Ratings

Standard & Poor's interactively rates 46 U.S. groups or independent companies that are predominantly in the business of providing commercial lines insurance. The median financial strength rating on these companies is 'A'.

 Chart 1

Through the first 10 months of 2007, there were six upgrades and two downgrades (see Chart 1). However, two of the upgrades were the result of upgrades of foreign insurance groups (Allianz AG and Zurich Financial Services) with a U.S. subsidiary considered to be core to the parent, so the rating on the subsidiary mirrors the rating on the parent. Another insurer—Ohio Casualty Corp.—was upgraded because of its acquisition by a higher rated entity: Liberty Mutual Insurance Co. By contrast, ratings changes were even in 2006 (five upgrades and five downgrades) and close to even in 2005 (three upgrades and four downgrades).

We expect the trend of the past three years to continue in 2008, with relatively few rating changes and similar numbers of upgrades and downgrades.

 Chart 2

The distribution of ratings on commercial lines insurers is concentrated in the middle of the investment-grade universe, with 56% of ratings falling into the 'A' category. Chart 2 shows that the distribution of ratings has changed very little over the past three years. Over a longer time frame, there was a more pronounced shift out of the 'AAA' and 'AA' categories into the 'A' and 'BBB' categories.

 Chart 3

In the past 12 months, the number of U.S. commercial lines companies with stable outlooks has grown significantly, offset by a corresponding decline in the number with negative outlooks. Stable outlooks now constitute 84% of the total (see Chart 3), up from 77% a year earlier and 63% in November 2005. As noted earlier, the outlook distribution is the best indicator of future ratings activity. The current distribution suggests fewer rating actions in the next six to nine months.

The number of companies with positive outlooks remained unchanged and now slightly exceeds the number with negative outlooks. Of our universe of 46 interactively rated commercial lines insurers, four have positive outlooks, and three have negative outlooks. We do not expect that this outlook distribution will change materially in the first half of 2008.

Underwriting results for the property/casualty industry in 2007 appear poised to exceed our expectations. At the beginning of the year, we had expected the combined ratio to deteriorate by about five percentage points from 2006's record results. This expectation assumed that the moderate price declines observed in 2006 would translate into higher loss ratios, as would a return to a more normal level of hurricane losses.

 Chart 4

The pricing environment has indeed been weakening throughout 2007, but margin deterioration has yet to have a significant impact on underwriting results. Through the first six months of 2007, the combined ratio for commercial lines writers actually improved slightly, to an exceptional 88.8% from 90.0% in the first half of 2006 (per ISO). From a total industry perspective, this was offset by the experience of personal lines writers, the average combined ratio of which deteriorated by 2.1 percentage points to 95.0%. Still, the property/casualty industry's results as a whole deteriorated only modestly, with the combined ratio slipping to 92.7% from 92.0%.

Both sectors benefited from a further decline in catastrophe losses—to $3.6 billion in the first six months of 2007 from $6.5 billion for the same period in 2006. Industry underwriting results declined about $600 million, but this was more than offset by a $1.6 billion increase in net investment income. Pretax operating income for the period declined by about $600 million, but this was entirely because of one large reinsurance transaction between a U.S. insurer and a foreign insurer.

Although aggregate industry results are not yet available, insurers benefited in the third quarter from another very mild hurricane season, and many reported strong earnings for the period. With only a month to go, we expect reported underwriting results for full-year 2007 to be similar to those of 2006 for commercial lines insurers and somewhat weaker for personal lines carriers. For the entire property/casualty industry, this means another exceptionally profitable year. The combined ratio is likely to end up at 93%-94%, well below the 97% combined ratio we forecast at the beginning of the year. The ratio for commercial lines carriers is expected to be 90%-92%.

With a strong 2007 largely a foregone conclusion, will 2008 be the year rate decreases finally start to have an impact on reported underwriting results? We believe so. In the first half of 2007, net premiums earned (premiums recognized as revenue in the income statement for the period) grew 1.4%, but net premiums written (premiums billed during the period) barely edged up 0.1%. Net premiums written actually fell by $600 million in the second quarter. For full-year 2007, we expect net premiums written to decline a modest 1%-2%, a trend that should continue in 2008. With top-line growth now negative and loss costs and underwriting expenses expected to continue growing, underwriting results will decline. Excluding any change in catastrophe losses, we expect the combined ratio to increase three to four percentage points to 96%-98%.

