Managing between a rock and a hard market. (Cover Story).

The market will make 2003 an attractive time for underwriting, but the investment environment poses real challenges for insurance companies, industry leaders say. Greater financial transparency, rising health-care costs and the ongoing need for tort reform are also part of the mixed forecast.

2002 was a year of ups and downs. Insurance prices tended to go up, capacity went down; health-care costs continued to climb and investment returns stayed low. The result is a mixed bag of opportunities and challenges awaiting insurers in 2003, which industry leaders say is driven largely by the state of the capital markets.

During 2002, the Dow Jones Industrial Average dropped from well over 10,000 to nearly 7,000, the Nasdaq fell from about 2,000 to nearly 1,000 and the prime interest rate went from 4.75 to 4.25, all continuing trends begun in previous years.

Consequently, insurance companies have seen the value of their assets and investment products decline dramatically and not just their domestic holdings. The decline in the capital markets globally is the event that will have the greatest impact on insurance and reinsurance over the next few years, said John P. Phelan, chairman and chief executive officer of American Re-Insurance Co. and American Re Corp., the U.S. subsidiary of reinsurance giant Munich Re. And the biggest concern going into 2003 "would be a further severe collapse of the capital markets," he said.

Many insurance companies made themselves deeply vulnerable to a market decline because in the previous soft market, they took less money for their products and then bought stock, said Joe Plumeri, chairman and CEO of Willis Group. "There was a lack of focus on what business the insurance industry was in--a lot of people thought they were in the investment business--and they gave away the product too cheaply to get money to invest," he said.

Focus on Underwriting

The fact that insurers can no longer rely on equity income will cause a continued focus on underwriting profitability--higher prices, tighter terms and restricted capacity, said Robert J. Cooney, chairman, president and CEO of Max Re Ltd.. The challenging investment market will especially affect "the long-tail classes of business, where expected investment income played a big part in the pricing," he said. "This will also affect reinsurance costs and reinsurance limits for primary writers."

"We all have to manage our business better," Phelan said. "On an accident-year basis, combined ratios in the mid-to-low 90s will be quite normal for commercial writers in the United States. Companies that can't produce those types of ratios will find themselves in some difficulty."

Pricing and selecting business to generate underwriting profit will prolong the hard market, several of the leaders said. The current hard market, which is more of a correction, "is an attempt to reorganize business, to get back to fundamentals, to become more focused on what business they are in and become more efficient and profitable," Plumeri said.

"It's great market conditions for underwriting and terribly challenging for making asset returns. Those who can combine the two ideas will be the winners," Cooney said.

The financial market challenge-- both equity markets and interest rates--is significant for life insurers, said W.G. Jurgensen, chairman and CEO, Nationwide Mutual Insurance Co. and Nationwide Financial Services Inc. "Depending on the kind of policy we're talking about, there are two things going on: a death-benefit aspect and investment aspect," Jurgensen said. "The investment aspect is the bigger part of the challenge. There's nothing new on the mortality front. But what's happening with the equity markets is coming at the same time as we're in a 30-year low in rates. That puts tremendous Strain on the business."

The equity-market situation also has a significant impact on the level of capital companies have available to them to underwrite additional risk or to expand their franchise through acquisition, Jurgensen said.

The state of the capital markets isn't all bad for insurers, however, according to Edward J. Zore, president and CEO, Northwestern Mutual. "People realized there's no quick way to financial security, and that plays into Northwestern Mutual's strengths," Zore said. "What we deliver to people is financial security--life insurance, long-term care, disability products, investment products and services. The stock market has proved to be volatile and not as predictable in generating returns. People realize they need help now; they need stability; they need guarantees. That's where we come in."

Cooney predicted another ramification of the equity market situation going into 2003 might be that insurers will have more interest in alternative investments, such as hedge funds. "They are likely to be a better performing investment than buying high quality bonds," he said. "Hedge funds that don't correlate with equity can make modest profits in very bearish times."

An Open Book

The new push for financial transparency as a result of recent corporate governance issues also ranks high as a trend that will influence how insurers conduct business in 2003. "Insurance has always been an interesting industry, especially on long-tail business where you put up reserves for losses, but won't know what will happen for several years," Cooney said. "I think companies will be even more focused on conservative reserving and disclosure to get a more true financial picture on what's going on. I expect companies may err on the conservative side. It will be good news for investors and shareholders, but may be bad news for stated financial results."

Steps corporate executives can take to promote financial transparency and integrity include diligence about internal audits and coordination of efforts, said Vicky Gregg, who will become CEO of BlueCross BlueShield of Tennessee in February. Even before corporate governance issues received national attention, BlueCross BlueShield of Tennessee recognized it needed more coordination in that area, Gregg said.

"We had legal, internal audit and compliance and regulatory areas, but they didn't necessarily coordinate and talk with each other," Gregg said. "So now we have a new chief risk officer in place, and we're making those three areas report up through him so we can have a total view of the organization with integrity and the tone coming from the top."

