Property/casualty insurers are basking in a nearly catastrophe-free year and soaring profits in 2006, but they know that glow could fade soon.

The key is whether they can maintain underwriting discipline in the wake of increased competition and lower prices in noncat-prone areas.

Life insurers, meanwhile, expect steady growth in 2007 and the prospect of surging demand from retiring baby boomers who are increasingly demanding assets, rather than mortality protection.

"This is a dream time for the property/casualty insurance industry," said Sean Mooney, New York-based chief economist for Guy Carpenter & Co. Inc., a unit of Marsh Inc.

"What keeps them awake is wondering how soft the market is going to get," Mr. Mooney said. "Historically, the industry gives its gains away."

Underwriting results in 2006 "are remarkable"--the best in 51 years, said Wendy Baker, president of Lloyd's America Inc. in New York. "I hope it is sustainable, but I don't think that it is."

The lack of catastrophes in 2006 was important, but "we can't count on good luck persisting," said Patrick Mailloux, president and chief operating officer of Armonk, N.Y.-based Swiss Re America Corp.

For property and casualty lines, "there is still relatively attractive rate adequacy," Mr. Mailloux said.

The "respite in catastrophe losses in 2006 combined with a strong performance in virtually all other major lines of property/casualty insurance will propel the industry to its best underwriting performance since 1955," according to the III's "Earlybird Forecast 2007," summarized by Robert P. Hartwig, the newly installed president of the New York-based Insurance Information Institute. The annual forecast is based on the opinions of a panel of stock analysts and industry professionals.

In addition, analysts estimate that the combined ratio in 2006 will be 94.3%, which "would represent the industry's best underwriting performance since the 94.9 combined ratio recorded 51 years earlier," he said. Analysts expect the industry's profitability will continue in 2007--with a 97.6% combined ratio--"albeit with an underwriting performance sufficient to generate a much smaller underwriting profit," he said.

Analysts also predict a "substantial slowdown" in the average increase in net written premiums, from 2.8% in 2006 to just 1.5% in 2007, he said.

While the III reports the industry has $10 billion in new capital, it "just doesn't go as far because of tighter solvency standards," said James H. Costner, a Nashville, Tenn.-based senior vp and senior risk consultant with Willis Risk Solutions Property Practice. "Rating agencies are becoming the regulators of the market and imposing their stricter solvency requirements on ceding insurers and reinsurers."

"It's been a great year, but you still need more capital," specifically, "twice as much as you did before," said Randy Schreitmueller, vp of operation sales and services at Johnston, R.I.-based Factory Mutual Insurance Co., which does business as FM Global. He said more conservative models and rating agency assessments are driving the demand for capital.

Mr. Hartwig identified several challenges that insurers must manage so they can avoid deteriorating profitability in 2007 and beyond. For example, insurers need "to avoid a significant sacrifice of margins on existing business lines while seeking out growth opportunities that leverage off current company strengths," he said. In addition, insurers face mounting competitive pressure in falling prices outside of high-risk areas, a slowing economy and regulatory rate suppression, Mr. Hartwig said.

"Agents and brokers will have a good year in '07," especially since they will have the Eliot Spitzer settlements mostly behind them, said Christopher J. McShea, Chicago-based national director for Ernst & Young L.L.P.'s property/casualty insurance and actuarial advisory services practice.

Generating adequate return on equity is an important challenge for the insurance industry, Mr. Mailloux said. Between 1995 and 2005, the insurers trailed many other industries in average ROE, he said, citing data from Swiss Re and A.M. Best Co. Inc. For example, reinsurers' average ROE was 8.1% and primary insurers' was 10.8% during that period, which is significantly lower than the 14.3% reported by some financial institutions, he said.

Several industry executives expect higher premiums and increased competition in 2007.

With 76 million baby boomers starting to retire, "we are still bullish on the retirement-income market, said Doug French, the New York-based global director of actuarial services at Ernst & Young.

"Companies continue to build products and address needs for retirees around cash flow management," he said. Specifically, variable and fixed annuities will continue to be popular, while demand for equity-indexed products will continue to fall off.

PRICING Trends

P/C reinsurance pricing increased from Jan. 1 to July 1 last year and likely will stay high for January 2007 renewals because of reinsurers' desire to catch up from prior years' losses, Mr. Mailloux said.

Thomas J. Tierney, chairman, CEO and president of Montpelier, Vt.-based Vermont Mutual Insurance Group, said, "I see 1/1 reinsurance renewals bubbling up to 7/1 rates."

The Jan. 1, 2007, reinsurance renewal market was characterized by more negotiations than the July 1, 2006, market, Guy Carpenter's Mr. Mooney said. Buyers cited limited catastrophe losses last year as justification for their requests, several observers said

The retrocessional market, though, still is experiencing "very strong rates," Lloyd's America's Ms. Baker said.

In 2007, "I don't think there will be dramatic changes from last year in terms of reinsurance capacity and price," Mr. McShea said. Consolidation among reinsurers has resulted in the emergence of large global players and Bermuda market companies, he said.

"Reinsurance underwriters will resist overreacting to the good experience in 2006," Mr. Costner said.

On the life side, reinsurers have gone through some consolidation in recent years, which resulted in price tightening, Mr. French said.

In addition, the catastrophe reinsurance market for accident and health insurance "is very competitive and getting even more competitive," with price drops of 5% to 7.5% in 2007, said Dean Kidd, Philadelphia-based managing director, for Guy Carpenter. That market hasn't had a loss since Sept. 11, 2001, which is one factor driving pricing down, he said.

