CORE RESERVING WORRIES BEST

OLDWICK, N.J.-Property/casualty insurers and some risk managers could be in for rough times within a year or two if insurers' loss reserving for core lines of business continues to deteriorate, warns an official with insurer rating agency A.M. Best Co.

Reserve shortfalls, which are being triggered by premium inadequacy, could spark rating downgrades, Oldwick, N.J.-based Best warns in a Jan. 20 report. The situation could force some insurers to seek buyers, shut down or harden rates in their most price-sensitive lines, said Eric Simpson, a vp in the agency's property/casualty insurance division.

The lines that insurers probably would harden first are commercial package, general liability and product liability, he said.

Best says the industry's core reserves do not pose a significant problem yet. But, Best says it "is concerned about the growing number of insurers whose reserve deficiencies are disproportionate to those of their peers and to their own capital levels."

Mr. Simpson estimated that 10% to 20% of insurers face "major shortfalls" in their reserves. Overall, fewer insurers, now estimated at 20%, carry reserve redundancies, he said.

"The seeds are being sown for a growing set of companies that will have problems," Mr. Simpson said. "We'll see increasing numbers of companies that will hit the wall this year."

A Standard & Poor's Corp. official said the reserving problem could be even more widespread than industry averages suggest.

Best's study is based on reserve information culled from Schedule P in 2,400 insurers' annual statements.

Those insurers account for about 90% of the industry's loss reserves, according to Best.

Insurers built up reserve redundancies in the early 1990s largely because of unexpected improved loss trends in the workers compensation and personal automobile liability arenas, the rating agency notes.

But, since 1993, insurers have released $15.7 billion of reserveredundancies built up from accident years 1987 through 1995 so they could maintain calendar-year profitability, Best says. As a result, insurers' prior-year reserve margins dwindled to $5 billion at year-end 1996 and will disappear over the next year or two.

Best projects that insurers' 1996 core reserves-all reserves except those for asbestos and environmental liabilities-will be $35.1 billion less than their ultimate required reserves. That shortfall represents 10.3% of the $341.3 billion of core reserves that Best projects the industry will carry in 1996.

However, more troubling to Best is that the shortfall would represent a $5 billion deterioration from the industry's 1995 core reserving levels.

And, when Best factors in its projection that insurers will carry $28.7 billion of A&E reserves at year-end 1996, the industry is 23% underreserved. That's because insurers should be carrying an additional $50.8 billion of A&E reserves, according to Best.

The total $85.9 billion shortfall in core and A&E reserves means the industry's 1996 surplus may be overstated by 34% before factoring in the time value of money and taxes, Best says.

A requirement that insurers obtain actuarial statements on the reasonableness of their reserves "provides considerable comfort," Best says. However, it notes that a growing number of insurers have experienced unanticipated larger losses after receiving clean actuarial opinions, which highlights "the fact that estimating required reserves is not an exact science."

Best also says that more insurers appear to be allowing their reserves to drift toward the low end of the wide range of acceptable reserve values.

To maintain a strong balance sheet for the long term, insurers should have reserve margins so they do not have to fund unforeseen liabilities with current accident-year reserves.

A prime example of how quickly a new liability can arise has occurred in California recently, Best notes. Courts there have adopted the continuous trigger theory of coverage in cases of continuing or progressively deteriorating injury or damage (BI, July 8, 1996; July 10, 1995).

There are several indications that the reserving problem flows from insurers' inadequate pricing, which barely covers the present value of expected losses and company expenses or does not even cover economic costs, Best says.

For example, the ratio of accident-year reserves to net premiums earned should rise or stay flat during soft market conditions. But, that ratio has fallen to 42.1% in accident year 1995 from 47.5% in accident year 1992.

In addition, both the developed reserves-to-net premiums earned ratio and the paid losses-to-incurred losses ratio have risen in recent years. That suggests "lower reserve margins being booked for current accident years in response to the poor pricing environment," Best says.

"Given the current highly competitive market, weakly reserved insurers find it difficult to strengthen reserves without materially hurting their earnings," Best says.

Insurers' after-tax income for the first nine months of 1996 increased 11.3% to $16.8 billion from $15.1 billion for the year-earlier period.

But, insurers' results have been "bailed out" by realized capital gains attributable to stock market investment gains, which are "things they can't control," Mr. Simpson said. Those gains soared 50% to $9 billion last year from $6 billion in 1995, Mr. Simpson said.

He noted that insurers' pre-tax operating income, which does not include realized capital gains, slipped to $17.9 billion last year from $19.5 billion in 1995 and that Best projects it will fall to $14 billion in 1997.

Mr. Simpson said Best is concerned because underwriting results, over which insurers have much greater influence, are deteriorating on an accident-year basis. Best projects that 1997 pre-tax underwriting losses will jump to $25.3 billion from $20 billion in 1996 and $18.1 billion in 1995. It also projects that the industry's combined ratio will jump to 108.8 this year from 107 in 1996.

Mr. Simpson noted that asbestos and environmental liabilities are hurting insurers' earnings less as more insurers "step up to the plate" to recognize those liabilities. Therefore, when the A&E earnings drag is factored out, the two-point combined ratio deterioration "translates into a 21/2-point deterioration."

That does not "sound like a big deal," but Best projects the industry's return on equity in 1997 will be 5.1%. That would be a sizable drop from 8.8% in 1996, and both figures are "anemic" compared to the business world's typical 15% ROE goal, Mr. Simpson said.

S&P also predicts slim profit margins for the insurance industry this year. "With that kind of profit margin, the industry doesn't have the financial capacity to be honest about its reserves," said Alan Levin, managing director. S&P also was disappointed by insurers' 1996 additions to reserves.

Reserve shortfalls could be more widespread than industry statistics suggest, he said. "Big companies' redundancies cover a lot of deficiencies by little companies."

Risk & Insurance Management Society Inc. President Louis J. Drapeau sees no need for a drastic response from risk managers.

Risk managers are not as dependent on the insurance industry as they were before the last hard market, said Mr. Drapeau, manager-insurance and risk management for The Budd Co. of Troy, Mich.

He also said that because of recent tort reforms at the state level, Best may be overstating the insurance industry susceptibility to unexpected liabilities.