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Insurers Retool Their Businesses to Adjust to Low Interest Rates

Companies are shedding capital-intensive business lines and using technology to sharpen their underwriting performance.

As a banker, most recently as head of consumer and small business at troubled Bank of America Corp., Liam McGee switched careers, becoming chairman and chief executive of Hartford Financial Services Group four years ago. It was a leap from the frying pan into the fire. The venerable insurer was suffering through the worst crisis in its more than two centuries of existence, having posted a loss of $2.75 billion in 2008 because of bad investments in its life business and the cost of guarantees it provided to holders of variable annuities. Without a $3.4 billion taxpayer bailout from the Troubled Asset Relief Program, the company could have foundered.

McGee was no insurance expert, but it was clear to him that a new business model was needed. Like many insurers, the Hartford for years had tolerated poor underwriting margins and relied on income from its $106 billion investment portfolio to generate earnings. But that strategy was no longer viable in the new era of record-low interest rates. Going forward, the company needed to focus on profitability instead of volume. Its main business lines “had to be generators, not consumers, of capital,” as McGee puts it.

So out the door went the individual life insurance and annuity businesses, which gobbled up capital and could barely make a return on their investments. Instead, the Hartford focused on property/casualty insurance, squeezing an ever-larger portion of earnings from underwriting rather than investment income.

Many other insurers have drawn similar conclusions from the financial crisis. There is a developing consensus in the insurance world that underwriting income must rise to offset declines in investment income, which is being hit hard by low bond yields and tougher capital requirements by regulators.

In the immediate aftermath of the crisis, insurers lived off average yields of 3.5 to 4 percent embedded in their investment portfolios, says Josh Stirling, a New York–based analyst at Sanford C. Bernstein & Co. Those returns were enough to cover policy obligations and still generate about 70 percent of an insurer’s income.

For the past two years, however, new business written would generate yields of just 2.5 percent or less on invested assets. The recent backup in rates in anticipation of tighter policy from the Federal Reserve Board has boosted yields by about 100 basis points, lifting returns on new business. But higher rates are a double-edged sword: They erode the value of insurers’ existing bond holdings. Stirling estimates that an additional 100-basis-point rise in rates from current levels could cause investment losses equal to as much as 15 percent of insurers’ equity.

Typically, fixed-income securities account for 90 percent of an insurer’s investment portfolio, with the remainder split between equities and alternative investments such as hedge funds and commodities. There is little wiggle room to change these ratios if a major insurer hopes to keep a strong credit rating of double-A or higher. (Read more: "Yield-Hungry Insurers Venture into a Range of Alternative Investments") At most, an insurer will increase its holdings of blue-chip corporate bonds by about 5 percentage points, as has been the case in recent years with Allianz Life Insurance Co. of North America, the U.S. subsidiary of the big German insurer.

“The only way falling money yields can be replaced is either by taking on more risk on the investment side, which is not a great strategy for an insurance company, or by increasing underwriting profitability,” says Meyer Shields, a New York–based insurance analyst for Keefe, Bruyette & Woods.

Institutional investors are also demanding greater underwriting returns. They have the investment expertise to match or surpass an insurer’s earnings on assets, but they cannot duplicate an insurance company’s acumen on the liability side of the balance sheet. “As an investor, underwriting is also more attractive than an insurer’s investment income because it diversifies my income stream and typically isn’t correlated to economic cycles,” says Markus Engels, a Frankfurt-based insurance analyst for Allianz Global Investors, which has substantial insurance company holdings among its €316 billion ($427 billion) in assets under management.

The new underwriting emphasis is producing results. Travelers Cos. recorded an underwriting gain of $883 million in the first half of 2013, a whopping 167 percent rise from $331 million in the same period a year earlier, while investment income fell by 8.2 percent, to $1.36 billion. The company’s combined ratio, which measures costs and claims as a proportion of premiums, moved into the black last year at 97.1, compared with 105.1 in 2011.

The trend toward stronger underwriting was much the same at other major insurers. ACE reported a 15.8 percent rise in p/c underwriting income in the first half, to $434 million, while investment income dropped 1.5 percent, to $1.07 billion. Its combined ratio improved to 93.9 in 2012 from 94.7 a year earlier.

