The Asbestos Tug of War

Phil Zinkewicz. Rough Notes. Volume 146, Issue 6. June 2003.

A few decades ago- it seems like only yesterday-there were only two words to describe the condition of the property and casualty insurance marketplace. Those words were "hard" or "soft." Independent insurance agents didn't really have to concern themselves with the "whys" of insurance industry cyclicality. It was enough to know that insurer's appetites for certain lines of business increased or decreased depending upon underwriting profit or loss results. Only those in the higher echelons of the property and casualty insurance business needed to concern themselves with the reasons for cyclical changes-regulatory and legislative developments, insurance company investment income results and the relationships between insurance companies and their reinsurers.

Definitely not so today.

Recently Standard & Poor's issued a report titled: Asbestos Driving a Wedge Between Insurers and Reinsurers, in which Ian Reed, author of the report, says: "A conflict is brewing between the insurance and reinsurance companies over who will pay for asbestos exposures. Successive rounds of massive reserve increases at primary companies not only fail in aggregate to capture the size of the industry's shortfall, but anticipate an unrealistic level of reinsurance backing."

Bob Partridge, a managing director in S&P's insurance ratings, says that S&P analysts are "not convinced" reinsurers are recognizing that liability. "If you add the amounts up, the primary sector's expectations don't correspond with what the reinsurers are recognizing," he says. "The fallout could affect reinsurers' credit quality."

The fact is, the fallout could affect more than that. It could affect the very financial stability of primary insurance companies that are, for all practical purposes, under-reserved for asbestos alone, not to mention what might happen should a major catastrophe, such as Hurricane Andrew, occur. Independent agents are already dealing with a hard market, and such a situation could only make matters worse.

The report says that when an insurer such as ACE Ltd. announces a $2.2 billion addition to gross reserves for asbestos, as it did in January 2003, but only a $0.5 billion boost to net reserves (after expected reinsurance has kicked in), it signals an overwhelming dependence on reinsurance for an exposure representing about 30% of its capital base.

"Across the industry, the difference between net and gross numbers raises all sorts of questions about who's ceding what to whom," says Jon Iten, director. "It's all smoke and mirrors. The liabilities are disappearing into thin air and nobody's capturing them."

Steve Dreyer, S&P managing director, says that cracks are already showing in the co-legal bonds that "once held the insurance and reinsurance camps together in amity." Dreyer says disputes between insurers and reinsurers appear to be intensifying. "The tone is getting ugly," says Dreyer. "Large cessions to reinsurers of asbestos liability, especially incurred-but-not-reported losses, will only invite more contention."

The S&P report notes that anticipated asbestos claims have prompted "dizzying reserve increases" at a number of U.S. insurers over the last couple of years. Travelers Property Casualty Corp. topped the list at $2.5 billion (fourth-quarter 2002), equivalent to almost all of its 2002 operating earnings. (Editor's note: Since S&P's report was compiled, The Hartford announced a $2.6 billion addition to its net asbestos reserves, resulting in a $1.7 billion after-tax charge to its first quarter earnings.)

CNA Financial Corp. has not increased asbestos reserves since its $1 billion addition in August 2001, but S&P estimated in February 2003 that reserves for the company's property and casualty operations were deficient by about 5% to 8%, says the report. Other companies that increased their reserves significantly include St. Paul's, Fireman's Fund, Allianz AG, Chubb Corp. and The Hartford, says S&P.

However, the report notes that reinsurers have not matched these exposures with commensurate increases in their own reserves, in part because of a natural lag in the process, but also because insurers are often failing to inform them about what level of reimbursement they are expected to come up with, even though the primary companies have built that anticipated income into their own numbers. S&P speculates that, for their part, reinsurers may not want to know. "In the days of high investment returns, they tended to reserve more generously than the primary insurers they were covering and could let the money sit and grow, but in the weak investment climate now prevailing, the incentive is to put up more meager reserves," says the report.

