6. PROPERTY & CASUALTY INSURANCE

PROFILE

The property and casualty (P&C) insurance industry is in two businesses: underwriting risk and investment management. In its underwriting function, the industry examines the frequency and severity of potential damage to physical assets (property) or injury to persons (casualty), and then places a value on insuring against, or underwriting, those risks (1). The legal structure of P&C firms can take one of two forms: stock companies, which are public companies freely traded on the open market, or mutual companies, which are owned collectively by the policyholders. Figure 6.1 summarizes four key characteristics of the property and casualty insurance industry of particular importance to the public interest community.

Size and Leaders

Globally, the P&C industry controls more than US$ 1.4 trillion in capital (2), and in 1996, the U.S. P&C industry alone collected more than US$ 250 billion in premiums. The industry is dominated by companies from Japan, Switzerland, the United States, Netherlands, Bermuda, the United Kingdom, and France. Bermuda is the offshore location of a large part of the global P&C industry. The largest stock firms in the United States are the American International Group (AIG), Allstate, Loews, the Travelers Group, ITT Hartford, and General Reinsurance. The only large mutual P&C insurance firm is State Farm. Most major corporations seeking P&C insurance utilize an insurance broker, such as J&H Marsh and McLennan Inc., or Alexander and Alexander, to serve as an intermediary between the corporation and various underwriters.

Key Features

Today the P&C industry is made up of three main components: primary issuers, reinsurers, and "excess" insurers - each of which manages different levels of risk and exposure. Primary carriers write policies for firms and individuals looking to insure themselves against known and yet to be identified potential risks. Reinsurers buy or are ceded a percentage of the premiums collected by the primary insurer in a pooled or aggregate manner that covers a large group of policies, and the reinsurer's insurance policy covers aggregate claims against the pool once the total amount of loss exceeds a certain value. Excess insurers tend to offer coverage above levels of US$ 10 million to US$ 100 million. For example, a corporation buys primary insurance or self-insures for the first US$ 100 million in losses and then buys coverage for the next US$ 100 million in coverage from an "excess" insurer. Reinsurers and excess insurers tend to take a more global approach, both in geographic markets and products, to spreading risk than primary issuers.

Figure 6.1 - Key Characteristics of Property & Casualty Insurance

Until the last decade or so, the P&C industry was not generally considered to be a member of the investment community. Firms in the industry thought of themselves as "underwriters" who also happened to make investments, utilizing a mix of internal and external advisors and investment managers to manage their capital. Historically, the industry invested conservatively only in extremely high quality bonds with maturity dates that matched the expected needs to pay out claims. High rates of return were a third consideration after the timing of investment maturity and a high level of security. Although change has occurred in recent decades, the overall investment portfolio of the P&C industry has remained relatively stable in the 1990s with approximately 75 percent being held in high-grade government and corporate bonds, 19 percent in equities, 2 percent in real estate, and the remainder in miscellaneous investments and cash.

Regulation

The United States is the only major country that does not regulate the insurance industry at the national level. Instead, the industry is regulated at the state level by 50 state insurance commissioners, who are appointed in some states and elected in others. The industry is shaped by statutory regulations that govern accounting rules, minimum capacity (risk, assets, and staff), and specific underwriting knowledge. The National Association of Insurance Commissioners (NAIC) serves as the umbrella organization for the state commissioners and coordinates regulatory issues at the national level. NAIC requires all insurance firms doing business in the United States to submit a report each year called an "annual statement." Annual statements, which are rich in information about the firm's financial condition and are publicly available, must disclose all environmental liabilities of the insurance company's underwriting activities. The NAIC has also issued official investment guidelines to insurers in an attempt to influence the overall direction of investment management within the industry.

Attention to Environmental Issues

The underwriting side of the P&C industry was the first segment of the financial services industry to become concerned about environmental issues. In the late 1960s, the industry began to face claims related to asbestos, and in the 1980s U.S. courts deemed P&C policies to cover risks related to toxic contamination under the so-called "Superfund" legislation. Many P&C insurers began to offer specialty environmental liability insurance in the 1970s and 1980s, but they significantly underestimated their exposure. It is estimated that unanticipated asbestos and environmental claims have cost the industry more than US$ 200 billion, driving several large insurance firms into bankruptcy and forcing several others into major divestitures, mergers, and restructurings.