The Hartford posted a p/c underwriting gain of $22 million in the first half, compared with a loss of $75 million a year earlier. The company’s investment income slipped 1.7 percent, to $639 million. The combined ratio was still a money-losing 101.9 for calendar 2012, but that was a notable improvement from 106.8 in 2011. Allianz boosted its first-half operating profit on p/c underwriting by 58 percent, to €897 million, while investment income dropped 9 percent, to €1.55 billion. The combined ratio in 2012 was 91.6, a vast improvement from the 107.3 recorded in 2011.

These robust underwriting results were achieved with the help of both the market and payoffs from investments in new technology. P/c rates in the U.S. rose by 20 percent over the 24 months ended August 31, according to Bernstein’s Stirling. In Europe the increase has been 12 percent, mainly because rates did not fall as steeply as in the U.S. in recent years. Many analysts on both sides of the Atlantic expect insurers to continue to boost p/c rates because investment income is likely to remain very low and reinsurance rates look set to rise thanks to heavy natural-catastrophe losses in 2011 and the massive costs of Hurricane Sandy in the northeastern U.S. last year. (Read more: “Investor Interest in Catastrophe Bonds Keeps Growing”)

To be sure, a sustained level of catastrophes could diminish underwriting earnings in coming years. So could surprise litigation, such as the hugely expensive asbestos suits of past decades. And a return to strong economic growth and higher investment income could erode underwriting discipline and tempt companies to cut rates, as typically happened in past insurance cycles.

But insurers and analysts believe this time will be different. “Traditionally, the industry would wait to experience three or four years of real pain before prices started to rise,” says Bernstein’s Stirling. “But today rates are hardening because the leading insurers have much better data and analytics.”

Companies are using a number of technology breakthroughs to enhance their underwriting performance. Automobile insurers, for example, are embracing telematics: the use of tracking devices to determine how much and how well their policyholders drive.

Progressive Corp. has emerged as the market leader in telematics, with a product called Snapshot. It took the insurer a dozen years to get it right. Beginning in 1998, Progressive launched a pilot program in Houston, but the product was a large, clunky device that had to be installed in a car by a specialist and was too expensive to be commercially viable.

In 2004 the insurer introduced a smaller device that plugged into a port in the car’s dashboard and collected data over six months. At the end of that period, drivers were supposed to use company-supplied cords to connect the devices to their computers and send Progressive the data, but many customers simply lost the cords. “So that didn’t work as well as we hoped, either,” says David Pratt, general manager of the Snapshot program.

Finally, the company ironed out the kinks and rolled out Snapshot in March 2011 with a national advertising campaign. Today 1.5 million of Progressive’s 9 million auto policyholders use Snapshot. They generated $1.5 billion worth of premiums in the 12 months ended April 30. Progressive does not disclose how much it has invested in Snapshot.

Policyholders can get discounts of as much as 30 percent off their rates if Snapshot demonstrates that they avoid driving from midnight to 4:00 a.m. — statistically, the riskiest period behind the wheel — and don’t brake too hard. The device can determine braking patterns because it records a vehicle’s speed every second. “If your car slows down more than seven miles per hour a second, then we know you are braking hard,” Pratt says.

For most policyholders who opt for Snapshot, the discount is 10 to 15 percent, for an average savings of about $150 a year. The program should enable Progressive to sign up — and retain — the safest, most profitable drivers. “If Snapshot really takes off, Progressive will end up cherry-picking a lot of good business from Travelers and Chubb Corp. — and leave them with the costlier, lower-margin clients,” says Bernstein’s Stirling. But competitors are starting to follow suit. Travelers has launched a similar program, called IntelliDrive, in eight states, offering discounts of as much as 30 percent.

At the higher end of the new insurance technology are so-called financial analysis platforms. These enable insurers to model assets and liabilities stochastically — that is, include many random variables — to determine if they are operating within risk tolerance parameters. Products such as ReMetrica, offered by financial services company Aon, and Towers Watson & Co.’s Igloo generate economic scenarios that project thousands of possibilities that can affect an insurer’s assets and liabilities. For example, consider a scenario that projects higher inflation: Such an event should translate into higher interest rates and hence adversely affect an insurer’s bond portfolio. That same higher inflation could also force an insurer to strengthen the reserves covering its liabilities.