Increased net investment income will partly offset this deterioration. We expect positive underwriting cash flows to boost invested assets, but a modest decline in portfolio yield will partly offset growth in fixed-income portfolios. Standard & Poor's economic forecast is for interest rates to decline somewhat in 2008. Therefore, new money will be invested at lower rates, which will pull down portfolio yields. Given the current low-yield environment, we don't see any danger of companies engaging in cash-flow underwriting, a practice seen in the past when interest rates were much higher. (Cash-flow underwriting is the practice of intentionally writing business at an underwriting loss to generate higher premiums, then counting on higher investment income from the invested cash to more than make up for the loss.)

Standard & Poor's is increasingly concerned that the softening market is driving the commercial lines sector to become more price-competitive. Although all parties agree that rates are declining, there is no agreement on the magnitude of the fall. Surveys of insurance intermediaries (brokers and agents) show the largest rate declines, pegging the current average rate decline at about 13% year-over-year. Meanwhile, surveys of risk managers and insurance companies, along with price change data disclosed by some large insurance companies, suggest a much more modest rate of deterioration in the mid-single-digit range.

There is a tremendous amount of noise surrounding the issue of how fast rates are declining. Anecdotal stories of huge rate cuts are certainly not hard to come by. For the reasons discussed below, we believe the rate declines reported by intermediaries are good directional tools but are overstating the actual rate changes occurring for the large majority of renewal business. Instead, these surveys appear to reflect what is occurring on the most competitive and widely shopped accounts. The rate changes reported by the insurers themselves and, importantly, the commercial insurance buyers are much more consistent with reported industry financial results. Looking at the broader U.S. commercial lines market, we believe that the average rate decrease for the large majority of accounts grew to a more challenging mid-single-digit level in the second half of 2007 from a very manageable low-single-digit level through 2006 and early 2007.

Without question, rates are falling more dramatically in some market niches, such as risk management (large, loss-sensitive casualty accounts) and surplus lines, but these remain exceptions. Still, even a mid-single-digit decline in rates is not good news for the industry. Combined with a modest increase in loss-cost trends, these rate declines will shrink profit margins fairly quickly, which is why we are watching these trends closely.

 Chart 5

The two most widely quoted insurance intermediary surveys of commercial lines pricing changes are the quarterly market survey conducted by the Council of Insurance Agents & Brokers (CIAB) and the monthly survey by MarketScout.

As can be seen in Chart 5, the CIAB survey indicates that rates have been deteriorating steadily since the second quarter of 2006. It also shows that the average year-over-year price decline across all commercial lines was 13% in the third quarter. MarketScout's survey shows similar rate changes. However, a closer look at these reported numbers raises some concerns. If we look at the reported year-over-year average rate change from the second-quarter surveys shown in the chart, commercial lines pricing should be down a cumulative 25% since the second quarter of 2003. Yet commercial lines writers' net premiums written in the second quarter of 2007, as reported by ISO, were 11% higher than in the second quarter of 2003. Using national GDP as a proxy for exposure growth, insured exposure grew about 12% during the period. Adjusting for exposure growth, commercial premium rates should have been nearly flat over this period, nowhere near the rate declines indicated by these surveys.

 Chart 6

The Tillinghast Commercial Lines Insurance Pricing Survey (CLIPS) is a less-well-known measure of pricing changes as reported quarterly to the actuarial consulting firm Tillinghast by participating insurance companies. Tillinghast only shares the detailed results with participating insurers. However, it publicly discloses the aggregate change in pricing across all commercial lines. Importantly, these results are broadly consistent with what the larger standard lines companies report publicly, so we view it as a good proxy for the rate changes companies are seeing in their renewal books. This survey indicates that pricing has been deteriorating at a low-single-digit rate since the survey's inception at the beginning of 2005 but that declines started to accelerate in the first half of 2007, reaching negative 5% in the second quarter.

 Chart 7

Chart 7 shows the results of the RIMS Benchmark Survey, which also measures changes in policy renewal pricing—but as reported by corporate risk managers. In contrast with insurance intermediaries and companies, which might have reason to overstate (intermediaries) or understate (insurers) premium declines, these buyers have no discernable conflict of interest.