The primary P/C product market for most risks was headed downwards, except for properties exposed to natural catastrophes and some niche casualty risks such as recall insurance, said Mr. McShea.

"The market is schizophrenic," Willis' Mr. Costner said. It is a hard market for terrorism, hurricane, earthquake and flood coverages, he said. Coverage is limited and premium increases are heavily dependent on where the risk is located, he said. For example, a casino located on a Florida beach may have seen a 1,000% premium increase from the prior year, he said. Yet a casino located inland--beyond the storm surge--may see increases of 100% to 200%, Mr. Costner said.

"Elsewhere, it's a soft market," with abundant capacity and competition, he said. Premiums in this segment of the market are flat to as much as 10% lower than last year, Mr. Costner said.

There have been reports of some single-digit price drops in noncatastrophe risks, Ms. Baker said.

Casualty markets are expected to see "continued softening" in most lines in 2007, Mr. Mooney said.

The only exceptions include low levels of workers compensation insurance. Contributing to that are increasing medical costs of such claims, although their frequency is down, according to industry data.

Other lines, such as directors and officers coverage, "are continuing to drop," with renewal pricing ranging from flat to down 15%, said Steve Shappell, the Denver-based managing director of legal and claims practice for Aon Financial Services Group. Contributing to the D&O decline is a reduction in the number of federal class action lawsuits, which dropped about 30% by late 2006 following a 17% reduction in 2005, Mr. Shappell said.

Life insurers are experiencing a more positive market.

"Although the direct market has been pretty flat over the last two to three years," Swiss Re is "actually seeing (premium) growth in the 4% to 5% range in 2006," though the company expects that it will be below the long-term trend, said Donna Kinnaird, president of Swiss Re Life & Health America Inc. in Armonk, N.Y.

In overall profitability, Mr. French predicted that life insurance production will continue to grow 3% to 4% per year.

There also is a shift in demand. "We see demand moderating for mortality protection products, but we see it accelerating for asset accumulation products," Ms. Kinnaird said.

The design of those products, though, "probably gets a little more conservative with regard to second guarantees on universal life products," E&Y's Mr. French said.

UNDERWRITING Discipline

A key element is to maintain underwriting discipline, executives say.

"I'm fairly optimistic that the industry will maintain underwriting discipline," this year, Swiss Re's Mr. Mailloux said. Insurers are receiving better quality data from clients, including more credible financial data, as a result of Sarbanes-Oxley Act reforms, he said.

The most favorable terms and conditions in reinsurance and insurance contracts will go to buyers who provide very detailed data sought by underwriters including up-to-date property valuations, Mr. Costner said.

For property risks, "generally, broker manuscript policies are off the table and insurers are requiring use of their own--and sometimes unique--property forms," Mr. Costner said. For example, utility service interruption coverage restrictions could include lower sublimits of $5 million to $10 million or longer waiting periods before coverage applies, he said.

Mr. Costner added, "A lot of underwriters are saying: 'Here are my terms and conditions. Take it or leave it.'"

In addition, typical flood exclusions in homeowners' policies need to be examined in light of the recent court decision that upheld some flood coverage for Louisiana homeowners because the levee failure was due to human error, Mr. Mooney said. While many say that decision is expected to be overturned on appeal, it adds uncertainty to the market, he said.

Until the issue is resolved, "reinsurers may consider adding flood exclusions in their reinsurance contracts" rather than agreeing to follow the terms and conditions of the underlying contracts, he said. The Louisiana judge found coverage in some underlying policies that did not expressly exclude all causes of flooding.

For D&O coverage from some insurers, buyers can expect "pro-policyholder" terms and conditions such as nonrescindable clauses that guarantee coverage even without all required underwriting data, Aon's Mr. Shappell said. Underwriters, though, continue to work at crafting exclusions because "people who engage in criminal behavior should not benefit from D&O policies," he said.

Also, multiyear policies are being proposed for some good risks, he said.

For life insurance products, underwriting terms may tighten as the industry reacts to life settlement schemes that made use of stranger-originated life insurance arrangements, Mr. French said.

In STOLI arrangements, speculators who have no relationships to insured persons initiate coverage on older persons and fund the premium payments for investment purposes, thereby circumventing the intent behind states' insurable interest laws.

A subgroup of the National Assn. of Insurance Commissioners last month sought to resolve the problem by recommending adoption of a five-year ban on cashing in a policy that is financed with the specific intent to be sold to investors.

We have seen "significant improvement over the last couple of years in our direct companies adhering to their underwriting guidelines," Swiss Re's Ms. Kinnaird said.

When selling asset accumulation products, "innovation is becoming more and more important," she said. Options can include guaranteed accumulation or guaranteed withdrawal plus riders to provide living care.

The most significant legislative issue the P/C industry faces this year is the proposed extension of a federal terrorism backstop, most sources said.

Democrats in control of both houses of Congress should make passage of TRIA "much easier," many executives said.

In addition, life insurers also are concerned about making progress toward principles-based reserving, which would require moving from a formulaic reserving methodology to one based more on an economic reserves, Ms. Kinnaird said.

According to the III's forecast, the biggest potential downside risks for all insurers in 2007 include exposure to catastrophic losses.

In addition, "insurers will need to come to grips with a variety of challenges unrelated to catastrophe losses, including increasing price pressure and the slow growth environment that could erode underwriting performance and profitability in the year ahead," Mr. Hartwig said.