In 1985, the P&C industry acted to limit future liability by introducing a new clause in the Commercial General Liability policy that in practice absolutely excludes liability for property damage or bodily injury caused by pollution. As a result, corporations needing to insure against environmental liabilities must choose between various specialty insurance policies that cover specific types of environmental damage and that normally have very narrow financial limits and types of coverage. An important recent development is that increasing numbers of corporations are choosing to self-insure by setting up reserve Rinds for specific types of risks, including environmental or catastrophic loss. It is not yet known whether a large percentage of corporations will aggressively pursue this path, given the potential of associated risks.

The P&C industry now employs thousands of environmental experts in various disciplines to analyze the financial implications of environmental exposures faced by clients and to work with clients to mitigate environmental risk. The industry is also on the leading edge of the financial services industry in analyzing climatological phenomena such as global warming and the increased frequency of storm events. As of July 1998, there were 78 signatories to the recently initiated United Nations Environment Programme's Statement of Environmental Commitment by the Insurance Industry. At this time, nearly all of the signatories come from Europe or Japan.

Remarkably little spillover appears to have occurred from the underwriting side of the industry to the investment side of the industry in terms of addressing environmental issues. As a group, environmental considerations do not appear to influence the composition of the investment portfolios of the P&C industry. (For an exception, see Box 6.1.)

Relevance to Developing and Transition Economies

On the underwriting side, the international P&C insurance industry is actively seeking markets in developing countries, although trade barriers have previously deterred the industry from such significant markets as India and China. There is a limited market for P&C insurance policies covering environmental risks in the developing world because legislation mandating coverage is unclear or nonexistent, and court decisions holding companies and their insurers liable for environmental damage are rare.

On the investment side, the P&C insurance industry invests in various domestic and international securities. Some global insurers are diversifying from traditional investment activities. For example, AIG has actively sponsored private equity funds in Asia. (See Chapter 8, Venture Capital.) The "Asian Infrastructure Fund" is capitalized at US$ 1 billion, and a second fund has been capitalized at US$ 1.53 billion for infrastructure investments (3).

PROPERTY & CASUALTY INSURANCE DIAGRAM

Figure 6.2 illustrates the operation of a property and casulty insurance company. The need for P&C insurance is usually identified by the risk manager of a corporation, the corporate client, who has ascertained a potential risk to earnings within the corporation in the case of property damage or employee casualty. Once other staff inside the corporation concur, the risk manager contacts one or more several large insurance brokers to discuss insurance coverage options. The insurance broker and the risk manager create a request for proposal (RFP) that will be used to approach various account/field offices of different primary P&C insurance companies.

Within the P&C firm, the underwriter and the review committee, with support from external counsel, actuarial, and technical and industry services, evaluate the risk, establish parameters for the policy, and price the transaction based on RFP characteristics and current market conditions. An offer is made and a policy written and signed between the client risk manager and the P&C insurance company. Once the contract is signed, customer service, with support from claims and monitoring agents, manages contact with the policyholder. If a client submits a claim, it undergoes vigorous review that often involves the legal department. Each claim is settled based on the merits and legal aspects of the transaction as well as the importance of the client.

Some of the following questions are considered by the underwriter:

· How does a potential policy fit within the insurance company's overall portfolio?

· What experience does the insurance company have with the potential client's industry and type of policy and geographic location?

· Is there a secondary market for the policy?

Concurrent to the underwriting process, the primary insurance firm must determine the percentage of its total collected premiums that will be ceded to the reinsurance market. The dollar amount ceded to reinsurance companies is negotiated on a case-by-case basis.

Once the insured client begins to pay premiums, the money is directed to the investing side of the insurer. The finance committee and treasurer set the investment guidelines. Typically, insurance company strategy is made on an annual basis with the assets of the firm divided up among various internal or external portfolio managers who will try to maximize rates of return by investing in various domestic and international instruments.

Rating agencies, such as A.M. Best, rate each P&C insurance company's overall underwriting and investment portfolio.