This survey reports rate changes since the beginning of 2006 for four major lines of business—property, directors and officers, workers' compensation, and general liability—rather than an aggregate change for all commercial lines. In stark contrast with the CIAB survey, this survey reports the mildest rate changes. Indeed, risk managers continue to report that commercial property rates are still increasing, driven largely by companies in earthquake-exposed areas. General liability and workers' compensation rates, however, have been falling, but the decreases have averaged in the low single digits.

Commercial lines writers achieved a significant milestone in 2006. For the first time since 1998, property/casualty insurers in the aggregate recorded favorable net reserve development. Property/casualty insurers released about $7 billion of reserves in 2006, a better-than-expected improvement from $7 billion of reserve strengthening in 2005.

Even if we look only at commercial lines, the industry was able to record positive reserve development. Chart 8 shows that the net reserve release for commercial lines, a modest $1.0 billion, nonetheless constitutes a significant improvement from 2005, when the industry strengthened commercial lines reserves by $12.5 billion (see "For U.S. Property/Casualty Insurers, Is Less Disciplined Reserving Once Again On The Horizon?" published Oct. 1, 2007, on RatingsDirect , the real-time, Web-based source for Standard & Poor's credit ratings, research, and risk analysis). The change in reserve development from 2005 reduced the 2006 combined ratio for the property/casualty industry by about 3.3 percentage points.

 Chart 8

Based on our view that reserves are now adequate for the large majority of insurers we rate, we do not anticipate that reserve adequacy will be a significant ratings concern in 2008. Whether insurers will sustain this improved level of reserve adequacy in the current softening pricing environment, however, remains to be seen.

As discussed in more detail in a commentary earlier this year (see "The Tide Has Finally Turned On Insurers' Exposure To Asbestos Claims," published Feb. 21, 2007, on RatingsDirect), we believe our ratings fully reflect the asbestos exposure of the companies we interactively rate, given current favorable trends in the legal and legislative environment for asbestos claims and the declining number of claims insurers are receiving.

Gross asbestos reserves held by the 13 insurers we interactively rate that have large asbestos exposure rose 3.6% to $33.6 billion at year-end 2006. The average change for the individual insurers we rate, though, was a decline of about 5%. Unless this positive trend in new claims reverses or paid losses accelerate, Standard & Poor's believes companies won't need to increase asbestos claims reserves significantly.

Still, the level of asbestos exposure relative to capital for many large companies remains substantial. Any deterioration in the legislative or legal environment for asbestos claims could lead to another round of reserve increases, which could result in downward pressure on some ratings. Another area of concern is the asbestos reserves that primary insurers have ceded to reinsurers. Ceded reserves averaged about 16% of year-end 2006 surplus for affected insurers. Reinsurers are often skeptical about the validity of these claims, largely because of the difficulty in determining when a claimant's asbestos exposure occurred, so the risk of a primary insurer not being reimbursed for these losses is greater. To address this risk, Standard & Poor's has incorporated a charge equal to 20% of ceded asbestos reserves in its capital adequacy analysis for the past two years.

As we near the end of 2007, the need to extend or replace TRIEA, which expires at the end of this year, becomes more urgent. Our ratings for commercial lines are based on having this mechanism, first enacted as the Terrorism Risk Insurance Act of 2002 (TRIA), in place for dealing with large-scale terrorist attacks that would threaten the solvency of many commercial lines writers. Fortunately, prospects for Congressional action and White House approval look good. Both houses have passed bills, and the White House has already signaled its willingness to accept the less-expansive Senate version. (See "The Extreme Risk Of Terrorism Insurance, With Or Without A U.S. Government Backstop," published Oct. 29, 2007, on RatingsDirect.)

We continue to view Congress's change to Democratic control as a positive factor for the industry, at least on this issue. Many Democratic members of Congress come from urban areas and are therefore more sensitive to terrorism as an issue and more sympathetic to the idea that a federal backstop is necessary to protect people and property from large-scale terrorist attacks. This increases the probability that Congress will pass legislation to maintain a federal backstop for terrorism events.

