GLOBALIZATION AND INSURANCE

A reprint of an article by Brendon Hunt, that originally appeared in the Cornwall Business Magazine, Spring 2000.

The global trend of consolidation, so evident during the latter part of the 90's, continues unabated into the new millennium. Evidenced by the early January announcement that world-wide insurance giants Zurich and Royal/Sun Alliance were in merger negotiations, the insurance industry has illustrated it too, is trending towards the "bigger is better" approach. There are a number of reasons why consolidation is paramount within so many insurance boardroom agendas.

The first is declining premiums over the past 5 years. This is followed closely by falling rates of interest, coupled with stagnant growth in real terms, as well as a large over-capacity in the marketplace, both for commercial (business) insurance and personal insurance (home and auto).

The insurance industry is one of a cyclical nature. With premiums falling as much as 25% over the past 5 years, combined with an increase in both the frequency and severity of claims being paid out, there is now increased pressure placed on insurance companies to either merge, consolidate, or to raise premium rates commensurate with the degree of risk involved.

Creative accounting within the industry has led to an over-confidence amongst some insurance companies. For example, in 1998 (the latest figures available) 96% of the pre-tax profit component for all Canadian private insurers, was comprised from a combination of takedown of prior year claims reserves, and capital gains garnered from their investment portfolios. Without such, the industry would have posted large losses, instead of the approximately 12% return on equity it had claimed!

Traditionally, insurers have made most of their profits not from their underwriting, but the investment float. Simply stated, this float is the interest and investment income garnered from the premiums paid by all the customer base, less the claims actually paid out. Relying upon the mathematical principal "the law of large numbers", it is actuarially supported that only a certain number of clients will incur losses within a given period of time, and although the simple principle of insurance is that the premiums of the many, are pooled to pay the losses of the few, it is this time-lag between the payment period and the loss period which is known as the float. It is this concept alone, which has enticed many astute investors, such as Warren Buffett, to invest heavily in the insurance industry. For Mr. Buffett then, this means the key to creating shareholder value in an insurance company, is to keep the cost of the float below the cost of alternative leverage such as debt. By doing this, insurers need not make an underwriting profit; that appears to be much of what has happened in both the Canadian, and global insurance venues over the past few years.

As the reserve take-downs of years prior become exhausted, coupled with lower interest rates, and declining bond yields on the float, many insurance companies going forward, will be faced with losses for their shareholders. Analysts have coined the phrase that the insurance industry is going from the "cheating" to the "pain" phase. The Moody's rating agency has postulated that many of the large carriers, will post losses for calendar 1999 and 2000. Salomon Smith Barney, Citigroup's investment-banking arm, calculates that, for an average insurer, the net effect of a drop in bond yields from 8% to 5%, is to halve profits, even without any deterioration in underwriting.

Recent exaggeration in the world stock markets explains two concepts. Firstly, why investors of insurance companies are understandably nervous, given the question of a market that is severely overvalued, and secondly, that many shareholders of insurance companies think of their investment in terms not of business fundamentals, but rather, little more than highly leveraged investment trusts. In the past few years, debt has become cheaper, and the float is getting more expensive as underwriting losses continue their ascent.

Given the above, many people continue to invest in insurance companies, not based on historical valued methods, but hoping for a quick return on their investment due to bloated stock pricing. This has recently been the case with industry darlings such as Fairfax Financial, Kingsway Financial and many other higher profile insurers. In the mid to late 90's, many carriers were trading up to 3 and 4 times the multiple of the current stock price ushered in with the new millennium.

Although the run-ups of the late 90's on both Wall Street and Bay Street brought good fortunes to many, it had increased the net-asset value of insurers to some of the highest levels. Insurance Company regulators were more than pleased as it made their capital (also known as surplus) somewhat bloated, and the excess capacity spelled, what many consider to be an increased safety net for insurance buyers, however, the rule of thumb is that for every dollar of surplus, and insurer can write two dollars of premiums. This over-valuation of the last decade then, spelled oversupply which forced the pricing downwards.

The traditional reaction to the past "soft" market cycle would be to simply raise rates and tighten underwriting criteria, however, securitization and derivative dealings, a banking phenomenon that was applied to the insurance industry in the mid-90's may dilute the previous "hard" market onset, as securitization puts private investors, and not insurers capital at risk.

In addition, large multi-national companies have elected to place their insurance within their own "captive" insurance company, which has a net effect of reducing the demand for traditional insurance products. Since many of these multi-national companies are larger than some insurers, they are able to meet losses out of their own cash flows. This serves to further reduce the demand for insurance policies, whilst the supply, or capacity continues unabated.

It has been surmized that the industry really has only two options surrounding the current over-capacity problem. Firstly, it can maintain status-quo, and wait for the smaller and financially weaker insurers to become insolvent. This is neither a practical nor an orderly solution however, as ultimately, it will be the survivor insurers who will pay the price for such liquidation.

The other solution of course, is consolidation. This trend has been led off by reinsurers. Taking the U.S. reinsurance market as an example, there were over 100 reinsurance companies only a decade ago, versus 36 right now. Merging, or buying does not however, shed capital, but rather only adds the capital of the merged or acquired insurers. Moreover, recent research has illustrated that when large insurers grow huge, or small ones grow to a medium-size, they become less, and not more, efficient. Insurance, unlike, say factory-based industry, faces no short-term capacity constraints, so even if a large insurer hikes rates, smaller rivals immediately pick up the market share, having the net effect of quashing the previous rate hikes.

When all is said and done however, the over-capacity problems facing insurance companies the world over may well be the same at the turn of the next millennium as they are currently. Only time will tell.

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