Stars and Spitzer

London Post Magazine
Robert Meder
December 2, 2004

Looking back over the US insurance market in 2004, Robert Meder concludes that the worst hurricane season in decades has been nothing compared to the New York Attorney General investigations and subsequent findings.

On 14 October, I was having lunch with an underwriter friend at The Full Schilling, a downtown Manhattan pub frequented by many in the insurance industry and coincidentally located directly across the street from 70 Pine Street, AIG’s worldwide headquarters.  We were a bit confused by the sight of several television news vans parked outside the building, but given AIG’s position as the world’s largest insurance company this was not that unusual.

We settled inside, placed our orders, and turned our heads toward the largest television screen on the wall where several other patrons were watching CNN.  We quickly realized that what was unfolding on that newscast was something so profound we could not begin to guess at its consequences:  New York Attorney General Eliot Spitzer was suing the world’s largest broker, Marsh and McLennan, for alleged bid-rigging and price-fixing, and several major insurers including AIG were also being investigated.

Customers fumbled for their mobile phones as they stared numbly at the drama unfolding on the screen, and the barrage of press releases in subsequent days provided more gory details of the investigation.

When I was initially invited by Post Magazine to provide a New York broker’s perspective on the US insurance market for the past year, I thought the main topic would be the overall softening of the market, despite this year’s abundance of hurricanes.  In addition, tort reform and the expiration of the federal backstop for terrorism insurance where high on the agenda for inclusion.  But as the saying goes, you never know what lies around the corner.

The final weeks of October 2004, however, will undoubtedly be remembered as a watershed in US insurance history.  In the weeks immediately following Spitzer’s charges, brokers and insurers alike scrambled for damage control – Marsh announced it was no longer accepting contingency payments from insurers, followed by Willis and Aon, while AIG announced it was no longer paying them.

Jeffrey Greenberg, chief executive officer of Marsh, stepped down, while other industry executives were suspended or arrested.  Insurance stocks plummeted, with Marsh losing 50% of its value within days and class action suits soon abounded.  All this happened at a time when, in general, the US insurance industry seemed to be responding nicely in terms of profitability and market conditions.  In many ways, October’s insurance scandals could not have come at a worse time.

The Insurers

For the first half of 2004, aggregate after-tax net income for the US property/casualty industry rose to a record $23.5bn (₤12.5bn), from $14.5bn in the same period last year, according to the Insurance Services Office.

This performance was based mainly upon improvements in both underwriting results and investment income.

The first half surge in net income and surplus was driven primarily by strong underwriting results, as illustrated by the fact that the industry’s combined ratio (losses and expenses as a percentage of net premiums earned) improved by 5.4% to 94.4%.  This represents the best first-half combined ratio in at least 19 years.  While these figures will be impacted by the second-half hurricanes, the results are still impressive.

For insurance buyers, the result has been lowering prices.  During the third quarter, commercial property/casualty premiums continued to decline significantly, with two-thirds of all large and medium buyers experiencing drops of up to 20%, according to the Third Quarter Commercial Market Index Survey conducted by the Council of Insurance Agents and Brokers.  On average, premiums declined 5.9% for all commercial buyers in the quarter.

Lou Roca, managing director at regional retail broker Treiber Group in Garden City, New York, feels that the return to underwriting profitability is a major reason behind this.   “Much of what we have seen is in large part driven by a return to profitability for many carriers, based on double-digit rate increases during the previous 24 to 30 months.  To a lesser extent, the continued availability of capacity from offshore companies and the virtual absence of catastrophic loss activity in 2002 and 2003 are also factors.  This has resulted in renewal reductions of as much as 20% for property-driven risks.”

Mr. Roca warns, however, that coverage expansions still need to be negotiated with insurers, while pricing for certain industries, such as construction contractors, remains firm.  He cautions that with insurers, “underwriting discipline is still strong, and the best broker negotiations will be based on first-class submissions supported by a compelling story to tell underwriters why a risk should be entertained at the targets requested.”

While many insurers announced significant hits as a result of this year’s hurricanes, at this point it appears the impact will be manageable.  When Hurricane Ivan first struck Florida, catastrophe modeling firm EQECAT estimated the damages would range from $3bn to $16bn.  Since then, several insurers have announced their own individual estimates of impact.  Arch Capital Group estimates $140m from Hurricanes Charley, Frances, Ivan and Jeanne; Ace estimates $100m from Charley alone and $480m overall from the season’s storms; and Risk Management Solutions estimates that total industry loses from Frances will be between $3bn and $6nb.  However, the overall impact of these storms is still minimal.

Mr. Roca feels that “their impact will have a negligible affect on pricing,” adding that, “2005 and beyond will likely see a continued softening spreading to difficult classes and lines of coverage.”  Not even the volcanic eruption at Mount St. Helens in October has impacted pricing.