Yet even with the flurry of reserving activity at the primary insurer level, the industry, as a whole, continues to drop behind growing estimates of its probable future payouts, notes S&P. Says the ratings organization: "Tillinghast-Towers Perrin currently expects the total worldwide bill for corporate asbestos liability will reach $200 billion, with insurers on the hook for about $120 billion, split roughly evenly between U.S. and non-US, carriers. For the U.S. insurance industry, the $60 billion price tag for asbestos liabilities compares with about $24 billion in payouts so far and current reserves of $13 billion. That means its reserves deficit is now close to $25 billion."

According to S&P, the reasons for these numbers are attributable to three factors: a regulatory environment that still permits some asbestos usage, flourishing litigation activity and a near paralysis in legislative maneuvers to counteract it. The flourish of litigation is documented by S&P from statistics garnered from the RAND Institute for Civil justice. According to the Institute, in 1982, there were 21,000 claimants in asbestos disputes. Today, there are 600,000 plaintiffs. In 1982, the number of defendants totaled 300. Today, there are upwards of 8,400. In 1982, total costs of the litigation reached $1 billion. Today, that figure is $54 billion. In 1982, there were three bankruptcies related to asbestos litigation. Today, there have been 64.

Says the S&P report: "RAND also reports that five states in the U.S.-Pennsylvania, Texas, California, Louisiana and Maryland-account for 79% of U.S. plaintiffs and 65% of trials, with Texas and Maryland showing the fastest growth. This illustrates the vogue for venue shopping, in which plaintiff lawyers scout for the jurisdictions most likely to render a favorable verdict. Meanwhile, verdicts to plaintiffs for asbestos-related diseases have increased dramatically. By 2001, the average for mesothelioma cases was about $6.5 million, compared with $2 million for 1998. Lung cancer cases increased to $2.5 million from $1 million, and asbestosis cases to $5 million from $2.5 million. But the most dramatic change on the litigation front has been driven by claimants who have yet to show any functional impairment. Loyola Law School reports that 65% of compensation is now going to this category."

These are the driving factors that are causing a rift between insurers and their reinsurers, according to S&P. "The world has changed for insurance companies," says Partridge. "The legal environment shifted and no one saw it coming. Even when lawsuits are deemed frivolous or are dismissed for any other reason, insurers still have to reimburse their clients for defense costs," he said.

The question is how much of all of these costs insurers will be able to shift over to reinsurers. Reinsurers apparently are holding their ground on what they are willing to pay for asbestos cases that may be decades old.

"There needs to be more clarity in insurance company reporting," says Andrew Barile, president of Andrew Barile Consulting Corp. Barile, who provides consulting services for insurers and reinsurers in reinsurance disputes, adds: "Rating agencies are going to have to step up to the plate and make it clear which companies are depending too heavily upon reinsurance collectibles from reinsurers that are either unwilling to pay up or unable to. Otherwise, the reinsurance collectible situation could have a disastrous effect on primary insurers in the United States."

Patricia Borowski, senior vice president of the National Association of Professional Insurance Agents (PIA National), agrees that rating agencies must increase the frequency of examinations of primary insurance companies and pay special attention to a company's reinsurance collectibles. "The average independent insurance agent cannot possibly do financial examinations of the companies he or she represents," says Borowski. "Agents depend upon the financial ratings of rating companies when placing business. For their part, agents should check the financial ratings of companies more frequently to determine what changes have taken place. But it is the rating agencies that must look at how companies handle their litigation exposures and how they manage their capital and surplus, on an individual, company-by-company basis.

"Moreover," continues Borowski, "insurance departments can do a better job of monitoring the financial stability of companies domiciled in their states. Companies have a responsibility as well. If a company knows or suspects that its rating will be downgraded, that company should communicate that to its producers. In the last hard market in the 1980s, it took longer for companies to go insolvent. Agents had an opportunity to recognize the signs and act accordingly. But today, companies can slide into insolvency much more rapidly. Agents should be aware of what's going on in the marketplace so that they are not taken by surprise."