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Incorporating the New Domestic Political Paradigm into
Financial ResearchInsurance Focus
Financial Management Association Annual MeetingNew York, NY
October 22, 2010Download at: www.iii.org/presentations
Robert P. Hartwig, Ph.D., CPCU, President & EconomistInsurance Information Institute 110 William Street New York, NY 10038
Tel: 212.346.5520 Cell: 917.453.1885 bobh@iii.org www.iii.org
2
Presentation Outline
Financial Services Reform: Provisions Affecting Insurers
Critical Distinctions Between Banks and Insurers
Financial Strength/Solvency Performance Trends Impairment analysis
Financial Performance Under Crisis Conditions
Public Opinion, Crisis and Perceptions of the Insurance Industry
Insurance Industry Financial Strength During the Crisis Distinctions between insurers and banks
Financial Services Reform Legislation Dodd-Frank & Insurance
Solvency II in the EU
Q&A
3
The New Domestic Political Paradigm: Insurance Industry Research
Education: Getting Public Policy Makers to Understand that Insurance is Not Like Banking
Fundamentally Different Approaches to Risk Management Between Banks and Insurers
Moral Hazard is Well Understood and Avoided
Insurance & Systemic Risk: Unlikely
Regulatory Arbitrage
State/Federal
Solvency Regulation in Europe
Solvency II
AIG: Non-Insurance Operations
Risk management of large, complex organizations
Financial Services Reform
4
Insurers Are Impacted, But Not Significantly
5
Financial Services Reform:What does it mean for insurers?
Systemic Risk and Resolution Authority
Creates the Financial Stability Oversight Council and the Office of Financial Research
Imposes heightened federal regulation on large bank holding companies and “systemically risky” nonbank financial companies, including insurers
Federal Insurance Office (FIO)
Establishes the FIO (while maintaining state regulation of insurance) within the Department of Treasury, headed by a Director appointed by the Secretary of Treasury
FIO will have authority to monitor the insurance industry, identify regulatory gaps that could contribute to systemic crisis
CONCERN: FIO morphs into quasi/shadow or actual regulator with a heavy emphasis on consumer protection issues
Surplus Lines/Reinsurance
Title V of the Dodd-Frank bill includes, as a separate subtitle, the Nonadmitted and Reinsurance Reform Act (NRRA), which eliminates regulatory inefficiencies associated with surplus lines insurance and reinsurance
The Dodd Frank Wall Street Reform and Consumer Protection Act
Source: Insurance Information Institute (I.I.I.) updates and research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
6
Systemic Risk: Oversight & Resolution Authority
Financial Stability Oversight Council created to oversee systemic risk
of large financial holding companies) [a.k.a. TOO BIG TOO FAIL]
P/C insurers potentially could be determined to present systemic risk to the
financial system and thus be supervised by the Federal Reserve.
Such supervision would subject such insurers to prudential standards, if the
Council determines that financial distress at the company would pose a threat to
the U.S. financial system.
Orderly Liquidation
The legislation provides an “Orderly Liquidation Authority” mechanism whereby
the FDIC would have enhance powers to resolve distress at financial institutions.
Insurance holding companies and any non-insurance subsidiaries of insurers
may be subject to this authority.
Issues Related to Systemic Risk & Resolution Authority
Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
7
Systemic Risk: Oversight & Resolution Authority
Orderly Liquidation (cont.)
Insurers are generally exempt from the liquidation authority, but the FDIC would
have “backup authority” to place an insurer into orderly liquidation under state
law if the state regulator has not done so within 60 days of a systemic risk
determination.
Liquidation Fund Assessments
The liquidation fund would be funded by assessments on large financial
companies, potentially including insurers.
But the insurance industry already has a funding system (state guaranty funds) to
pay for the unwinding of failed companies. Therefore, contributions to these state
guaranty funds must be considered.
Issues Related to Systemic Risk & Resolution Authority
Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
8
Federal Insurance Office (FIO):What Would it Do?
Establishes office within US Treasury headed by a Director appointed
by Treasury Secretary, and charged with:
Monitor the insurance industry to gain expertise (oversight extends to all lines of
insurance except health insurance, long-term care insurance and federal crop
insurance).
Identify regulatory gaps that could contribute to a systemic crisis in the insurance
industry or the U.S. financial system.
Gather information from the insurance industry in order to analyze such data and
issue reports. May require insurers, with exception of small insurers which are
exempt, to submit data and FIO director can issue subpoenas to gain such info.
Deal with international insurance matters.
Monitor the extent to which underserved communities have access to affordable
insurance products.
Duties of the Federal Insurance Office
Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
9
Federal Insurance Office (FIO):What Would It Do? (Cont.)