Both the House and the Senate bills would expand the scope of TRIA by removing any distinction between domestic- and foreign-sourced terrorism events. The House bill, which would extend TRIA for 15 years, would also require insurers to make coverage available for nuclear, biological, chemical, and radiological (NBCR) events. The Senate's bill would continue to exclude NBCR but would renew TRIA for seven years.

For the past two years, we have been expecting consolidation in the property/casualty industry to increase, but until recently, M&A activity has been sparse. Acquisitions of commercial lines carriers are always potentially dangerous because of legacy issues, but we theorized that stronger insurer capitalization and fewer concerns about reserve adequacy might overcome these reservations and generate more deals.

In the past six months, we have seen an uptick in the number of transactions—but with an unexpected twist. The decline in the value of the U.S. dollar relative to other major currencies, rather than stronger balance sheets, emerged as the primary driver of M&A activity in 2007. In May 2007, Australia's QBE Insurance Group Ltd. acquired Praetorian Insurance Group, a niche U.S. specialty lines insurer, from Hannover Rueckversicherung AG for $800 million, to expand its existing U.S. program business. QBE also bought Winterthur U.S. Holdings Inc.'s U.S. regional property/casualty insurance group from AXA for $1.2 billion. On Oct. 17, German reinsurer Munich Reinsurance Co. announced that it was acquiring Midland Co., an Ohio-based insurer specialized in coverage for manufactured housing, for $1.3 billion. On Oct. 30, Spanish insurer Mapfre S.A. announced it had reached an agreement to acquire Commerce Insurance Co., a regional writer of personal lines based in Massachusetts, for $2.2 billion. The ratings impact of these deals is usually positive because the foreign acquirer is typically a much larger, higher rated entity. We expect to see more such transactions in 2008.

The only acquisition of note by a domestic insurer was Liberty Mutual Insurance Co.'s purchase of Ohio Casualty Corp., a publicly traded insurer, for $2.7 billion. This is the latest in a series of acquisitions made by Liberty to grow its distribution through independent agents.

Another trend worth noting is that of smaller Bermuda reinsurance companies purchasing shell companies in the U.S. to establish a platform for expanding into specialty lines written on a primary basis. Two recent examples of this trend occurred in September when Montpelier Re Holdings Ltd. and Ariel Reinsurance Co. Ltd. both announced the acquisition of shell insurance companies. The value of such transactions is quite small, but the entry of these new participants into the specialty lines market is a significant driver of increased competition in that segment.

After a one-year lull, state regulatory reviews of insurer and broker activities deemed anticompetitive have picked up. These investigations began in November 2004, with the New York attorney general filing a lawsuit against Marsh Inc. (an affiliate of Marsh & McLennan Cos.; MMC) alleging price-fixing activity in the excess casualty market. Several large commercial lines carriers reached settlements regarding these allegations in 2006, but there have been no new settlements since August 2006. The only company that refused to settle was Liberty Mutual Group Inc. The attorneys general of New York and Connecticut responded by filing a lawsuit in May 2006, which is still pending.

Things were quiet until August of this year, when Ohio's attorney general filed an anti-trust lawsuit against Marsh, American International Group Inc., Chubb Corp., and Hartford Financial Services Group Inc. over the same practices. About a week later, in early September, the industry scored a major victory over these allegations when a U.S. District Court judge dismissed all antitrust claims against numerous brokers and insurers in a case that consolidated several class action lawsuits.

The latest development was the filing of a lawsuit by Connecticut's attorney general against reinsurance broker Guy Carpenter (another affiliate of MMC) and several reinsurers, alleging price-fixing in collusion with a number of reinsurers to inflate the cost of reinsurance contracts purchased by primary insurance company clients.

We don't anticipate that any of these investigations will have a significant adverse impact on our rated insurers.

Despite improved reserve adequacy and strong surplus growth, capital strength has emerged as a potentially negative ratings factor because of the introduction of Standard & Poor's enhanced insurance risk-based capital model in May 2007.

This new approach to measuring insurer capital strength is a material update of the model we've used for the past 15 years. We expect the enhanced model to lead to an increase in capital requirements for many commercial property/casualty insurers across all rating categories. The primary reason will be the higher premium and reserve risk charges put into place to capture the increased volatility observed in the property/casualty sector in the past decade.