“These platforms are incredibly important because they improve the accuracy of underwriting and insurance pricing,” says KBW’s Shields. “If there is a common characteristic, either positive or negative, that is being overlooked by the market and it can be extracted from an insurer’s premium or loss data, then it can be used to build a fundamentally better portfolio risk.”

Credit rating agencies and regulators have pushed insurers to acquire financial analysis platforms to improve their risk management. Stochastic modeling has been a standard in Europe for some time as insurers move to comply with the stricter risk management and capital requirements that are expected to emerge under Solvency II, the European Union directive that seeks to harmonize EU insurance operations and enhance consumer protection. “Allianz has been using these platforms, including Igloo, for many years to simulate insurance risks for our portfolio,” says Gary Bhojwani, who heads the German insurer’s U.S. life and p/c businesses.

Solvency II has yet to be finalized, so its ultimate impact is still unclear. “If Solvency II were implemented in its current form, Allianz as a group would benefit because of the diversification of its business,” Bhoj­wani says. “But some of our individual companies — for example, Allianz Life here in the U.S. — would face greater capital demands and constraints.” Allianz is also among nine global insurers designated as systemically important institutions by the Basel-based Financial Stability Board — and thus potentially subject to additional capital requirements.

Even without Solvency II to worry about, U.S. insurers have embraced financial platforms with as much enthusiasm as their European peers. “These platforms are great,” says Sridhar Manyem, a risk management specialist at Standard & Poor’s. “But you still need a management that makes good judgments based on these tools.”

Financial analysis platforms are helping insurers deal with less profitable, long-tail businesses, like workers’ compensation, that have required higher reserves in recent years to cover rising costs and lower interest rate income. Rather than unloading workers’ compensation wholesale, American International Group is using the new data-gathering and analytic tools to determine the impact of certain costly prescription drugs on that insurance.

“Let’s say a particular prescription drug was an important driver of losses and led to higher reserves, but we knew that cheaper generic options to that drug would become available in a year or two,” says John Doyle, head of AIG global commercial property insurance. If that was the case, the workers’ comp insurance rate could be kept down and higher reserves avoided.

By and large, though, insurers have been reducing their exposure to workers’ comp because of fears of rising medical costs and litigation. Consider Allianz’s U.S. p/c subsidiary, Fireman’s Fund Insurance Co. “We are still willing to write workers’ comp policies in industries or niches that we understand well,” Bhojwani says.

But that list of industries has dwindled to mainly small and medium-size businesses and some segments of the entertainment industry. Even then, states a Fireman’s brochure, a premium can’t exceed $250,000, and the business must be “located in jurisdictions that promote return-to-work over litigation.”

“If workers’ comp is appropriately priced in one of those industries, well, bring it on,” says Bhojwani. “If profitability isn’t good enough, then thank you but no.” Allianz does not disclose financial results for the workers’ compensation business at Fireman’s Fund.

Long-tail exposure is difficult for p/c companies but a much worse problem for life insurers, whose policies can run for decades. That’s why a number of insurers have reduced or sold off their life insurance businesses.

The Hartford is a notable example. Life, annuities and retirement plans accounted for 27 percent of the company’s $21.8 billion in revenue in 2011. The following year the Hartford sold off all its assets from those lines, with the exception of group life insurance. In September 2012 it agreed to sell its individual life business to Prudential for $615 million and its retirement plans business to Massachusetts Mutual Life Insurance Co. for $400 million. Those deals freed up more than $2 billion in capital for investments in other businesses and shareholder-friendly moves like share buybacks. The future focus of the company will be largely in p/c business lines.

“At the end of the day, what all this means is that the capital generated by these businesses can be used for holding company needs and the rest can be used to invest in our businesses or for shareholder buybacks,” says chief executive McGee.

Even though underwriting income is becoming more important to companies, there still remains a basic divide among insurers. Most major insurers — Travelers and Chubb among them — are committed to returning much of their profits to shareholders through higher dividends and share buybacks. But a distinct minority — ACE, most prominently — is eager to accumulate capital both for new acquisitions and to be flush with cash in case of big underwriting opportunities.