Gregg also said the role of the corporate board is paramount. "Having them engaged and involved, asking the right, questions, with separation between management and the board is important," she said.

"I think it's good that more independent directors are becoming more involved in the business, rather than just showing up four or five times a year," Willis' Plumeri said.

Rising Health-Care Costs.

For Tennessee Blues and other health insurers, the trend of 2002 that will have the greatest impact going forward is "exploding health-care costs," Gregg said. Costs rose 13.7% in 2002, according to a study by Pricewaterhouse Coopers, and are expected to increase anywhere from 15% to 20% in 2003.

Driving those increases are more costly drugs, technologies and procedures and an aging population, Gregg said. "That gets combined with the current state and federal deficits which drive cost shifting to the private side. That combines with the shortage of health-care workers and the liability and malpractice environment. When you add all of that up together, people have referred to it as the perfect storm," she said.

To cope with increased costs, many insurers are focusing on how to impress upon consumers the real cost of the health care they consume, Gregg said. "We're going to have to engage the consumers, and they're going to have to understand and change some of their buying practices to be successful at containing costs," she said.

Going into 2003, another concern for health insurers is that the market could shrink in terms of private customers. "If people opt out because the cost is too high, then our membership declines and typically it's the sicker people who stay in. So you end up with a pool where the costs are going up even faster because you don't have a hea1thy mix," Gregg said.

Tort Reform

An important issue with ramifications for property/casualty insurers--both commercial and personal lines writers--is the need for tort reform, Nationwide's Jurgensen said. "I don't think anyone has disputed the need for a system that allows people to seek and obtain relief from situations in which they have clearly been harmed and there has been egregious behavior," he said. "But all settlements of this nature find their way back into the price of products and services that consumers purchase and pay for. Certain people think there's some endless deep pile of money, and that these outside settlements come from it. In fact, the pile of money they come from largely belongs to policyholders."

Gregg also noted that liability troubles health insurers. "There are a number of class-action suits both in our industry and others, and you come to the conclusion that any group of people who can find a good lawyer can take you to court," she said. "So what might those settlements be, and if you don't settle, how much time and energy will you have to put into dealing with that?"

Reinsurance

Max Re's Cooney predicted the erosion of capital due to the declining equity markets and the realization that investment income will be much lower could create "a fun [reinsurance] renewal season that will probably still be going on in March." He also predicted a greater interest in alternative risk transfer--both by large corporations and primary writers who buy reinsurance--because of restrictions in coverage and dramatic increases in pricing, maybe for the second time in two years. "Companies will be thinking of retaining more risk one way or another," he said. "They'll consider self insurance, keeping better retention, buying less traditional capacity."

RELATED ARTICLE: John R Phelan

Position: Chairman and chief executive officer

Company: American Re-Insurance Co. and American Re Corp., the U.S. subsidiary of Munich Re

Headquarters: Princeton, N.J.

Primary products: Treaty and facultative reinsurance and related services

The biggest concern going into 2003 "would be a further severe collapse of the capital markets."

Vicky Gregg

Position: Chief executive officer, effective Feb. 1, 2003

Company: BlueCross BlueShield of Tennessee

Headquarters: Chattanooga, Tenn.

Primary products: Individual and group health insurance

"We're going to have to engage the consumers, and they're going to have to understand and change some of their buying practices to be successful at containing [health-care] costs."

Edward J. Zore

Position: President and chief executive officer

Company: Northwestern Mutual

Headquarters: Milwaukee

Primary products: Traditional and variable life insurance, disability insurance and fixed and variable annuities 

"The stock market has proved to be volatile and not as predictable in generating returns. People realize they need help now; they need stability; they need guarantees. That's where we come in."

Robert J. Cooney

Position: Chairman, president and chief executive officer

Company: Max Re Ltd.

Headquarters: Hamilton, Bermuda

Primary products: Traditional, finite and alternative risk transfer reinsurance of long-tailed liabilities

"It's great market conditions for underwriting and terribly challenging for making asset returns. Those who can combine the two ideas will be the winners."

W.G. Jurgensen

Position: Chairman and chief executive officer

Company: Nationwide Mutual Insurance Co. and Nationwide Financial Services Inc.

Headquarters: Columbus, Ohio 

Primary products: Personal automobile, homeowners, commercial lines insurance

"Civil justice--or tort reform--is a critical issue that will require some resolution. That has both commercial and personal lines ramifications."

Joe Plumeri

Position: Chairman and chief executive officer

Company: Willis Group

Headquarters: London

Primary services: Global insurance broker, professional insurance, reinsurance, risk management, financial consulting

The current market, which is more of a correction, "is an attempt to reorganize business, to get back to fundamentals, to become more focused on what business [insurers] are in and become more efficient and profitable."

Barbara Bowers, Lorraine Gorski, Meg Green, Ron Panko and Sally Whitney contributed to this article.