able to replenish lost capital with rising investment markets, some capital raises, and disposition of non-essential operations. According to the Insurance Services Office:

Policyholders’ surplus increased $33.5 billion to $544.8 billion as of September 30, 2010, from $511.4 billion at year-end 2009. Additions to surplus in nine-months 2010 included insurers’ $26.7 billion in net income after taxes, $3.1 billion in unrealized capital gains on investments (not included in net income), and $23.8 billion in new funds paid in (new capital raised by insurers).

However, investment yields remain low, product demand is weak, and reserve cushions have been reduced. As such, recovery from future shocks to capital will prove more difficult.

Investments: Investment yields remain near zero on the short end and historically low on the long end, and some insurers are stretching for yield. Moreover, insurers hold large investments in government and agency bonds. Many states and municipalities are encountering significant financial difficulties, and they are raising taxes, cutting services, and otherwise trying to rein in spending in order to meet interest payments on debt and pension outlays. While historically there have been few cases of defaults among state, municipal, and agency securities, we are now in unexplored territory. There is higher risk of such defaults, and that could drive future investment losses for insurers.

Regulation: Financial regulatory reform (Dodd-Frank) will create a new federal insurance office, which could raise additional regulatory hurdles. Moreover, with 20 new state regulators taking office in 2011, and with many tenured state insurance employees soon retiring, it will likely be more difficult for insurers to file rates and forms in the future. Also, Solvency II will force a change in risk management practices, with its requirements for greater capital per unit of risk, and more documentation, transparency and disclosure. It will add to cost pressures, especially for smaller firms.

Other: While the Federal Reserve sees no inflation in its current calculations, inflation is apparent in higher commodity prices, especially oil, copper, and gold. Inflation in claims costs in the face of lower premiums, could wreak havoc on the industry. Indeed, a tort crisis could easily develop from the coupling of an active trial bar with inflated claims from existing and emerging risks. Underwriting losses could also result from extreme global weather, terrorism, or other events. Without substantial reserve cushions, and with low investment returns, any such underwriting losses would hit earnings hard.

Another area to watch in 2011 is development of any problems related to the mortgage bust, and possible skirmishes between insurers and banks. Like the banks, many problem mortgage-backed securities remain on balance sheets. Life insurers, in particular, still hold ample quantities of mortgage-backed securities. Especially noteworthy is the fact that Allstate (NYSE:ALL) has just filed a federal complaint against Countrywide FinancialCorp., (acquired by Bank of America Corp. (NYSE:BAC) in 2008), and 17 other defendants. Allstate alleges that these firms sold $700 million of toxic investments to Allstate in 2005 by misrepresenting their value. Other insurers could follow Allstate’s lead in pursuing such litigation.

While there are many issues that could hurt insurers, the biggest one appears to be a lack of concern among investors about the likely slowdown in earnings growth from reduced investment income, as well as the risks that insurers are taking to make up for lower investment yields. Investors, including insurers, pulled over $9 billion from municipal bonds from mid-November through mid-December. Such withdrawals accelerated following Meredith Whitney’s prognosis that hundreds of billions in municipal defaults was in the offing. The monies have largely flowed from municipal bonds into higher risk corporate bonds and stocks.

Disclosure: None