“It is definitely coming, but maybe not as fast as some people would think if they did not have this type of look,” he said, referring to a line graph of the composite ALIRT scores over the past 15 years.

ALIRT scores—derived every quarter from the analysis of operating and investment ratios as well as other financial strength measures—range from 0-100, with higher scores assigned to stronger insurers. The 10-year median industry score is right in the middle—at 50.

Although carrier scores have been trending downward since 2007, the composite has been above 50 since the middle of 2005, according to the graph. In contrast, back in 2001, the composite was closer to 35 as the market turned from soft to hard.

PAIN GAUGES

Paul intends to include this graph, titled “Pain Gauges,” in a presentation he will deliver to members of the Target Markets Program Administrators Association at their midyear meeting in Boston next month. (For more meeting information on the meeting, see related article.)

Giving NU a preview, Paul begins his analysis with a historical review of industry surplus levels, which trended downward from 1999 to 2002, to a low point of just under $300 billion. Surplus levels have been rising since 2006, but Paul notes that “just because there's a lot of surplus doesn't necessarily mean that people are going to continue writing business.”

Capital (or policyholders surplus in the world of insurance statutory accounting) is not the same as capacity, he says. Capacity reflects this financial capability to write, but also the willingness to do so. “We could end up with a lot of surplus, but with underwriters and managers just saying enough is enough”—and that could cause the market to harden, he suggests.

“That's what we hope for. But history has shown there has to be some type of pain” for this to happen. Alluding to the competitive nature of the market, Paul says, “You really have to hit them over the head.”

That's where this concept of “pain gauges” comes in, Paul continues, noting that his firm is uniquely positioned to measure the relative financial strength of companies over time through its quarterly analysis of pain points—surplus losses, rising combined ratios, reserve hiccups and investment risks. All these factors are captured in the derivation of ALIRT's numerical scores.

Turning to the graphical representation of historical composite scores for the top 100 commercial lines writers, he notes that ALIRT started seeing a downward trend in the stability of companies in late 2000 as the market started to turn. The composite scores fell from 50 in 1998 to around 45 in 2000 and plummeted to about 37 in 2001.

Turning his attention to current scores, Paul says that “as a pain gauge, we'd really need to see the composite start to fall below the long-term average.” At year-end 2010, however, it stood at 54.

He points out that the line graph of the scores “almost made a straight shot up [from 2002] to 2007,” when the score reached its high of more than 65. “That was all the hard-market pricing and redundant reserves starting to develop over time,” which contributed to very strong earnings and a buildup of capital.

In 2008, the financial crisis pushed the score down to 55, and it has been trending slightly downward over the past two years, Paul observes. “But nothing right now is indicating that we're at the point where pricing would necessarily turn,” he concludes, noting that the level is 10 points above the prior tipping point of the year 2000.

EARLY WARNINGS

At TMPAA, Paul will review composite scores for meeting attendees eager to hear about industrywide turn signals. But on a daily basis, it is the individual insurance company scores that clients hire his firm to provide.

A broker might provide a list of hundreds of carriers it works with, hiring ALIRT to screen those carriers every quarter for early warnings of trouble, Paul tells NU. “Traditionally in our work, if a score gets into the low 30s or below, some remedial action is taken,” he says.

“Back 10 years ago, our clients were able to say, I'm going to get out of Reliance now because scores were in the teens before A.M. Best would have them at an A-minus,” he reports.

Paul explains that rating agencies can be slow to respond because they recognize that their downgrade actions can put companies into a death spiral. He also notes that ALIRT's scores, unlike letter ratings assigned by credit rating agencies, are for individual insurance companies within insurance groups.

Right now, ALIRT scores are showing few signs of trouble in the program carrier space. Focusing in on TMPAA members, Paul reveals that:

• Twenty-six of 38 admitted TMPAA insurers—or roughly 68 percent—had scores between 40 and 60 at year-end 2010.

• That's on par with the historical distribution of scores across the industry, he says, noting 70 percent of company scores typically fall in that range year after year.

• TMPAA carriers writing on an excess-and-surplus lines basis fared slightly better, with only one of 27 coming in under 40 and four above 60.

TMPAA CARRIER SCORES LESS VOLATILE

Paul does not at this point identify the six admitted and one E&S carrier with scores below 40, reserving that information for his clients. But over time, he notes that TMPAA composite carrier scores have moved up and down in tandem with industry composite scores.

Referring to another line graph of historical composites—this one with TMPAA composite superimposed on top of the commercial lines composite—he reveals that the TMPAA scores move in a tighter band—with lower high scores and higher low scores over time.

While he speculates that one reason for the flatter TMPAA-score line graph is the absence of carriers like Legion (a program carrier that became insolvent during the last turn) from the database, he believes another reason relates to the nature of specialty business.

“Specialty business is so price-dependent and so underwriting-specific,” that the scores really reflect “the ability of the underwriter” to price well and to select risks carefully.