Establishes office within US Treasury headed by a Director appointed by
Treasury Secretary, and charged with:
Make recommendations to the FSOC on whether an insurer (incl. reinsurers) poses
a systemic risk and should be placed under supervision of the Federal Reserve.
Annual reports to Congress and the President on the insurance industry are
required.
A study on the modernization of insurance regulation in the U.S. is required within
18 months, as is a report on the U.S. and global reinsurance market
Oversee the federal Terrorism Risk Insurance Program.
Insurance will continue to be regulated by the states, but the FIO has limited
preemption authority over state law in cases where it determines that state law is
inconsistent with a negotiated international agreement and treats a non-U.S.
insurer less favorably than a U.S. insurer.
Duties of the Federal Insurance Office
Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
12
Other Matters Impacting Insurance
Derivatives:
The bill would require most standardized derivatives to be routed through
clearinghouses and traded on exchanges.
Two new classes of regulated entities would be created: swap dealers and major
swap participants.
Both would be required to register with the SEC and/or the CFTC and would be
subject to margin, capital, record-keeping and business conduct requirements.
Bureau of Consumer Financial Protection:
The Bill creates a new federal level entity within the Federal Reserve with the
authority to regulate financial products offered to consumers.
Insurance products are specifically exempted from this bureau’s authority.
Derivatives and Bureau of Consumer Financial Protection
Source: Insurance Information Institute (I.I.I.) updates/research; The Financial Services Roundtable; Adapted from summary by Dewey & LeBoeuf LLP
New Rulemakings Under The Dodd Frank Wall Street Reform and Consumer Protection Act
24
6156
31
54
2
17
4
95
9
0
10
20
30
40
50
60
70
80
90
100
Bureau ofConsumerFinancialProtection
CFTC FinancialStability
OversightCouncil
FDIC FederalReserve
FTC OCC Office ofFinancialResearch
SEC Treasury
A total of at least 243 new rulemakings are expected under the Dodd-Frank financial reform by Federal Agency*
* Total eliminates double counting for joint rule-makings and this estimate only includes explicit rule-makings in the bill, and thus likely represents a significant underestimate.Source: Wall Street Journal, July 14, 2010; Davis Polk & Wardwell. 13
Source: James Madison Institute, February 2008.
ME
NH
MA
CT
PA
WV
VA
NC
LA
TX
OK
NE
ND
MN
MI
IL
IA
ID
WA
OR
AZ
HI
NJRI C
DE
AL
VT
NY
MD
SC
GA
TN
AL
FL
MS
ARNM
KYMOKS
SDWI
IN
OH
MT
CA
NV
UT
WY
CO
AK
= A= B= C= D= F= NG
Source: Heartland Institute, May 2010
A- A-
A-
B-
B-
B-
B-
B-
B-B-
B-B-
B-
B-
B-
B-
B- C-
C-
C-
C -
C-
D-D-
A
A
A
A
B+
B+
B+
B
B
B
B
B
B
C+
C+
C
D+
D+D+
D
NG
NG
D F
F
2010 Property and Casualty InsuranceState Regulatory Report Card
Not Graded: District of ColumbiaMississippiLouisiana
The Longstanding, Raging Debate Over Federal vs. State Regulation
Could Re-emerge in 2011
15
Consumer Poll: I.I.I. Pulse Survey
Q. Of The Following Industries, Which Do You Think Has Been Hurt Most By The Financial Crisis?
Source: Insurance Information Institute Annual Pulse Survey.
More than Half of Americans Think that Banks Are the Industry that Has Been the Most Affected by the Financial Crisis
15%
7%
11%53%
14%
Mutual fund companies
Don’t know
Banks
Securities firms
Insurance companiesThe concern people
express over their insurers remains small compared to concern over banks, mutual
funds and securities
firms
Critical Differences Between P/C Insurers and Banks
16
Superior Risk Management Model and Low Leverage Make a Big Difference
17
How P/C Insurance Industry Stability Has Benefitted Consumers
Bottom Line:
Insurance markets – unlike banking – operated normally throughout the entirety of the crisis and continue to do so today
The basic function of insurance – the orderly transfer of risk from client to insurer – continues uninterrupted
This means that insurers continue to: Pay claims (whereas 300 banks have gone under as of 10/15/10)
– The promise is being fulfilled
Renew existing policies (banks are reducing and eliminating lines of credit)
Write new policies (banks are turning away people and businesses who want or need to borrow)
Develop new products (banks are scaling back the products they offer) Compete intensively (banks are consolidating, reducing consumer choice)
Source: Insurance Information Institute
18
Reasons Why P/C Insurers Have Fewer Problems Than Banks
Emphasis on Underwriting Matching of risk to price (via experience and modeling) Limiting of potential loss exposure Some banks sought to maximize volume and fees and disregarded risk
Strong Relationship Between Underwriting and Risk Bearing Insurers always maintain a stake in the business they underwrite, keeping “skin in the game” at
all times Banks and investment banks package up and securitize, severing the link between risk
underwriting and risk bearing, with (predictably) disastrous consequences – straightforward moral hazard problem from Econ 101
Low Leverage Insurers do not rely on borrowed money to underwrite insurance or pay claims There is no credit or
liquidity crisis in the insurance industry
Conservative Investment Philosophy High quality portfolio that is relatively less volatile and more liquid
Comprehensive Regulation of Insurance Operations The business of insurance remained comprehensively regulated whereas a separate banking system
had evolved largely outside the auspices and understanding of regulators (e.g., hedge funds, private equity, complex securitized instruments, credit derivatives – CDS’s)
Greater Transparency Insurance companies are an open book to regulators and the public
A Superior Risk Management Model
Source: Insurance Information Institute
Financial Strength & Ratings
19
Industry Has Weathered the Storms Well
P/C Insurer Impairments, 1969–20098
15
12
71
19
34
91
31
21
99
16
14
13
36
49
31 3
45
04
85
56
05
84
12
91
61
23
11
8 19
49 50
47
35
18
14 15
7 65
0
10
20
30
40
50
60
70
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
Source: A.M. Best; Insurance Information Institute.