Since 2007, ACE, a Zurich-based and New York–listed outfit, has spent $5.8 billion on acquisitions. In the U.S. it spent $2.6 billion to buy accident and health insurer Combined Insurance in 2008 and $1.1 billion for crop insurer Rain and Hail in 2010. Elsewhere, ACE shelled out $865 million last year to buy Mexican nonlife insurer ABA Seguros and $425 million in 2010 to acquire New York Life Insurance Co. units in Hong Kong and South Korea.

This expansion has led to a growth of net earned premiums from $12 billion in 2007 to $22.4 billion last year, with Asia and Latin America accounting for 24 percent of the total.

Because of its priority of acquisitions, ACE has done few share repurchases, though it bought back $212 million in shares in the first half of this year — its first meaningful purchases since 2011.

Chairman and CEO Evan Greenberg makes no apologies for spending capital in Asia and Latin America rather than on buybacks. “That’s where we see the most attractive environments from both an economic and underwriting point of view,” he told analysts in April.

This is especially the case with life insurance and accident and health insurance — the two major businesses hardest hit by low investment returns in the developed world. By contrast, in countries like Indonesia, Malaysia, Thailand, Brazil and Mexico, there is not nearly as much price competition as in the U.S. and the EU.

The insurance industry is much less developed in emerging markets, and most customers there are looking for basic life and savings products, such as simple term policies with minimal coverage, or health and accident policies to provide for their families in case they get injured or die. Also, the risk of litigation in most emerging markets is much lower than in the U.S., reducing the need for higher reserves. All these elements translate into higher underwriting margins, which is the main attraction for ACE’s Greenberg.

The company currently holds about $3.5 billion in excess capital so as to be ready to pounce on big opportunities — a long-lasting hardening of p/c rates, for example, something that hasn’t been seen in 15 years. “Greenberg’s idea is that you really want to have plenty of capital for underwriting capacity when the opportunity to write new business at higher rates presents itself,” says Tom Mitchell, an insurance analyst at Miller Tabak & Co.

But ACE’s capital management leaves some investors unimpressed. The company’s share price had risen 15.4 percent this year as of mid-September, lagging the 19.4 percent gain in Travelers’ stock. ACE was trading at 10.1 times trailing 12-month earnings, compared with a multiple of 11.1 for Travelers. “The perception of acquisition-related risk is something that dampens ACE’s multiples a bit,” says KBW’s Shields. “Travelers is very active in repurchasing its stock.”

That’s an understatement. In 2012, Travelers returned more than $2.1 billion to shareholders through dividends and share repurchases. Since 2006 the insurer has returned more than $18 billion to shareholders and reduced its shares outstanding by almost 50 percent.

Travelers has spent considerably less capital on foreign expansion than ACE has. Its most significant investment abroad was the $1.1 billion cash purchase of Dominion of Canada General Insurance Co. in June. Travelers also spent $371 million to buy a 43.4 percent stake in Brazilian surety insurer J. Malucelli Seguradora in 2010; the company increased its stake to 49.5 percent last year, paying an undisclosed amount. International operations accounted for only 5.5 percent of Travelers’ total net written premiums last year.

Most major European insurers are also focusing on returning capital to shareholders rather than growing via acquisitions. “Insurers in Europe have moved ahead of other financial business sectors in terms of payouts and yields,” says AGI’s Engels. “And this is something that investors want them to do.” Only insurers that need to strengthen their balance sheets have lagged in payouts and yields. “Among well-capitalized insurers you rarely find yields below 4 percent, and for some reinsurers you see 6 or 7 percent,” Engels adds.

Despite its underwriting gains and stronger capital management, the Hartford still needs another year or two to fully regain its growth momentum. The insurer repaid its $3.4 billion TARP loan in March 2010, just ten months after receiving the funds. In April 2012 it agreed to pay $2.43 billion to buy back securities it sold to Allianz during the crisis.

In March of this year, the Hartford announced plans to reduce its debt by $1 billion and repurchase $500 million in stock. Additional buybacks will have to await a stronger bottom line. Although core earnings in the p/c business rose 19 percent in the first half, to $458 million, the company posted a net loss of $431 million, compared with a $5 million loss a year earlier, largely because of losses on hedges in its Japanese variable annuity business. Not surprisingly, McGee is considering selling that operation.

The new focus on property and casualty will still require the Hartford to expand its product offerings. The rising contribution of underwriting results to overall income is fine, says McGee, “but we need to grow the top line.” • •

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