Noting that the graphs also reveal slightly higher scores for TMPAA E&S companies than the TMPAA admitted carriers, he says the relationship makes sense. “They should be stronger, and this shows that they generally are because they don't have the cover of a guaranty fund,” he says. “If you're an E&S writer, you had better have better financials.”

Eyeing those seven scores on the low end of the spectrum, NU asks how many less experienced startup carriers fall in this range. Paul reports that while 14 of the 64 TMPAA carriers (eight admitted and six E&S insurers) included in his analysis have operating histories of five years or less, only two (both admitted) were outsized to the low side with scores of 31 and 36.

THEN AND NOW

Tying just a few national carrier names to their scores—both at September 30, 2010 and year-end 2000—Paul provides more support for his conclusion that a market turn is coming, but not as quickly as some carrier executives are now saying.

• Seven of eight national commercial carriers all had higher scores in 2010 than in 2000, and five are above 60, including ACE American Insurance Company, Federal Insurance Company and Travelers Indemnity.

• The only one of the eight national commercial carriers with a lower score in 2010 than 2000 was National Union Fire, a member of the Chartis/AIG group—43 in 2010 vs. 64 in 2000.

• In an analysis of nine specialty carriers, Chartis' Lexington also had a lower score in 2010 than in 2000—58 vs. 65.

• Seven of nine specialty carrier scores came in higher than in 2000, with five over 60 in 2010 and only two scores below 40 (Markel and Argo).

The scores reveal little evidence of market-turning pain, Paul suggests, also comparing the carrier combined ratios for 2000 and 2010—an important financial metric behind the scores. He notes, for example, that ACE American's nine-month 2010 combined ratio was 87 vs. 119 in 2000. On the specialty side, Houston Casualty reported an 84 combined ratio in 2010 vs. 109 in 2000.

And for the commercial composite overall, the nine-month 2010 combined ratio was 99 vs. 109 in 2010.

“Does a market turn on break even? It's hard to imagine,” Paul concludes.

CANARY IN A COAL MINE?

“We're constantly going over these companies quarter after quarter, and we are now seeing the deterioration in the individual results quite clearly,” Paul says, suggesting that the year-end 2010 and first-quarter 2011 scores and combined will show a bleaker picture.

In a March research report, he reveals that the year-end ALIRT P&C industry combined ratio was 102.6 for the full year compared to 100.2 in 2009. In addition, industry surplus levels rose more slowly last year—increasing only 2.5 percent in 2010 compared to a 8-20 percent jumps in the last seven years (with the exception of the drop in 2008 tied to the global financial crisis), the report reveals.

“At some point, especially if financial deterioration continues, some catalyst could move carriers to dial back their appetite to place business. This would lead to harder pricing and a market turn,” he writes.

What might be the catalyst that lowers the willingness to write business?

In addition to large global catastrophes or a marked deterioration in economic conditions, he suggests “continued dramatic increases in prior-year reserves” might fit the bill.

While Chartis was the only insurance group to announce a major boost in reserves last year—$5.2 billion—Paul notes that 28 percent of the total related to recent accident years (2007-2009).

“It could be argued that Chartis is a proverbial 'canary in the coal mine,'” taking necessary steps to strengthen near-term accident years before most of its peers,” he writes.

“If they're taking big charges on some of this stuff, you've got to believe some of the other folks, potentially, will have them, too,” Paul tells NU. If that's the case, then subsequent reserve hikes by additional carriers could mark the beginning of a pain cycle that drives pricing higher, he says.

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Understanding The ALIRT Scores

• ALIRT produces a two-page analysis for roughly 1,600 P&C companies every quarter.

• The top page is a scorecard that can range from 0-100, with the higher score being the stronger relative strength of the company.

• The bottom page provides raw financial ratios used by the analysts to develop the scores.

• The 10-year median score for P&C companies is 50, and 70 percent of the carrier scores fall in the 40-60 range.

• Traditionally, scores below 30 indicate that a carrier is headed for some type of near-term remedial action.

• Unlike letter ratings assigned by credit rating agencies, ALIRT scores are recalculated each quarter based on statutory financial information

• ALIRT scores are calculated for individual insurance companies with insurance groups—the names behind the policy paper—rather than parent companies.

• The ALIRT analysis looks at four tiers of risk, with the first two tiers—operational risk and investment risk—accounting to 75 percent of the score.

• The remaining tiers look at the financial flexibility at the holding company level as well as the impact of credit ratings (assigned by Moody's, S&P, Fitch and A.M. Best)

• The biggest components of the operation risk score are underwriting profitability, capitalization and reserves.

Related articles:

• Will Next Market Turn Be Traumatic For Program Administrators?

• MGAs Uncork Multiple New Program Niches

• Events: Program Administrators To Gather At TMPAA Midyear