The Number of Impairments Varies Significantly Over the P/C Insurance Cycle, With Peaks Occurring Well into Hard Markets
5 of the 11 are Florida companies (1 of these
5 is a title insurer)
22
Summary of A.M. Best’s P/C Insurer Ratings Actions in 2009
3.8%
2.9%3.2%
2.4%
11.9%75.7%
.Source: A.M. Best.
P/C Insurance is by Design a Resilient Business. The Dual Threat of Financial Disasters and Catastrophic Losses
Are Anticipated in the Industry’s Risk Management Strategy
Despite financial market turmoil and a soft market
in 2009, 76% of ratings actions by A.M. Best were affirmations;
just 2.9% were downgrades and 3.2%
were upgrades
Affirm – 1,375
Downgraded – 53
Upgraded – 59Initial – 44
Under Review – 69
Other – 216
23
Reasons for US P/C Insurer Impairments, 1969–2008
38.1%
14.3%8.1%
7.6%
7.9%
7.0%
9.1%
4.2%
3.7%
Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2009
Deficient Loss Reserves and Inadequate Pricing Are the Leading Cause of Insurer Impairments, Underscoring the Importance of Discipline.
Investment Catastrophe Losses Play a Much Smaller Role
Deficient Loss Reserves/Inadequate Pricing
Reinsurance Failure
Rapid GrowthAlleged Fraud
Catastrophe Losses
Affiliate Impairment
Investment Problems
Misc.
Sig. Change in Business
Solvency II
24
Move Toward More Stringent Regulatory Requirements for
Insurers Originating in Europe
25
Solvency II: The EU’s Effort to Modernize Insurance Solvency Regulation
Solvency II: Provides a Comprehensive Framework for Risk Management for Defining Capital Levels and to Implement Procedures to Identify, Measure and Manage Risk Levels Solvency I was primarily a Directive aimed at revising and updating existing EU
solvency regimes, which had been in existence since the 1970s. The emphasis was on solvency margins.
Since deficiencies had been identified over the years, individual EU members adopted various fixes resulting in a patchwork of regulatory requirements inconsistent with the goal of harmonized insurance regulation across the EU. Solvency II addresses this goal of harmonization.
Scheduled to Come into Effect in the EU on Dec. 31, 2012
Consists of 3 Main “Pillars”
Pillar 1: Consists of Quantitative Requirements (e.g., amount of required capital) Establishes qualitative and quantitative requirements for calculation of technical provisions and
Solvency Requirement Ratio (SCR) using either a standard regulator-provided formula or an internal model developed by the (re)insurer itself
Pillar 2: Establishes Requirements for Governance
Pillar 3: Focuses on Disclosure and Transparency Requirements
Source: European Commission; Wikipedia: http:en.wikipedia.org/wiki/Solvency_II; Insurance Information Institute
26
US Non-Life Insurance Industry Performance
Insurer Resilience
P/C Net Income After Taxes1991–2010:H1 ($ Millions)
$1
4,1
78
$5
,84
0
$1
9,3
16
$1
0,8
70
$2
0,5
98
$2
4,4
04 $3
6,8
19
$3
0,7
73
$2
1,8
65
$3
,04
6
$3
0,0
29
$6
2,4
96
$3
,04
3
$1
6,5
31$2
8,3
11
-$6,970
$6
5,7
77
$4
4,1
55
$2
0,5
59
$3
8,5
01
-$10,000
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10:H1
2005 ROE*= 9.6% 2006 ROE = 12.7% 2007 ROE = 10.9% 2008 ROE = 0.3% 2009 ROAS1 = 5.8% 2010:H1 ROAS = 6.3%
* ROE figures are GAAP; 1Return on avg. surplus. Excluding Mortgage & Financial Guaranty insurers yields a 7.5% ROAS for 2010:H1 and 4.6% for 2009. 2009:H1 net income was $19.2 billion and $10.2 billion in 2008:H1 excluding M&FG.Sources: A.M. Best, ISO, Insurance Information Institute
P-C Industry 2010:H1 profits rose $10.6B from $6.0B in 2009:H1, due mainly to $2.2B in realized
capital gains vs. -$11.1B in previous realized capital losses
28
ROE: P/C vs. All Industries1987–2009*
* Excludes Mortgage & Financial Guarantee in 2008 and 2009.Sources: ISO, Fortune; Insurance Information Institute.
