Towers Perrin’s Perspective on How Financial Crisis is Impacting the Insurance Industry

The insurance and financial services industry is at a crossroads. In the midst of the biggest financial crisis since the Great Depression, the combination of volatile economic conditions and a rapidly changing competitive landscape has many firms facing a challenging future. As the situation continues to evolve, Towers Perrin experts Patricia L. Guinn, Managing Director, Risk & Financial Services, Stephen P. Lowe  
Managing Director, Global P/C Insurance Practice, and Prakash Shimpi, Managing Principal, Global ERM Practice, offer their insights into the current state of the insurance industry, and how developments on Wall Street and around the world will impact insurers in both the short and long term.  
  
Overall, the insurance industry is strong and well capitalized; thus far, it seems to be weathering the storm. But the landscape may look quite different when the storm is over. The crisis is affecting both the liability and the asset sides of company balance sheets, but the degree of impact varies significantly by industry sector and individual company. Companies that entered directly into credit guarantees of one form or another will be hardest hit by the subprime crisis. Companies may also face write-downs and losses on their investments in failed financial institutions. However, since insurers generally do a good job of diversifying their investments, these losses are not likely to threaten any individual company’s solvency.  
  
Recent events were, in fact, a failure in risk management, not of risk management. Companies that don’t want to become the next headline should be taking a hard look at their current risk management approaches. There are many lessons to be learned from the current crisis about risk governance, risk tolerance and the importance of transparency. The importance of the chief risk officer’s role must continue to be reinforced. The timing may also be right for introducing some actuarial principles for managing risk exposures across all industries.  
  
Prices for commercial property/casualty insurance products will likely stabilize. While there will certainly be competition for AIG's business, we expect that most commercial insurers will maintain underwriting discipline. Beyond the short term, price levels will depend on broader economic factors that affect the capital base of insurers. Further deterioration in the stock market, additional catastrophic losses and a recession would all create upward pressure on prices.  
  
However, the financial strength of property/casualty insurers will be tested. For the first nine months of 2008, we are forecasting an 8% decline in the industry’s capital base due to investment write-downs and underwriting losses. While declining capital may precipitate a few downgrades of individual companies, we don't think it’s likely that a property/casualty insurer will fail, unless there is a further deterioration in the value of investments or a major catastrophic event in the fourth quarter.  
  
The life insurance sector will be much less impacted by collateralized debt security defaults and write-downs than the banking sector. However, life companies that have a large proportion of assets in equities or strayed too far down the credit curve could be facing difficulty. The recent plunge in equity values will greatly reduce the future profitability of separate account variable and unit-linked products. Insurers that have taken a somewhat more aggressive investment posture may experience a sizable reduction in their statutory capital levels that could result in some rating downgrades. Other companies with either cash on hand or the ability to access the capital markets may well find opportunities to buy some very attractive properties and position themselves more strongly for the future.  
  
Expect further industry consolidation. A turbulent climate such as the one we're in right now often leads to opportunities for stronger firms to act as consolidators, taking over the business of weaker firms. We expect insurers to consolidate for scale and diversification, adding product lines and management talent. However, given the well-publicized difficulties companies are having borrowing and raising capital, deals are likely to be limited to those that are already cash rich or have special access to financing.  
  
There's no need to abandon fair-value accounting. We believe that fair value is a good principle. Under normal market conditions, the benefits of marking assets to observable market values include transparency and increased investor confidence. When there are no observable values, however, or when the market is in a period of great disruption, as we see now, it's clear that additional guidance is needed. In our opinion, regulators and accounting authorities around the world should set forth standards of independence, competence and methodology for ensuring that fair-value accounting is objective, state of the art and transparent.