Logically speaking, one might assume that 2003 should be a pretty good year for insurance companies. Premiums for almost every type of insurance are increasing by double digits for the third year in a row. The industry managed to secure a federal fund that exempts it from covering the bulk of another devastating terrorist attack. And recent bankruptcies among marginal insurers have cleared away some of the clutter from certain markets.

So are insurers happy? Let’s say, they’re not ecstatic. Sure, as an industry their stocks have managed to outperform the S&P 500 Index. But between the debacles at giants like Enron Corp. and WorldCom Inc. and the destruction of the World Trade Center at the hands of terrorists, carriers found themselves entering this year significantly low on reserves and basically unprepared for any unforeseen tragedies produced by Mother Nature or by man himself.

In February, American International Group Inc. decided to take advantage of the current favorable market conditions and post a fourth- quarter charge of $1.8 billion to boost its insurance loss reserves for potential liabilities from workers compensation, directors and officers (D&O) and healthcare coverage. The move startled analysts, and shares of New York-based AIG, the largest commercial insurer and arguably among the property/casualty industry’s most respected underwriters, fell 7% in value.

From the perspective of risk management, the move made all the sense in the world: If not now, then when? Consequently, there is a strong possibility other insurers will follow suit and fund their loss reserves. According to rating agency A.M. Best Co., the industry’s general loss reserves are still deficient by some $40 billion, on top of $60 billion in deficient reserves for past asbestos and environmental claims.

But from the viewpoint of the insured, AIG’s decision signals only one thing: More disciplined underwriting and higher-priced products will likely persist well after 2003. The reasoning is simple. While the reserve actions would clean up insurers’ balance sheets, the dollars directed to reserves create a big hole in a company’s capital. And given the current economy and the outlook for both the equity and fixed-income markets, that cavity is unlikely to be filled by income drawn from insurers’ investment portfolios. The only option is to keep the leash tight on underwriting and choke more price hikes out of companies.

For risk managers with less than a decade or so under their belts, the last three years have been nothing short of frightening. “People take notice of risk management now,” says Andrea Dudek, the director of risk management at global clothing retailer Gap Inc. In the profession only seven years, Dudek reports to Gap treasurer Sabrina Simmons and is now preparing for the company’s April 1 renewal of its diverse property/casualty insurance policies. “We just can’t push insurance costs through like we used to. We’re challenged and should be, forced to look at all the options before we renew a policy. We rip everything apart now to make sure it makes sense.”

She is not alone, of course. Scores of risk managers are bracing themselves for a continuation of the hard insurance market that has gobbled up their insurance budgets for at least two years running. Other than slower growth in premium increases for commercial property insurance–thanks to no major earthquakes, hurricanes or tornadoes–and the availability of terrorism risk protection, courtesy of the U.S. Congress, 2003 doesn’t look as if it will be much different from 2002, and for corporate risk managers, that means headaches and shot budgets.

When will it end? Given the higher cost of reinsurance, stricter regulatory governance of corporate officers and directors, an increase in independent rating agency downgrades of insurers, uncertainty over the economic impact of war with Iraq and the threat of another terrorist attack on U.S. soil, the consensus among everyone from insurance brokers, rating agencies and consultants to large commercial insurers is not any sooner than 2005.

PROPERTY INSURANCE

Property insurance is the one bright light in the dark insurance policy renewal season. Excluding extra premiums tacked on for terrorism risk protection, pricing is either stable or up some 5% to 10%, according to John T. Sinnott, chairman of insurance broker Marsh Inc. “It’s the one line, like aviation, that had spiked the most radically in price, going up 10% to 20% in 2001, then jumping some 80% to 90% a year ago,” Sinnott explains. “The rate of [premium] growth has slowed considerably this renewal season.”

Some risk managers are even receiving price reductions, notes Mario P. Vitale, CEO of insurance broker Willis North America. “Terrorism aside, this is the one market where we see a return of competition,” Vitale says. “Going out on a limb, I’ll even say it is the first line of business to rebound. But having said that, it also is the first line that would respond negatively to a major natural catastrophe like a hurricane, earthquake or windstorm.” In effect, Mother Nature controls pricing in the property market.

When terrorism risks are added to the cost of property insurance, it’s a different ball game. Congress told insurers they no longer could exclude terrorism losses caused by foreign entities on U.S. soil and gave them 90 days to quote the additional premium for what is now a covered risk. Upon receiving the quotes, risk managers either could accept them or, if the extra premium was deemed overly expensive, opt out of terrorism protection. The 90-day deadline passed in late February, and it appears most companies are opting out.

“The prices we’ve seen have ranged from 2% to 150% of the property premium,” Vitale says. “Only 10% to 15% of our commercial property clients are buying the terrorism coverage. Most tell us they’d rather bear the risk of loss than pay the premium.” Those companies that are taking the terrorism protection are the ones considered low risk, he adds.

