The State of the Market - Conference Call Transcript
Good morning and thank you for joining us today. We have received numerous inquiries from our clients about the current turmoil in the financial markets and the resultant impact on the insurance industry. We have sent out several email communications recently but we thought it would be worthwhile to spend a few minutes talking to you directly and then opening up the line to specific questions you may have.
Before we start, there are a few technical housekeeping items. The way this call is structured, your phones will be muted until the Q&A portion at the end. As a result, you will not be able to jump in immediately with questions or comments. If you have a question now or find you want to follow-up on something you hear during the call, simply press *1 - your question will be put in a queue, and we will address it later in the call.
Let me start with what we know today.
Unlike in the credit and equity markets, to date, the insurance market has seen no major disruption in the availability of coverage. Likewise with pricing, premium rates are similar to what we were seeing 3-4 months ago. This is not to say that the insurance industry has not been impacted by recent events. Insurance companies maintain very large investment portfolios and have seen the values of these portfolios decline. Life insurance companies in particular hold large amounts of publicly traded debt and equity.
However, two companies - AIG and Hartford - have experienced difficulties well beyond declines in their stock price. AIG's problems have been fairly well documented. Valuation issues with collateralized debt instruments forced the company to accept an $85.0 billion federal reserve loan/investment in late September. Last week, that amount increased by another $37.8 billion for a total of $122.8 billion. As of last week, AIG had drawn down $70.3 billion of the available funds. Large parts of the company will need to be divested in order to raise the funds to pay down the debt. The investments that caused AIG's problems were in its non-insurance subsidiaries. AIG's core insurance operations remain strong and AIG management has said repeatedly in recent weeks that it intends to retain its U.S. Commercial insurance companies. Only time will tell whether enough cash can be raised from the sale of non-insurance businesses to spare the insurance operations. Like AIG, Hartford experienced valuation issues with assets backing some of its annuity investment products. The company took a large write-down in the 3rd quarter and negotiated a $2.5 billion equity investment from the German insurer, Allianz. Also like AIG, Hartford's commercial insurance operations remain strong. Both companies have combined ratios < 100%.
As you have undoubtedly seen, the reporting of the events to date - as well as the proposed solutions - have been significantly driven by the fact that we are in an election year. The faux populism and blatant pandering has - and will to continue - to cause more problems than it solves. But, that is the reality of our current culture. Our objective is not to change the culture, but, rather, to help you maneuver through the minefields that are created as a result of the government's "response". (I am making a quotation mark sign with my hands right now)
As I stated in my letter to you on Monday, I am a glass is half full kind of guy. I am also - unabashedly - a proponent of a market free of government intervention.
What we don't have is any inside or non-public information. We continue to believe that the rating agencies are the best sources of the most complete, accurate, and up to date information on the financial health of specific insurance companies. Right now, both AIG and Hartford have acceptable financial strength ratings that range from strong to excellent depending on the rating agency.
What we don't know is what additional problems exist and, more importantly, where they reside. To an extent, we can view the recent events as positive, in that they exposed potential weaknesses in AIG's and Hartford's balance sheets. Both of those companies have now addressed the deficiencies. What trouble lurks in the balance sheets of other carriers? We have no way of knowing. We believe that the rating agencies will pay even closer attention to the investment portfolios and loss reserves of the major insurers.
So, given what we know, what is Equity Risk Partners doing?
First and foremost, we are continuing to watch all of the external developments in this area very closely. Those include relevant news stories, insurance carrier personnel changes, and any changes or comments by the rating agencies.
Internally, we are continually reviewing which insurance companies provide coverage(s) to each of our clients and have developed contingency plans in the unlikely event any of that coverage needs to be replaced with a different carrier. We have done this with a particular focus on AIG and, to a lesser extent, Hartford. I would liken the process we have been going through to management succession planning that most of you probably spend time on. You hope nothing happens to the incumbent but, if it does, you need to have pre-identified a list of people qualified to step in.
In this area, our clients have a unique advantage. Since most of our clients are private equity firms or portfolio companies of private equity firms, their insurance programs tend to be far more dynamic than a traditional static insurance program. Our clients have significantly more acquisition, divestiture, and overall account activity than the average firm. As a result, we market renewals more frequently and review programs mid-term on a regular basis, already. This activity will allow us to "turn on a dime" if current conditions require a midterm carrier change.
We are also expanding our disclosure of insurance company financial ratings. It has always been our policy to provide our clients with the financial strength ratings of the companies with which we place business. Historically, we have relied on the ratings of one well known agency, A.M. Best. Going forward, we will continue to show the A.M. Best ratings and will add the ratings from two other major agencies - S&P and Moody's. While all rating agencies tend to be reactive, we have found that the S&P and Moody's ratings are timelier than A.M. Best and have a more meaningful ratings band.