Some of the following questions are considered by the portfolio managers:

· How will the rating agencies react to a change in investment approach?

· How much risk can the portfolio assume?

· How should the overall portfolio be divided into different investment vehicles and financial instruments?

FIGURE 6.2 - PROPERTY & CASUALTY INSURANCE

At this time, the investing side of the organization appears not to be leveraging (either intentionally or unintentionally) the environmental knowledge that has been acquired on the underwriting side of the firm.

In the United States, state insurance regulators oversee both the underwriting and investment activities of the P&C industry. Per NAIC regulation, each insurance company must submit an annual statement of its underwriting and investing activities. Trade associations, such as the American Insurance Association and the Reinsurance Association of America, provide information and educational materials to their members.

LEVERAGE POINTS

Underwriter - Bottom-line leverage. The underwriter is the most influential individual on the coverage side of a P&C firm. He or she decides what risks to insure, and what value, if any, should be placed on the environmental management system policies and practices of the company seeking insurance. The underwriter decides on the relevance of environmental exposures to a particular policy, and has an incentive to know and influence how the corporate client is managing and mitigating those risks.

Reinsurance Companies - Bottom-line leverage. Reinsurance firms are leading the discussion in the insurance industry regarding the impact of trends such as climate change and ozone depletion. They have strong incentives to understand the financial ramifications of environmental risks and to convince others of the importance of mitigating those risks, especially those associated with catastrophic events.

Insurance Brokers - Bottom-line leverage. Because relatively few major brokers exist worldwide, a small number of firms exercise an enormous influence over the P&C insurance market. Brokers, for example, are in a position to influence the scope of coverage and the type of policies available for companies exhibiting superior environmental performance.

Corporate Client Risk Manager - Bottom-line leverage. The risk manager in the company seeking insurance has incentive to be proactive in mitigating environmental risk because lower risk should translate into lower rates.

Board/Senior Management - Bottom-line/Reputational leverage. These groups oversee the long-term health of the insurance company. Issues related to image, costs, or loss of customers will likely get the attention of senior management. Actions or decisions from this group will influence the entire company.

Regulators - Policy leverage. The NAIC establishes national reporting and disclosure guidelines on liabilities and assets, including what information must be provided in a firm's "annual statement." Additional regulatory guidelines could be promulgated to integrate environmental criteria into investment strategies, and more stringent guidelines could be provided to ensure environmental disclosure within the annual statement.

Investing: Finance Committee, Treasurer, and External or Internal Portfolio Manager - Bottom-line leverage. At present, these individuals in the P&C industry do not appear to integrate environmental variables into their investment decisionmaking process any differently than do other mainstream investment managers. If these investment officials could be convinced of the value of integrating environmental criteria into the investment side of the business, they could leverage internal expertise from the underwriting side of the business.

Box 6.1 A Property & Casualty Insurance Industry Giant Looks to the Future Background: In the eight years since official negotiations toward a climate change convention began, the US$ 1.4 trillion insurance industry has become increasingly sensitive to the potential implications of climate change for their business. Several industry analysts have noted that property-catastrophe losses from windstorms in particular have reached record levels in the 1990s. Although these losses cannot be definitively linked to climate change, industry insiders are concerned about the mounting evidence of changes in underlying weather patterns. This attention has been fruitfully channeled into a sustained dialogue among insurance firms, policymakers, and environmentalists. Action: From 1993 onward, Greenpeace has organized a series of seminars with insurance and other financial services sectors to share perspectives on the costs of potential climate change and to seek productive ways to move forward. Following this initiative, the Solar Century was established in 1997 as a commercial entity to promote the development and use of solar power, with profits targeted towards community solar power projects. Solar Century has sought to involve the P&C insurance industry in a drive to achieve critical mass in the global solar-energy market, by showing how the industry could play a role both as consumers of energy as well as investors in the technology and its applications. Solar Century has been engaged in dialogue with several industry leaders to facilitate participation in this effort, including the giant Gerling Konzern group of insurance companies. Outcome: In June 1998, Gerling decided to establish a separate entity to demonstrate the viability of sustainable development projects. These projects include but are not limited to solar power. This new group, known as "Gerling Sustainable Development Project Company," will develop projects that integrate environmental, social, and economic goals and formulate indicators by which to evaluate progress. The long-term goal is to integrate such projects into the investment portfolios of Gerling and other industry leaders based on a track record of demonstrated success. Analysis: The message of enlightened self-interest, forged jointly through repeated conversations between industry and environmentalists, has been embraced by some insurance industry leaders. In the notable case of Gerling, discussion has led to actions with extremely long-term horizons. Gerling's actions are based on a fundamental reevaluation of long-term energy futures and a corresponding shift in values to embrace long-term goals of sustainability. This value shift was forged through a long process of collaboration and engagement between Gerling and partners at Solar Century. Sources: Jeremy Leggett, ed. 1996. Climate Change and the Financial Sector. Munich: Gerling Akademie Verlag; Solar Century website: http://www.solarcentury.co.uk; and personal communication, Dirk Kohler, Gerling Konzern.

