The next few years will present significant opportunities for investment gains in the property and casualty insurance industry coupled with a large and equal amount of failure. As always, the profits reported by insurance companies are only as factual as you want to believe. You need to look beyond operating ratios, leverage and liquidity tests, and loss reserve development to core business practices in order to decide whom you want to financially support.   

For example, last week the senior management changed abruptly at a company I was once closely tied to. A decade ago, my agency produced 15% of the underwriting profit for this company, over a seven-year period. We understood and believed in their core philosophies. Things changed and we sold that book of business. We no longer represent them, but it still is hard to see them going through this trauma, which will no doubt impact many of their personnel.

The company I’m referencing has an “A” rating by Best and a “positive” outlook. They recently posted a combined ratio over 100, which isn’t unusual in this environment. However, they also have an expense ratio of nearly 50%, which might be considered atrocious. Also troublesome is the drop in policyholder surplus (net worth) over the last five years.

Since they write a large percentage of bond business an expense ratio of 50% isn’t really all that bad. Western Surety Company is a pure bond market and has an expense ratio of just over 50%. In contrast they’ve combined that with a loss ratio around 20% and have consequently doubled their policyholder’s surplus over the last five years. They’re also “A” rated by Best’s.

Corporations create cultures around their goals. Management fosters those cultures through carrots and sticks. Their actions often have unintended consequences. Those unintended consequences usually come home to roost when the market moves to where we are in the insurance cycle. When loss and expense ratios deteriorate improper actions become apparent.

The above company I once represented had a system of significant bonuses for their employees tied to underwriting results. Although only the most foolish companies instruct their claims departments to knowingly under-reserve losses, I’ve personally experienced corporate cultures that question those with “overactive scruples”. Every reserve contains an element of conjecture and surmise. Companies run afoul when their internal questions put pressure on “adequate” reserving. Companies set their rates for the future based on their prior loss experience. If their prior loss experience is understated due to inadequate reserves, they set rates that will naturally be inadequate for the risk they assume.

I’m not aware of this particular company having any of these specific problems. It’s possible their holding company is merely taking them in a new direction, but I’ve seen many companies experience severe trauma, including the company that gave me my first job, which no longer exists.

The personal lines insurance segment of the property and casualty insurance industry has been experiencing difficulties. Much of this can be blamed on the weather. Over the last fifteen years, the amount of total loss attributed to weather related catastrophes has gone from approximately one percent to six percent.

Many insurance companies state that they don’t know what the “new normal” is. They have set their rates based on their best estimate. The good companies have planned for the worst, setting their rates based on weather stabilizing at something around six percent and are monitoring trends.

During 2013 the property and casualty industry had a very good year with less than one percent in weather-related catastrophe losses. Yet, the personal lines segment of the industry had a combined ratio over 100.  Even though a small amount of the loss ratio gain was due to increased bodily injury severity, a combined ratio over 100 threatens disastrous future underwriting results, because even in a good year many companies still posted an underwriting loss.

Many more had “bad” years, despite the good weather, with combined ratios of 105 to 110. Given an investment income of under three percent, in most cases, many companies suffered surplus impairment. I expect that we will eventually discover that they’re the same companies who are waiting to see what the new weather “normal” will be before adequately adjusting their rates.

Getting behind the rate-taking curve can be lethal. If a company missed several years of normal rate taking and has to increase their rates by twenty to thirty percent in one year, they’ll lose premium volume and experience a reduction in policies in force.

Once premium decreases, expense ratios can become adverse without substantial accompanying decreases in underwriting expense. Much of that expense is fixed, or close to fixed making adequate decreases easy to achieve.

Those companies who had a poor underwriting year in 2013 should be reviewed closely before increasing your investment. A better investment would be with those companies who posted profits or near profits during 2013. As stated above, all numbers aren’t created equal, so due diligence is necessary.

Over the next few years it’s obvious if the “cat” levels stay at six percent or above several companies will suffer seemingly irreversible losses. Others will have a substantial opportunity to gain market share at profitable levels.

Some of this might be mitigated by the black box capabilities for rate adjustment, but the market competitive position will restrict the ability to “catch-up” quickly.

Worse yet, many of the companies who are behind on the rate adjustments to adverse catastrophe losses are also those companies who still are trying to understand “predictive modeling”.  Under “predictive modeling” it is seemingly as important to underwriting profits to be able to accurately pre-determine length of retention as it is loss costs.

If those companies get their predictive modeling wrong and stumble on setting length of retention they may never recover the loss involved in their initial “teaser” premiums.

Companies that will be successful in the future, in the attention by establishing a “trust” sale, rather than going toe-to-toe on a “commodity” sale. Those companies will succeed by constructing their product to make it easier for the independent agent to be a “trusted counselor” rather than an “order taker”.

In conclusion,

• If a personal lines property and casualty company has a combined ratio of 101 or less, that appears valid in all respects, and
• the company is actively engaged in predictive modeling and has been for more than a few months, and
•  the company is truly committed to the independent agent and is willing to work to help the independent agent with a “trust” sale,

they appear to be a good place for you to consider an investment.

If the company lacks one or more of the above, I would avoid them.

I’m not a financial advisor. I’m merely an insurance agent who has been watching companies succeed and fail for forty-four years. As always you’re responsible for doing your own due diligence and to take my advice purely as one man’s opinion.

About the Author

Jim Holm is the president of Enhanced Insurance, was National Agent of the Year for Metropolitan in 1993 and Midwest Agent of the Year for Travelers in 2011. He also serves as a founding board member of Surplus Lines Association of Minnesota.