May 1, 2002

Overview

2001 was a year for significant change within the property insurance marketplace. Prior to 9/11, the property insurance market was already reducing capacity and increasing pricing at a pace that would have returned the market to its pre-soft market levels of 1987 within 5 years. Of course, with several catastrophic losses prior to 9/11 (Tropical Storm Allison, for example), reinsurers were looking to better their returns on the earthquake, flood and wind lines of business.

September 11th brought an entirely new philosophy to the insurance market. The idea of a true catastrophe had widened beyond the typical manufacturing/petrochemical or weather/seismic related events. The “standard” markets (Swiss Re, Chubb, Hartford, Royal, Travelers, among others) learned that the large limits they put up were not just “sleep at night” coverage for Insureds - these large limits could actually be pierced and encounter losses.

“No Thanks, I’m On A Diet”

Reinsurance, until 1/1/02, had been the source of insurance company capacity in a similar fashion to how high yield bonds were a source of private equity purchasing power. Insurance companies were ceding far more exposure to reinsurance companies than they were assuming for their own account. Post 1/1/02 (the first reinsurance treaty renewal after 9/11), the fundamental reality for the “standard markets” is that they must assume risk in order to survive. This has led to a completely new underwriting philosophy for underwriters who had not been in this position previously.

For all property insurance perils, underwriting capacity is now as tight as it has ever been. Any large single exposed value is now subject to the underwriter’s fear of paying a claim up to the loss limit. Prior to 9/11, that same underwriter believed the worst-case scenario would be in line with “Maximum Loss calculations” (i.e. a Fire Resistive building would normally have a Maximum Loss percentage of 15% or so of the total value). Underwriters are now faced with the reality that their previous calculations are now more of a guess as opposed to actual scientific facts, and their company now pays for “mistakes.”

Most markets have cut the amount of limits they are willing to post by 75% or more. For example, IRI, an A.M. Best rated “A++ XV insurer that has historically carried up to $1.5 billion in limits (net and through treaties) can, today, write up to $10.0 million. Other insurance companies, such as Travelers, Allianz and ACE have cut their primary capacity to a maximum of $25.0 million - and only where there are minimal exposures (i.e. non-manufacturing or process, non-frame, non-habitational).

“Just The Facts, Ma’am”

“Blanket limits” are no longer available. Insurance companies, in general, will only provide “scheduled limits” in order to reduce the likelihood of insuring the “unknown” values that had previously been picked up without declarations. In addition, markets are looking to add co-insurance clauses and are pressing for accurate statements of values that truly represent the replacement values of the insured property. Over the past several years, insureds had been able to report values that were likely less than the Replacement Cost Value and underwriters would turn a blind eye. While waiving value changes and ignoring incorrect valuations was a big part of soft market decreases in the past, insurers are getting full rates on all values now.

“Back To The Basics”

The insurance industry has historically underwritten its policies to an expected loss. That loss figure was usually more than offset through the investment returns generated from the premiums collected prior to loss payments. “Cash flow underwriting” had become the standard in the industry.

Due to the lack of significant investment returns since the market declines of 2000, coupled with the 9/11 losses, the insurance company mantra today is “Profitability.” Growing top line revenue is secondary to turning a profit. Many senior managers of insurance companies are facing performance related repercussions if their results do not improve during 2002. This sense of urgency has found its way through the underwriting community. Consequently, if we are to continue to deliver the most comprehensive and cost effective risk transfer products to our clients, it is important to recognize that the marketplace is going through a fundamental change, and is markedly different than the market of the past decade.

“Great, What’s Next?”

The first half of the 2002 has brought further changes. With rates rising and year to date combined ratios for many insurers still in excess of 100%, companies are under increased pressure to continue to raise rates and push insureds to increase retentions (deductibles). The reinsurance treaties scheduled to renew on July 1 are likely to be more expensive and these increased costs will again be passed on to Insureds. In many cases, reinsurers will again require already gun-shy insurers to take more capacity on a net basis.

Capacity, while adequate, is declining from prior years - a key difference from the “hard” market of the 1980s when risks were going bare for lack of capacity. However, there are some similarities to the 1980’s hard market - markets are “quota sharing” accounts and multiple layers of insurance carriers are required to obtain the needed capacity. Many of the same names of the hard market are showing up on placements again - Lexington (AIG), Lloyd’s, and Berkshire Hathaway, to name a few.

“Great, What’s Next?”

Premium increases are ranging from 30% for a clean “name account” business to multiples of expiring premium for “difficult” risks. The definition of a “difficult risk” includes poor loss record, specific occupancies (chemicals, plastics, steel, woodworking, utilities), catastrophe prone accounts, and any insured that has squeezed every last cent in savings from the soft market and/or may be coming out of a competitively priced multi-year deal. Despite increases, incumbent markets are generally still offering the best renewal terms and are retaining their accounts. If an incumbent offers renewal terms, the hit ratio has been greater than 80%.

“But, My Deal Closes In Two Weeks”

Underwriters are reporting up to a 200% increase in submission count due to the massive marketing of every renewal in an attempt to mitigate premium increases and contractions in terms. This has slowed the turnaround time for quotes substantially. Most underwriters will require a detailed spreadsheet of exposure data and an e-mailed submission in order to provide a quote. There is an obvious preference to doing business on line. As always, the best submissions in this market get the best attention. Faxed copies of ACORD applications generally find their way to the bottom of underwriter’s piles.

Underwriting requirements have had a significant impact on the due diligence/post-closing insurance process. The historical norms allocated for insurance due diligence on the more difficult risks are no longer adequate. While the ability to quickly turnaround a due diligence assignment has not changed, the ability to obtain replacement coverage (for asset purchases, spin-offs, roll-ups, etc.) has been meaningfully lengthened. Additionally, the data requirements of underwriters are more detailed, less flexible, and subject to greater supervisory scrutiny. All of these issues manifest themselves in a longer turnaround time for “go-forward” coverages.

“But, My Deal Closes In Two Weeks”

The changes in the property market are much more than a short-term reaction to the 9/11 events. There are substantial underlying changes in underwriting philosophy and appetite for risk. There is a fundamental shift in understanding that underwriting profit is the key to long-term viability. While the swiftness of the changes may appear to be drastic, there is historical precedent. Underwriting cycles have been a constant factor in the insurance marketplace. Macro and micro economic factors (capacity, stock market returns, catastrophic events) combine to exacerbate or mitigate the natural cycle. Ultimately, the market will stabilize. However, we are still too close to the recent events for a prediction as to the length or depth of the down cycle. So, for now, to paraphrase the popular automobile bumper sticker, “Get In, Sit Down, and Hold On!”

Please do not hesitate to contact your Equity Risk Partners professional for advice, counsel, concerns, or sympathy. We look forward to working with our clients and their portfolio companies in navigating the ups and downs of this unprecedented time in the insurance market.

Thank you for your consideration and continued support.

Sincerely,

Michael C. Marcon
President
Equity Risk Partners, Inc.