One interesting result from the lowering property rates has been the increased casualty capacity in Bermuda as underwriters seek to take advantage of the still-buoyant market.  For example, Renaissance Re, originally set up in the wake of Hurricane Andrew, now writes about one-third of its business in casualty lines.  Arch has also significantly expanded its casualty book.  These factors may ultimately contribute to a softening casualty market tool.

Financial lines of coverage, such as directors’ and officers’ and fiduciary liability, are also seeing reductions, while terms slowly revert to more favorable language.  According to results of the Risk and Insurance Management Society Benchmark Survey, released in October, the third quarter of 2004 was the first quarter in which average pricing for all D&O renewals declined.

The survey also marked a significant downturn for fiduciary liability, a line that has been experiencing healthy increases all year.  Fiduciary rates dropped between 2% and 3%, while D&O dropped about 1%.

Editor in chief David Bradford of Advisen, who summarized results of the survey, said: “While the declines are modest, they indicate that most underwriters seem to be losing more pricing negotiations with brokers than they are winning.”  Higher D&O limits are also being pursued, induced in part by Sarbanes-Oxley, the theory being that smaller public companies may not have the resources to comply to the absolute letter of the law and want increased protection if shareholder suits increase.

While current investigations into broker practices have diverted the industry’s attention from terrorism, the clock continues to tick on the looming expiration of the Terrorism Risk and Insurance Act.  Speaking at November’s annual executive conference for the property-casualty industry, Hartford Financial Services Group chairman Ramani Ayer said: “There is a reduced sense of urgency surrounding the issue of terrorism” three years after 11 September.  “Our intelligence community has told us there is a high probability of another terrorist attack within our borders.  We have to be prepared for such an eventuality.”  TRIA is, however, scheduled to expire in 12 months.

The Brokers

For US insurance brokers, the primary issue will continue to be the Spitzer inquiry, while attorney generals in other states conduct their own investigations into contingency payments.

The big question going forward will be how brokers make up for revenues lost due to abolishment of contingent agreements.  When Marsh announced it was suspending the contingent payments, or market service agreements, it also announced that a total of $845m in such payments were generated during 2003 alone.  These fees represented 7% of the firm’s total revenue but a much greater portion of its profits since the acquisition cost of these fees was minimal.  In November, Marsh announced it was laying off 3000 employees and is looking at its worst profit scenario since 1997.

While trying to retain apprehensive brokers, as well as assure clients, the Marsh situation has been compared to trying to patch a hole in a ship taking on water, while selling tickets to the next cruise, during hurricane season.  But Marsh is not alone in the investigations, and many feel it will rebound with the new management structure.

As far as acquisition activity is concerned, it is anticipated that the Spitzer investigations will have a slowing effect for the remainder of the year and into 2005.  They said activity has been substantial among the regional brokers throughout 2004.

According to a study of regional brokerage acquisition activity conducted by WFG Capital Advisors, brokers studied had spent 15% more on acquisitions during the first six months of 2004, than they did for the whole of 2003.

Furthermore, acquired revenues for the same periods indicated that during the first half of 2004 there was a 15% increase in total acquired revenue.

One factor contributing to this increased acquisition activity is the softening market, which is forcing brokers to accelerate buying strategies to cover declining organic growth.

Robert Lieblein, managing principal and president of WFG, says that while the Eliot Spitzer cases “may temporarily slow industry consolidation, our belief is that when there is so much scrutiny on contingent, wholesale and reinsurance commissions being funneled back to the retail segment, when the dust settles, acquisitions will actually have to play a larger role in firms’ growth.  We believe the rate of consolidation will increase, especially with little or no change in product pricing”.

Regional brokers’ acquisitions during 2004 were more strategic-driven than growth-driven, allowing them to access specialized sectors or niches.

Some examples include the October acquisition by Arthur J. Gallagher of Arthur Yanoff, a wholesale specialist in surplus lines; and the November acquisition by Hilb Rogal Hobbs of Smith Bell Thompson, a wholesale specialist in the social services sector.  Other regional acquisitions this year have included USI’s acquisitions of Summit Global Partners and Bertholon-Rowland, as well as Hub International’s acquisition of Talbot Financial.

US brokers and carriers alike are struggling with how to communicate information about the current investigations effectively to clients.  Many publicly held brokers have sent broadcast messages to their client bases, and/or posted information on their websites.  Meanwhile, additional industry suspensions and resignations continue to be announced in the press on a regular basis.  Are changes ahead for US insurance brokers in the way they earn income and, for that matter, client confidence?  Absolutely, but the changes being discussed are clearly in the best interests of all parties.  Maybe our industry was due for some changes; towards the end of 2004, rest assured, we got some.

- Robert Meder is director of marketing at Hagedorn and Company in New York.  Hagedorn, founded in 1869, is a privately held retail insurance brokerage with offices in Manhattan and Ossining, New York.