CASUALTY COVERAGES

While the entire casualty market continues to present higher premiums to risk managers, three lines of insurance –D&O, workers compensation and professional liability–are off the charts price-wise.

The woeful legacy of Enron, WorldCom and other corporate scandals is narrower D&O coverage terms and conditions, on top of three-digit premium increases. Why? “In 1996, there were 11 restatements of earnings per 1,000 publicly listed companies; last year, that number spiked to 35 restatements per 1,000 publicly listed companies,” responds Greg Flood, chief operating officer at National Union, the AIG company that writes the lion’s share of D&O policies in the U.S. “Some of this we can attribute to the complexities of accounting, some to human error and a chunk to what I’ll call aggressive accounting by management teams trying to placate the stock analyst community. What they add up to is great uncertainty for D&O underwriters.”

What’s more, “the number of companies named as defendants in securities class actions is soaring,” Flood adds. “For example, between 1996 and 2002, there were 1,800 publicly listed companies named as defendants. Meanwhile, there are only about 9,300 publicly listed companies overall. The statistics tell the tale.”

Robert Hartwig, chief economist at the Insurance Information Institute, says D&O is in crisis mode. It’s “the hardest market out there,” he comments. “We’ve got a new SEC chairman [Wall Street veteran William Donaldson] who will want to make his mark. Not all the skeletons are out of the boardroom closet, which will make D&O problematic at least through 2004.”

Workers compensation is yet another migraine, given accelerating medical cost inflation and the doleful economy–layoffs mean claim increases because workers fearing termination are more apt to fake an injury and file a fraudulent claim. Workers compensation insurers also are required to cover terrorism risks and, in this case, corporations can’t opt out. The prognosis: 20% to 100% premium hikes, depending on the level of increases the previous year. Amazingly though, it is still “not as tight a market as D&O,” Vitale says.

A ray of hope is tort reform. In a Republican-controlled Congress, the possibility of some modest reforms, such as changes in joint and several liability and a cap on jury awards, is greater than in decades. But Marsh’s Sinnott is skeptical: “Maybe we’ll hit a few singles, but if the industry tries to go for a home run they might not get anything.”

As for the rest of the casualty market–environmental impairment liability, employment practices liability, general liability, excess casualty and umbrella policies–the consensus is for more of the same market constriction and price hikes through 2004. Even specialty lines like cyber insurance, covering both third-party and first-party property and liability exposures from theft of intellectual property to a virus-induced business interruption loss, are under stress. The culprit, says Ty Sagalow, chief operating officer of AIG eBusiness Risk Solutions, is higher-priced reinsurance.

Overall, Hartwig says risk managers “can expect a moderation in pricing from the casualty market next year,” meaning smaller but still significant increases in cost. He adds, “The financials of the casualty industry are still abysmal.”

Others agree. “Frankly, I don’t see any end in sight to the hard market,” says Paul J. Krump, chief operating officer of Chubb Commercial Insurance, the large commercial insurer based in Whitehouse Station, N.J. “I fully recognize the property/casualty market is cyclical, but with the industry’s recent performance, the economy bouncing along at the bottom, the unpredictability of war and terrorism, the cost of reinsurance going up and up and investment income nowhere in sight, the pressure is on to really practice disciplined underwriting.”

REINSURANCE

The reinsurance market is as bad, if not worse, than the primary insurance market. The catastrophic losses caused by the terrorist attacks, coupled with underwriting losses from asbestos and environmental liability, compel reinsurers to strengthen their own loss reserves, meaning they, too, must charge more for their products to replace the redirected capital. Last year, industry leader Munich Re announced a $2 billion charge related to reserve shortfalls at its U.S. subsidiary, American Re. Other reinsurers are expected to announce similar reserve actions.

The upshot for buyers of reinsurance, both traditional insurance companies and corporate-owned captives, has been an “abrupt change in terms, conditions and risk retention levels,” says Robert Farnum, senior financial analyst and actuary at A.M. Best Co. “Insurers, in some cases, had to double their retentions just to maintain a consistent pricing level. Buyers are assuming more risk at the same or more cost than they paid for reinsurance last year.”

Hartwig says global reinsurance capacity is dwindling. “A number of major reinsurers have pulled back, in large part because of the poor performance of the reinsurance industry, which is even worse than the performance of the general property/casualty industry,” he explains. How bad are the results? In late February, Zurich-based reinsurer Swiss Re announced its first dividend cut since 1906, causing its shares to plummet 12%.

There is a silver lining–the more than $25 billion in new capital invested in the insurance market to fund start-up insurance and reinsurance companies. Seven Bermuda-based start-ups emerged after Sept. 11, 2001, helping to replenish the capacity subtracted by the attacks. Says Hartwig, “For the right price, the capacity is there for buyers.”

INVESTMENT INCOME

Investment income, on the other hand, isn’t anywhere. Just ask your stockbroker or banker. When investments produce robust gains, insurers put much of their investing capital in bonds, relax their underwriting and compete more on price. When the economy is weak, the opposite scenario holds true.