We are starting the marketing process earlier. We are going out to more markets. We will present more options to you. We will give equal weight to insurer quality and financial stability as we do to price. That will include a renewed focus on admitted carriers as compared to non-admitted carriers.
And, perhaps most importantly, we are taking every opportunity to communicate with our clients to keep you informed as this unprecedented situation evolves.
Let me shift gears to the state of the insurance market. To paraphrase every president who has ever done a state of the union address, "the state of the insurance market is strong"...for now.
The soft market for commercial property/casualty insurance won't be ending any time soon. This is despite increased catastrophe losses and deteriorating underwriting results. For the record, the Wall Street meltdown does not qualify as a catastrophe for insurance purposes.
The current conditions will certainly slow the rate of price declines, most rates should remain relatively unchanged into the 1Q of 2009. Obviously, an unforeseen catastrophe can move that needle in an instant. Barring catastrophe, we believe that D&O rates should be the first to start heading up. We believe that the breadth and depth of shareholder litigation that will arise out of the recent events will make the events following Worldcom, Enron, Tyco, et al. seem like a church picnic.
Similarly, there are a few pockets of coverage and/or geography where AIG has a unique hold and little competition where resistance to further rate decreases will be stronger.
As we discussed in our recent letter to you, continued rate decreases - coupled with lower investment returns and exacerbated by claims arising out of the inevitable business failures stemming from the financial crisis - will negatively impact insurer profitability. A.M. Best estimates that the industry combined ratio for 2008 will be 103.2% (to refresh your memory, the combined ratio is an insurance industry metric that measures the percentage of each premium dollar that goes to paying claims and operating expenses). A.M. Best's original projection for 2008 in January was 98.6% best based its revision on "the soft market, unusually high catastrophe losses (we had little to no hurricane losses in the years since Katrina), and significant underwriting losses for mortgage and financial guarantee companies." It is important to note that losses from credit default swaps - technically insurance - not only are not part of the A. M. Best numbers, they are not part of the insurance industry regulatory oversight. We will need a completely different conference call - preferably with beer served - to discuss the soundness of that decision.
As we discussed, combined ratios would need to approach 110% before we see significant price increases. Also factoring into the equation is the estimated $50.0 - $100.0 billion of excess capacity in the market place.
As a result, we expect to see 10% - 25% rate increases by 3Q 2009. Obviously, the timing will be impacted by the severity of any write-downs to insurance company investment portfolios.
We may also see an insurer fail. This is something that happens more often than most people realize. The difference in 2009 is that it could be a firm that we recognize and that is providing some of your coverage. This has happened before. We all remember Kemper insurance. That company is currently in run-off. It is being managed by a high quality team of executives and is overseen by the insurance departments of each state where it wrote business. To date, I am not aware of one single Kemper policyholder missing a valid claim payment. Since insurance is the ultimate in "belt and suspenders", the industry has guaranty funds in each state. These guaranty funds exist to take up the financial slack, should an admitted carrier become insolvent. For more information on this issue, please visit our website. My colleague, Josh Warren, has written a Partners' Perspective on this subject.
What can you do?
Good question. I'm glad you asked.
First, like your scout master told you in 2nd grade - be prepared. We will start your renewal process early. Work with us to make the process timely and efficient. Suffer through the endless inspections and questions that will arise as we seek broad alternatives for your program.
Second, think long term. We are entering into a period that focuses on insurer quality, not price. It is time to stop asking what is the least amount of premium I can pay and to start asking what is the least amount of premium I can pay for the most financially sound provider of coverage. Insurance is a unique animal. It is the only business where the price is determined before the seller knows his cost.
Last, look for leverage. Portfolio companies of private equity firms have a unique advantage. It is in your name - portfolio. Portfolio leverage is a wonderful thing. As the market transitions from soft to hard, the timing is perfect to begin looking at portfolio leveraging options - from a true portfolio program to a "mass market" approach. My colleague, Tony Marcon, will be releasing a Partners' Perspective on the topic of mass marketing portfolio company insurance programs within the next few days.
In closing, this is an unprecedented time in our financial markets. While titans of Wall Street have crumbled before our eyes, the overwhelming majority of the insurance industry has remained solid, responsive, and focused on the future. With patience, determination, and focus, we will ride these uncharted waters together - and, only when you brave uncharted seas do you find the treasure.
We appreciate your continued support of Equity Risk Partners. We value your business and will continue to work tirelessly on your behalf. Thank you for listening in this morning.