US reserves running out but not enough to turn market

But the analysts at KBW say that some companies will continue to post releases for a while yet and do not believe that the impact of the pending additions will be dramatic enough to help force a rapid hardening in rates, as occurred in the early part of last decade.

The KBW findings were published this week in the form of its annual industry reserve review. In total KBW believes that the reserve deficiency of the US P&C sector accounts for roughly 0.5% of the total reserves held by the group as of year-end 2010.

The analysts concluded that the insurers will inevitably therefore experience a reduction in the boost to earnings provided by favourable development in recent times.

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“P&C insurers have benefited tremendously from favourable loss reserve development in recent years. Undoubtedly, some companies will continue to book favourable development, boosting earnings. However, we believe most P&C insurers will see a drop-off in the earnings benefit they receive from favourable development, and we expect many companies will even need to take reserve charges in the next couple of years,” stated the report.

“Given our expectation for weaker investment income in the near term, solid underwriting results will be even more imperative for companies to achieve acceptable returns. This dynamic may force insurers to raise rates and maintain underwriting discipline, hardening the market,” it continued.

“However, we may still be years from any significant improvement in market conditions. Underwriting results continue to be solid for many insurers, reducing the need for them to push rate. New capital continues to enter the market looking for opportunities, which increases competition and makes rate increases more difficult to achieve. Right or wrong, many management teams believe their companies’ reserves are still redundant, and expectations for further favourable development may reduce the urgency to seek substantial rate increases now,” said KBW.

The stockbroker said that it believes there will be ‘winners and losers’ in this underwriting environment. “In addition to reviewing a company’s operating performance, we caution investors to carefully consider the company’s balance sheet strength (both on the asset side and the liability side) and the track record of its management team when making investment decisions. When the mask of favourable loss reserve development is removed, these factors may very well determine whether or not the company achieves its targeted earnings,” stated the analysts.

The analysis is based on 2010 Schedule P data for the domestic US property and casualty insurance industry that is compiled by A.M. Best. The data do not include reserves carried by offshore re/insurers, including those affiliated with US companies. Financial guaranty and mortgage guaranty composites are also excluded from the overall data because of ‘the significant distortion’ related to these business lines in recent years.The analysis did not include reserves for pre-2001 accident years. KBW stated that most of the P&C industry’s $586.2bn of loss reserves are for the last 10 accident years, but some 17% of the total is from pre-2001 accident years.

Significantly the stockbroker did not review loss reserves for old asbestos and environmental liability (A&E) claims that remain a relatively significant factor.

During 2010, about $5.3bn of reserves were added to accident years prior to 2001. Since 2001, almost $100bn has been added to the reserves for older accident years, much of which is for A&E claims.

KBW said that total favourable reserve development reported by the industry in 2010 was some $10bn (or 2.4% of the total). According to A.M. Best data, Berkshire Hathaway, Travelers and State Farm recorded the biggest positive releases to deliver a combined total of $4.2bn. AIG bucked the trend as it reported $5.1bn of adverse reserve development last year as part of its ongoing restructure.

If AIG were removed from the data, calendar year reserve development for the industry would have been favourable by $12.8bn, $13.8bn, and $15.1bn for calendar years 2008, 2009, and 2010, respectively.

KBW said that it believes accident years 2008 to 2010 are under-reserved and it expects to see adverse development related to those accident years in the future. However it believes accident years 2003 to 2007 remain redundant.

The analysts said that reserve adequacy varies by line. Reserves still appear to be redundant in the medical malpractice and other liability lines, while reserves are deficient for the workers’ compensation, product liability and non-proportional assumed reinsurance–liability lines, according to the stockbroker.