-5%
0%
5%
10%
15%
20%
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
US P/C Insurers All US Industries
P/C Profitability IsCyclical and Volatile
Hugo
Andrew
Northridge
Lowest CAT Losses in 15 Years
Sept. 11
Katrina, Rita, Wilma
4 Hurricanes
Financial Crisis*
(Percent)
29
-5%
0%
5%
10%
15%
20%
25%
71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
10F
Soft Market Appears to Persist in 2010 but May Be Easing: Relief in 2011?
(Percent)1975-78 1984-87 2000-03
Shaded areas denote “hard market” periodsSources: A.M. Best (historical and forecast), ISO, Insurance Information Institute.
Net Written Premiums Fell 0.7% in 2007 (First Decline Since 1943) by 2.0% in 2008, and 4.2% in 2009, the First 3-Year Decline Since 1930-33.
NWP was flat with 0.0% growth in 10:H1 vs. -4.4% in 09:H1
30
Policyholder Surplus, 2006:Q4–2010:Q2
Sources: ISO, A.M .Best.
($ Billions)
$487.1$496.6
$512.8$521.8
$478.5
$455.6
$437.1
$463.0
$490.8
$511.5
$540.7$530.5
$505.0$515.6$517.9
$420
$440
$460
$480
$500
$520
$540
$560
06:Q4 07:Q1 07:Q2 07:Q3 07:Q4 08:Q1 08:Q2 08:Q3 08:Q4 09:Q1 09:Q2 09:Q3 09:Q4 10:Q1 10:Q2
2007:Q3Previous Surplus Peak
Quarterly Surplus Changes Since 2009:Q1 Trough
09:Q1: -$84.7B (-16.2%) 09:Q2: -$58.8B (-11.2%)09:Q3: -$31.8B (-5.9%)09:Q4: -$10.3B (-2.0%)
10:Q1: +$18.9B (+3.6%)10:Q2: -$10.2B (-1.9%)
Surplus set a new record in 2010:Q1*
*Includes $22.5B of paid-in capital from a holding company parent for one insurer’s investment in a non-insurance business
31
Ratio of Insured Loss to Surplus for Largest Capital Events Since 1989*
* Ratio is for end-of-quarter surplus immediately prior to event. Date shown is end of quarter prior to event** Date of maximum capital erosion; As of 9/30/09 (latest available) ratio = 5.9%Source: PCS; Insurance Information Institute
3.3%
9.6%
6.9%
10.9%
6.2%
13.8%
16.2%
0%
3%
6%
9%
12%
15%
18%
6/30/1989Hurricane
Hugo
6/30/1992HurricaneAndrew
12/31/93NorthridgeEarthquake
6/30/01 Sept.11 Attacks
6/30/04Florida
Hurricanes
6/30/05Hurricane
Katrina
FinancialCrisis as of3/31/09**
The Financial Crisis at its Peak Ranks as the Largest
“Capital Event” Overthe Past 20+ Years
(Percent)
Property/Casualty Insurance Industry Investment Gain: 1994–2010:H11
$35.4
$42.8$47.2
$52.3
$44.4
$36.0
$45.3$48.9
$59.4$55.7
$64.0
$31.7
$39.0
$25.8
$58.0
$51.9$56.9
$0
$10
$20
$30
$40
$50
$60
$70
94 95 96 97 98 99 00 01 02 03 04 05* 06 07 08 09 10:H1In 2008, Investment Gains Fell by 50% Due to Lower Yields and
Nearly $20B of Realized Capital Losses 2009 Saw Smaller Realized Capital Losses But Declining Investment Income
Investment Gains Are Recovering So Far in 20101 Investment gains consist primarily of interest, stock dividends and realized capital gains and losses.* 2005 figure includes special one-time dividend of $3.2B.Sources: ISO; Insurance Information Institute.
($ Billions) 2009:H1 gain was $12.5B
Investment gains in 2010 are on track to be their best since 2007
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