Just a year ago, the top concerns of insurance companies were too much regulation and natural catastrophes. Executives believed that the biggest risks facing their industry stemmed from unpredictable acts of God and heavy-handed government interference in the free market.
In the meantime the sector has learned – by watching the spectacular failures of their colleagues in banking – about the dangers of manmade disasters and light-touch regulation.
A report by PWC and the UK's Centre for the Study of Financial Innovation published early this month – 'Insurance Banana Skins 2009' – found that this year insurers are most worried about investment performance and capital availability. These issues did not even crack the top 10 in 2008's survey, but are crucial in the midst of economic crisis.
As the report's summary points out, insurance companies depend on investments to pay claims, stay profitable and protect their capital reserves. Premium income is not enough to cover these commitments, especially as claims tend to rise in recessions while both new and repeat business falls off. So the industry is forced to lean more on stock market investments to bridge the gap, but the markets are in the middle of the deepest crisis since the Great Depression and returns are extremely volatile.
The resulting squeeze on profitability threatens the solvency of insurance companies, which is why they are suddenly so focused on capital availability. And as any banker could tell you, capital is pretty hard to find out there.
The ratings agencies have taken note of the situation. This month alone, Standard & Poor's cut Aviva's credit rating and put Zurich and Axa Ireland on negative watch. Nothing dramatic, nothing to panic about, but the analysis is telling.
"Amid a daunting financial landscape, [insurers'] ability to raise capital is more restricted than would previously have been the case," S&P said in a research report. In a separate note, the agency was more specific about Axa Ireland, where shareholders' equity has been cut in half because of huge falls in the value of equities the company holds, predicting further weakening of its capital position due to weakness in investment markets.
What's happening here? Are insurance companies – supposedly the experts in pricing and managing risk – heading the same way as banks?
Well, not so fast. Some industry observers dismiss the recent downgrades as merely a sign that the ratings agencies are acting tough after badly misjudging the risks associated with subprime mortgage-backed securities and watching much of the financial sector go down in flames as a result.
But the dangers facing the insurance sector have grown and become more serious because of the economic crisis. For life companies, poor investment performance is proving a real challenge as customers turn away from savings products that are producing dire returns, in turn reducing fee income. Companies that came to depend on investment income during the boom have a big hole to fill.
For general insurers focused on motor, home and commercial products, the loss of contributions to investment returns means there is less money to protect reserves. This is why Irish consumers are experiencing higher premium costs even though prices in general are coming down in other parts of the economy.
The danger here, according to industry analysts, is that some companies might be tempted to underprice for risk and hope to plug the hole with now-unreliable investment income.
"If someone tries to cashflow out of the pricing cycle they could get into real trouble," said Garvan O'Neill, insurance partner with PWC Ireland.
The deeper the downgrades go, the more expensive financing becomes and the more tempting it is to try this trick. And without the central bank lines of credit available the way they are for banks, insurers could find themselves more isolated if liquidity becomes a problem.
According to a source at a major Irish insurer, the risk will be at its greatest two years after growth slows – in other words, this year.
According to figures from the Irish Insurance Federation, most non-life business has been written at a loss since 2007. During a period of rapid growth, income – even on business written at a loss – can cover claims because policy-holders prefer to keep their no-claims bonuses intact. But as economic and business growth slows and claims catch up, the insurer has to release reserves to meet commitments. If investment income does not compensate, the company eats into its capital and risks insolvency. It's not unlike the situation Irish banks got into by lending with the expectation of continuing property price appreciation.
Not coincidentally, since the banking crisis erupted last September, regulators have moved to ensure the stability of the insurance industry. The Financial Regulator already required insurance companies to keep a buffer of 50% above the minimum solvency margin required by EU regulations. But late last year the regulator instituted a new electronic reporting system to monitor financial performance and demanded quarterly – rather than annual – returns.
At the same time, the regulator conducted a survey of insurance companies to get a sense of their solvency positions and asset distribution. While there has been a downward trend in solvency generally in the sector, the regulator told the Sunday Tribune its is still "monitoring closely the solvency position and compliance with prudential requirements of all companies under our supervision and, in general, is satisfied that companies remain well capitalised."
Acting chief executive Mary O'Dea has her hands full with the banking crisis, but the regulator has beefed up its insurance division recently by appointing a former Hibernian executive as deputy head in an effort to get more practitioners involved in supervision.
The big change in the industry, however, is coming with the so-called Solvency II regime, which was passed by the European Parliament last week. Solvency II will force insurers to set their capital according to the risk levels in the policies they underwrite, rather than according to the premiums they collect. The changes are expected to eliminate some of the dangers of underpricing by removing the incentive to discount risky business for the sake of cash flow.
The new rules take effect in 2012 and promise to bring with them sweeping changes to the structure of companies and the industry as a whole. But as we've seen with banking, a lot can change in just one year, let alone three.