ACE Limited (NYSE:ACE) writes insurance policies including property & casualty and accident & health insurance as well as professional policies like errors & omissions or directors & officers insurance (protecting companies and their employees from the potential liabilities associated with lawsuits from clients, stakeholders, etc.). The company was founded by 34 Fortune 500 companies that were worried about rising premiums and a failure to find takers for some large-risk policies. Thus ACE has a history of insuring largely low-frequency, high-severity risks for institutional customers.
ACE has diversified in the past decade into sectors such as energy, financials, healthcare, retail, aerospace, and transportation, signaling that the playing field is open for a wide array of potential new business. ACE has focused on maintaining underwriting profitability by insuring risks that are high in severity but low in frequency (e.g. E&O policies, catastrophe insurance, etc.). Such fat tail risks can be very difficult to assess, and often the ultimate day of reckoning can be far in the future, distorting present results and leading to wide fluctuations in year-to-year results.
ACE operates in four different segments, including:
In 2009, ACE generated a net income of $2.55 billion on net premiums of $13.24 billion. This represents a 117.3% increase in net income and a 0.3% increase in net premiums earned from 2008, when the company earned $1.17 billion on $13.20 billion in net premiums.
For example, the company's directors and officers are seldom sued successfully in major tort cases, but when they are, damages awarded in court can be enormous. Directors and Officers insurance protects against these unlikely events. Similarly, exceptionally severe weather causing major property losses are relatively uncommon, but when they occur can cause billions of dollars in damage. ACE's property and casualty lines insure such occurrences. The strategy of insuring these types of risks has advantages and disadvantages. Because modeling the risks associated with these policies is inherently difficult (for example, due to the probability distributions of such events often having fat-tails or due to the lack of adequate data on occurrences), the company can often take on business that competitors shy away from. This leads to attractive premium prices and substantial float from policies. However, for these same reasons, it is also exposed it to greater uncertainty than competitors as well as greater fluctuations in its year-to-year results. Furthermore, because such risks are often borne out at later dates than traditional “short-tail” policies, ACE may enjoy investment returns from float on a given policy for long periods even though the eventual cost of such insurance may not be known for years.
A large part of ACE’s property and casualty insurance operations focus on underwriting risks associated with natural and man-made disasters. Risks related to such policies are generally very difficult to assess and model given the year-to-year variability of severe weather frequency and intensity as well as the potential for long-run shifts in patterns, in light of the effects of global warming. For instance, while many meteorologists do not immediately blame climate change for the impact and severity of hurricanes like Katrina and Rita, there is more and more evidence that severe weather and climate change are linked. The company attempts to mitigate such effects with third-party reinsurance and sensible underwriting to compensate for the risk, but large, unexpected events can have a significant impact on the company’s bottom line and, perhaps worse, its financial strength.
While insuring high-severity risk is an uncertain game with distinct advantages and disadvantages, ACE's ability and willingness to price a wide variety of these risks is an attractive practice for the brokers with whom it does business. The company sells most of its policies through brokers, who prefer its appetite for many different types of risk as they can rely on ACE to cater insurance policies to their clients' specialized needs and protect institutional clients from often hard-to-insure risks. This encourages the brokers to bring an ever-increasing flow of customers to the company. That said, the company also depends substantially on two brokers, Marsh, Inc. and Aon Corporation (who brought in 17% and 11% of total premiums respectively), so it must continue to foster a positive relationship with them.
An insurance company can make money in two ways. One is taking in more money in premiums than it pays out - this is called an "underwriting profit". The second is investing the premiums taken in from customers and not yet paid out and earning interest on this - these are returns on invested "float". Many companies actually lose money on underwriting (often 1-2% of premiums) but make up for it with the investment income received on the float money. For example, if a company takes in $100 in premiums, invests it at 5% and eventually pays $101 in claims, it still earns $4 despite the underwriting loss. If, on the other hand, it pays out, say, $99 in claims, it earns $6. So an insurance company effectively enjoys a negative interest rate loan (due to its underwriting success) which it is free to invest.
Insuring and estimating losses associated with asbestos liabilities has been a notoriously difficult game over the last two decades. Variables including regulatory shifts and judicial rulings - both nearly impossible to predict with high accuracy - have played a major role in determining ultimate outcomes from asbestos risks. ACE's net loss reserves for asbestos exposure. This leaves ACE notably exposed to the creditworthiness of its reinsurers (who may or may not be able to pay up on their own insurance policies to ACE) and to its own estimates on how much in losses can ultimately be recovered.
Because of ACE's diversified product base, the company competes with many types of other insurers. While ACE attempts to differentiate itself by pursuing a strategy of insuring risks that others may not, the insurance industry at large is generally marked by low barriers to entry, significant price competition, and an alternating cycle of under- and over-capacity that can at times pressure pricing and returns. The industry is also highly fragmented: ACE's share is a tiny 0.33%. Indeed, discussing market share as a competitive advantage in insurance can be largely misleading - no company commanded any more than a 2.5% global market share.
While apples-to-apples comparisons of insurers as diversified as ACE can be difficult, the following is a table that includes comparable companies' net premiums, most recent combined ratio, and 5 year average return on equity. ACE's low combined ratio indicates that the company has operated with superior underwriting discipline as it is below industry average and has been for over a decade.
Ace's competitors include: