Commentary: Insurance: Now Come The Real Storms

The specter of price wars and increased regulation could send industry executives running for cover

Howling Winds. Baying lawyers. What could be worse? After four hurricanes and major industry scandals, you'd think U.S. insurers would want to forget 2004 quickly. Yet, according to the Insurance Information Institute (III), the industry generated its first underwriting profit since 1978 and its best return on equity since 1997.

Conditions in the New Year, however, may dampen industry spirits. For one thing, insurers have a tendency to initiate price wars as soon as money starts flowing. Already they are putting through slimmer premium increases -- in the 3%-to-4% range, and tripping over one another in pursuit of new business as the economy picks up. At the same time, New York State Attorney General Eliot Spitzer's investigation into industry practices -- including how brokers are compensated -- will increase the industry's transparency, making it tougher to squeeze clients.

For now, insurers are feeling flush. Even after four hurricanes that racked up insured losses of $20.5 billion last year, the industry enjoyed strong revenue from premiums, smart underwriting, and a 3.9% increase in investment income through the first nine months of the year. The industry's ratio of losses and expenses to premiums, known as the combined ratio, was expected to close out 2004 at less than 100, according to III, marking the first underwriting profit in a generation. Total property/casualty premiums are estimated at $435.2 billion for 2004 and could rise about 3.4%, to $450 billion, this year.

In coming months, disciplined underwriting will remain critical. With interest rates rising, there's no guarantee of double-digit stock market returns to offset payouts. A.M. Best Co. analyst Matt Mosher notes that premium revenues are softening to the point that they are not keeping pace with loss costs.

As for Spitzer's probe this past fall, the industry may be underestimating the importance of his action and the investigations by state regulators that followed. Robert A. Rusbuldt, CEO of the Independent Insurance Agents & Brokers of America Assn., expresses a widely held view when he says investigations into "a few bad actors" could end up tarring an entire industry. Those bad actors happen to hail from some of the biggest names in the business -- such as American International Group (AIG ) and Marsh & McLennan Cos. (MMC ) -- and Spitzer has subpoenaed players in almost every area of insurance.

At issue isn't bid-rigging as much as the use of a widespread, fundamentally flawed business model that creates conflicts of interest. Brokers are supposed to work in their clients' best interest, yet they take vast fees from insurers for delivering business -- often without disclosing those fees to customers. That practice must change. Bad publicity has already forced many insurers to scrap contingency commissions.

Health insurers have also come under scrutiny from regulators, mostly over compensation practices. Still, 2005 could be a fine year, especially if they get some relief on rising drug prices. More important, there's hope that the Bush Administration may finally enact tort reform to reduce the damage of escalating lawsuits. Any caps would help increase predictability, which is critical in an industry where losses are never known at the time companies set prices on coverage. Notes Aetna Inc. (AET ) CEO John W. Rowe: "The total number of suits may not be that great, but the defensive medicine that the threat of suits induces -- in the extra medical tests and things like that -- adds up."

Right now, the insurance industry is in a spending mood. Datamonitor PLC predicts that North American insurers will pay out $30.7 billion for technology in 2005, an increase of $1.18 billion over 2004. That will be a boon if it helps obliterate outdated legacy systems and the labor-intensive manual processes that have long burdened the insurance industry. But with price-conscious consumers and more vigilant government regulators, insurers may find that the halcyon days have blown clean away.

By Diane Brady

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