“Interest rates [on bonds] aren’t what they used to be,” says Stephen Lowe, insurance practice director at global consulting firm Tillinghast-Towers Perrin. “We use an economic return model that indicates the property/casualty industry would have to achieve a combined ratio of 99% across all lines to achieve attractive returns this year. We’re predicting a combined ratio of 105% to 106% for the year. Even if loss costs are stable, that means the industry will have to generate another 7% in capital. It won’t come from investment income so it has to come from higher premiums.” (A combined ratio above 100 indicates that a carrier is paying out more in claims and expenses than it is taking in premiums)

SELF INSURANCE

The hard insurance market has driven companies by the boatload to offshore captive insurance havens like Bermuda, Barbados and the Cayman Islands, not to mention the dozen U.S. states like Vermont that also license captive insurers–insurance companies owned by the companies they insure. “Last year was a boom year for captive formations, with our data showing an overall 32% increase in new captives formed globally,” says JoAnn M. Ralph, managing consultant at RK Risk Management, a subsidiary of the accounting firm Rothstein Kass & Co.

Willis’ captive management unit formed more captives in 2002 than in the previous six years combined, Vitale notes. Most new captives were formed to absorb the much higher deductible layer of risk that companies must retain or have elected to retain to lower their overall cost of commercial insurance. But self-insurance doesn’t get companies off the hook entirely. “Thinking you can escape the higher cost of traditional insurance through a captive is a bit of a fallacy,” III’s Hartwig asserts. “When you finance your own risks, you are subject to the same underlying cost drivers as traditional insurers. And in the event of a major loss, you’re either caught with the loss entirely or perhaps have some limited amount of reinsurance.” The upshot: There is no escaping the hard market.

SOLVENCY, RATINGS AND RESERVES

No one is predicting the wave of insurer and reinsurer insolvencies that accompanied the last hard market in the mid-1980s, when Mission Insurance Co., Transit Casualty and other large insurers bit the dust. Other than Reliance Insurance Co., which collapsed before 9/11, A.M. Best’s list of the 38 insurer insolvencies in 2002 and the 30 in 2001 had no really large companies on them, although the number has clearly moved up

Some carriers are distressed, such as Kemper Insurance, which was downgraded by Best to B from A-minus. As a mutual insurer, Kemper has been bedeviled by difficulties raising capital and maintaining an adequate surplus. It also ventured outside its core middle-market areas of expertise, a strategy that never panned out.

For the most part, insurers and reinsurers are expected to come through the hard market in better financial shape. “Overall, they’re paying more attention to underwriting and generating more top line growth,” says John Andre, vice president for property/casualty at Oldwick, N.J.-based A.M. Best.

Others take the same position. “We expect the industry as a whole to be slightly more profitable this year,” says Michael Weinstein, director of research at New York-based research firm Conning & Co. “They’re getting their balance sheets in order by addressing reserve deficiencies, which is bringing a sense of realism into executive office suites that they are in the risk pricing business.” Conning estimates the industry’s general reserve deficiencies at $38 billion, slightly lower than A.M. Best’s estimate.

But not all insurers will come through the hard market financially viable, Weinstein warns. “Some insurers will be able to address the reserve issues for prior losses, while others may not be able to because of capital strains,” he explains. “If I were a risk manager, I’d make my broker work for me by not just getting me the best price, terms and conditions, but by assuring me that my insurance company will be solvent for its past losses.”

A voice in the wilderness

While most prognosticators project the hard market will last through much of 2004, only one–Bob Hunter, the insurance director of the Consumer Federation of America–predicts a soft market is just around the corner. “We’ll see a softening in the next six months to a year,” Hunter asserts. “All the industry is doing now is holding on to the hard market as long as possible.”

A former Federal Insurance Administrator and one-time Texas insurance commissioner, Hunter maintains that the strengthening of loss reserves by insurers is merely a way to conceal profits. “It’s all part of the dance,” Hunter says.

“The feathers are up, saying we have to strengthen reserves,” he says. “But it’s just a way to hide profits until the soft market returns, when the reserve dollars will be released into profits. The only reason to jack up reserves is to justify huge rate increases.”

In Hunter’s view, there is little reason for the current hard market. “There’s still tremendous insurance capacity out there,” he argues. “All the capacity lost on 9/11 was returned in the first month by the new Bermuda companies. Sure, there are pockets of trouble like terrorism risks, but the industry will simply use its capacity gingerly in those cases. Other than that, the capacity is there and insurers should be competing.”

Prices won’t swoon in the next six months, “but they will definitely stop going up,” he contends. “Measured against inflation, they actually will be dropping a year from now.” Until interest rates rise, Hunter says prices won’t drop dramatically. “But the soft market is near. Tell that to risk managers.”

Risk managers, like the Gap’s Dudek, remain wary. “Do I sense the worst is over? I don’t know,” says Dudek. “No way I’m going to say that to management. I’ll believe it when I see it. One better renewal does not make a market turn.”