NOTES

1. The modern P&C industry began in the 18th century at a London dockside coffeeshop named Lloyd's with the underwriting of England's worldwide merchant fleet. The term "underwriting" dates back to the days when a vessel's cargo or manifest was listed and valued at the top of a sheet of paper; individuals willing to insure the cargo wrote their names along with the percentage amount they would cover in case of loss under the manifest listing, thus becoming known as "underwriters."

2. Stephen Schmidheiny et al. Financing Change. Cambridge, MA: MIT Press. 1996. p. 118.

3. John Arthers. "AIG Raises 41.53 Billion for Asia," Financial Times. December 11, 1997.

AVAILABLE INFORMATION

American Insurance Association: http://www.aiadc.org

National Association of Insurance Commissioners (NAIC): http://www.naic.org

Risk and Insurance Management Society, New York, (212) 286-9292

Society for Risk Analysis, McLean, VA, (703) 790-1745

Reinsurance Association of America, Washington, DC: http://www.raanet.org

The London International Insurance and Reinsurance Market Association: http://www.lirma.co.uk

Insurance Services Office, Inc., New York, (212) 898-6000

A.M. Best: http://www.ambest.com

United Nations Environment Programme, "Insurance Industry Initiative for the Environment." http://eande.lbl.gov/CBS/climate-Insurance/UNEP.html

Annual statements (required and available at NAIC, libraries, or companies)

Annual reports (direct from companies)

Trade periodicals:

A.M. Best's Property & Casualty
National Underwriters
CPCU Journal

BIBLIOGRAPHY

Altman, Edward and Irwin Vanderhoof. The Financial Dynamics of the Insurance Industry. 1995.

Altman, Edward and Irwin Vanderhoof. The Strategic Dynamics of the Insurance Industry: Asset/Liability Management Issues. 1996.

Cathcart, Sanders B. The Impact of Catastrophes on Property Insurance. New York: Insurance Services Office, Inc. 1994.

Environmental Liability Committee. Report of Environmental Liability Committee: Improving the Climate for Insuring Environmental Risk. Toronto: Insurance Bureau of Canada. August 1994.

Ganzi, John T. and Brian T. Neubert. "Research on the Financial Impact of Environmental Events and Issues on the Property and Casualty Insurance Industry." U.S. EPA Cooperative Agreement #CR824410-01. Fall 1996.

Harries, James. Proceedings from an Industry Symposium: Improving the Climate for Insuring Environmental Risk. Toronto: Insurance Bureau of Canada. June 7, 1995.

Insurance Services Office, Inc. Homeowners Insurance: Threats from Without, Weakness Within. December 1996.

Insurance Services Office, Inc. Insurer Financial Results 1995. July 1996.

National Association of Insurance Commissioners. Investments of Insurers Model Act. Kansas City, MO: National Association of Insurance Commissioners. 1996.

Kroner, Ralph P. Transnational Environmental Liability and Insurance. London: Graham and Trotman. 1996.

Reinarz, Robert, J.O. Schloss, G.S. Patrick, and PR. Kensicki. Reinsurance Practices: Volume I & II. Insurance Institute of America. 1996.

Schmidheiny, Stephen et al. Financing Change. Cambridge, MA: MIT Press. 1996.