Through 2007, we used the old model as our primary tool for evaluating capital adequacy. However, in 2008, we will begin to use the enhanced capital model exclusively. This new view of capital adequacy could hinder upgrades in 2008 and might result in rating downgrades for a few credits. This would most likely happen if we deem a company has little chance of bringing its capital adequacy to a level commensurate with the current rating level within a reasonable time frame.

For some of the insurers we rate, enterprise risk management (ERM) could emerge as a major ratings issue in 2008. If the soft pricing environment continues throughout 2008, insurers' cycle-management capabilities will increasingly be put to the test, and companies with weaker underwriting controls will begin to stand out.

The conversion to Standard & Poor's enhanced capital adequacy model might also increase the importance of ERM. If the new model were to call into question the capital strength of an insurer relative to the existing ratings, our evaluation of an insurer's ERM adequacy would become a key ratings driver.

So far, Standard & Poor's considers the majority of primary property/casualty insurers' ERM practices to be Adequate (see "Enterprise Risk Management Can Help U.S. Commercial Lines Insurers Ward Off Irrational Pricing," published on RatingsDirect on April 30, 2007). An Adequate classification, however, captures a wide variety of practices that are active or that insurers are in the process of implementing. Because ERM practices at many insurers haven't yet been tested under adverse conditions, an affirmation that an insurer's risk management across the enterprise can manage losses within acceptable limits—including emerging risks and multiple events, today as well as prospectively—will be crucial to sustain current ratings.

Although our ratings on insurance brokers reflect their current market conditions, we are seeing heightened potential for isolated downgrades and negative outlook revisions. Today's soft market environment is generating premium declines for new insurance business in the mid-teens, which is leaving insurance brokers more exposed to losses than ever before.

Sustaining a client base and expense structure in an environment of declining premiums is sure to equate to bad news for insurance brokerages, a sector where the concept of variable costs does not exist. This was demonstrated recently when Marsh, the primary risk and insurance subsidiary of MMC, reported third-quarter operating losses because of a negative 1% underlying growth rate (including the impact of declining premium rates) and an increased expense base.

For brokers, top-line revenue growth correlates highly with bottom-line performance. As brokerage commissions are, for the most part, a percent of premiums, the accelerating decline in premium rates and volume is challenging the sector's financial health. The percent of premium that brokers charge has always moved inversely to premiums. When premiums are high, broker rates drop (as they did earlier in the decade), and in a soft market, in which premiums drop, brokers will raise the percent of premium charged.

With the soft market now at the one-year point, to maintain financial strength, brokers must once again raise the percent of premiums they charge. It is critical that they do so by strategically communicating to customers the value of the services they provide. A misstep could cause a backlash and ultimately result not just in the loss of clients but also in hits to the top and bottom lines. Achieving rate increases without losing clients, however, will help brokers sustain profitability and demonstrate operational excellence.

Short-term costs for brokers, which include expenses, are fixed, which makes expense management and optimization by client essential for sustained, profitable growth. As the soft market continues and revenue pressures intensify, brokerages must continue to reduce and optimize their expense structure while providing the level of services their clients demand and for which they are remunerated. Global, national, and regional brokers are all implementing initiatives to optimize their overall expense structures and, more significantly, to better enable the measurement of expenses by client. By doing so, they can pinpoint unprofitable clients on their rosters and either restructure pricing, service delivery, or—in some cases—drop the client.

Compounding the earnings pressure is the high degree of debt on many brokers' balance sheets. Although the large global investment-grade brokers such as MMC, Aon Corp., and Willis Group Holdings Ltd. have the financial resources to adjust debt levels to reflect diminished earnings performance, smaller brokers with speculative-grade credits, including the several acquired by private equity groups over the past two years, are an even larger concern, as the balance among earnings, cash-flow generation, and debt-servicing obligations is the most tenuous. (See "Private Equity Finds Good Acquisition Deals On Insurance Brokers, But Brokers? Credit Takes A Hit," published Nov. 7, 2007, on RatingsDirect.)

Going forward, insurance brokers' ability to achieve operational excellence in revenue and expense optimization will be crucial. We will monitor developments as they arise.

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