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June 28, 2007

Dr. Robert P. Hartwig, CPCU
President and Chief Economist
bobh@iii.org

The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 12.9 percent during the first quarter of 2007, down from 14.0 percent for calendar year 2006 and 15.5 percent from last year’s first quarter. The decline in profitability occurred despite the fact that the industry turned in one of its best underwriting performances ever, with a combined ratio of 91.7, down from 92.4 for full-year 2006 but up from 91.1 from the first quarter of last year. The results were released by ISO and the Property Casualty Insurers Association of America (PCI). Though profits remain reasonably strong, industry margins are virtually guaranteed to fall well short of those realized by the Fortune 500 group of companies, which is expected to turn in an average return on equity (ROE) in the 14 to 15 percent range this year.

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2007: Past the Peak, Hold on to Your Seat

The financial performance of the property/casualty insurance industry during the first quarter of 2007 was generally excellent, but at the same time provided confirmation that the industry is now past its cyclical peak in profitability of 14.0 percent achieved in 2006. The only question that now remains is how long the decline in profitability will last and how many years it will take to get to the bottom. History may offer some guidance. Since 1975 there have been four cyclical troughs in profitability: 2.4 percent (1975); 1.8 percent (1984); 4.5 percent in 1992; and -1.2 percent (2001). The descent from previous peak to trough can be steep or gradual—lasting anywhere from 3 to 7 years (4.75 years, on average). The associated decline in profitability, however, has invariably been severe, tumbling 13.5 percentage points on average over the last four market cycles. If historical norms for the past 35 years hold, the industry can expect ROEs to bottom out in 2011 at about 1 percent—not reaching another peak in profitability until 2015 or 2016.

Most industry observers are probably surprised by how rough the ride ahead could be. At the same time, many insurance CEOs vow that it will be different this time around. We shall see. There are many reasons to suggest insurers will be more successful at navigating the treacherous soft market shoals that lay ahead. Yet, it is also true that managing the market cycle has befuddled several generations of CEOs.

The first-quarter results—as good as they are—provide a useful glimpse into the future. Profits (net income after taxes) declined by $0.9 billion, or 5.5 percent, to $15.8 billion during the first quarter of 2007, down from $16.7 billion during the same quarter in 2006. The erosion in profits primarily reflects the general downward trend in price for most types of insurance. The average expenditure on auto insurance—which accounts for 34 percent of industry premiums—is forecast to fall in 2007 by 0.5 percent, the first decline since 1999. Commercial (business) insurance account renewals during the first quarter of 2007 plummeted by 11.3 percent, according to the Council of �Ӱ�ԭ�� Agents and Brokers. Profitability, measured in terms of ROEs, suffers not only from the weak pricing environment but also from accumulation of capital on insurers books that exceeds their ability to earn profits on that capital. The effect is a dilution of profits that translates into a lower ROE. Rising taxes don’t help either. According to ISO/PCI, federal income taxes paid actually increased by $100 million to $5.4 billion during the first quarter of 2007, despite lower profits.

That being said, full-year 2007 profits, assuming normal catastrophe losses, could come in close to $60 billion, or about $4 billion under the 2006 figure, which was a record in dollar (though not ROE) terms. Profits are being powered primarily by strong, across-the-board underwriting results in virtually every key line of insurance. Healthy investment returns also contributed to the bottom line. Declining charge-offs for adverse reserve development and even releases of redundant reserves are another key factor.

Catastrophe Losses: The Worst Has Yet to Come

Catastrophe losses during the first quarter were relatively light—at $1.3 billion, according to ISO’s Property Claims Service. This sum is a pittance compared with the record $62 billion in insured losses in 2005, $40.6 billion of which was due to Hurricane Katrina. The first quarter is generally light on catastrophe losses. The reality is that the 2000s has already established itself the “decade of disaster,” with record catastrophe losses set in 2001, 2004 and 2005. Insurers and reinsurers today actively plan for a $100 billion event (or sequence of events summing to $100 billion). There are a frightening large number of scenarios capable of generating a $100 billion loss, ranging from a repeat of the 1906 San Francisco earthquake, to a strong hurricane striking Miami or New York, to a major terrorist attack.

The 2007 hurricane season is illustrative of the risk. According to forecasters at Colorado State University, this year’s hurricane season is expected to be 85 percent above average. Seventeen named storms are anticipated, five of them intense, compared with long-run averages of 9.6 and 2.3 storms, respectively. There is also a 74 percent chance of a major (Category 3, 4 or 5) hurricane making landfall this year, well above the long-term average of 52 percent. Two named systems were recorded in June while the statistical peak of hurricane season does not occur until mid-September.

Not all catastrophe risk is associated with hurricanes. The looming December 31 expiration of the Terrorism Risk Extension Act has once again made terrorism a front burner issue for insurers. Interestingly, recently introduced legislation to extend the federal terrorism risk insurance program actually increases the potential for large-scale insured losses. While the proposed legislation (H.R. 2721), known as the Terrorism Risk �Ӱ�ԭ�� Revision and Extension Act (TRIREA), contains several favorable provisions such as eliminating the distinction between domestic and international acts of terrorism and providing for a 10-year extension, the Act also calls on insurers to assume nuclear, biological, chemical and radiological (NBCR) risks. Insurers have not historically insured most NBCR risks and nuclear/radiological exclusions have been in place in most insurance contracts for decades. A successful NBCR attack in a major urban area could easily produce insured losses in excess of $100 billion. Under TRIREA, insurers would responsible for a substantial share of these losses.

Profits: The Key to Rebuilding Claims-Paying Capacity and Reinvestment in the Industry

Continued strong profits in 2007 will allow insurers to make significant reinvestments in the industry. Profits bolster the industry’s policyholder surplus—a measure of claims-paying capacity or capital—and provide an additional buffer against the mega-catastrophes that lie ahead. An improved capital position will also help insurers meet the higher capital requirements imposed on them in the wake of Hurricane Katrina by ratings agencies, requirements that oblige insurers to demonstrate an ability to pay claims arising from more than one major catastrophe per year in order to maintain and improve financial strength ratings.

From year-end 2006 through March 31, 2007, policyholders’ surplus increased by $9.5 billion, or 1.9 percent, to $496.6 billion. Since March 31, 2006, policyholders’ surplus is up $57.5 billion from $439.1, a gain of 13.1 percent. These significant increases in surplus demonstrate that insurers are reinvesting the majority of their profits (and unrealized capital gains) in the property/casualty insurance industry, bolstering industry claims-paying resources in advance of what is already predicted to be an above-average 2007 hurricane season.

Consumers and regulators can expect that insurers will continue to increase their claims-paying capacity through the remainder of 2007. In fact, property/casualty insurance industry policyholders’ surplus almost certainly surpassed one-half-trillion dollars (i.e., $500 billion) during the second quarter of 2007.

Profitability and Pricing

Rising profitability is also intensifying competition throughout most of the property/casualty insurance industry and buyers of insurance are the unambiguous winners when it comes to reaping the benefits of lower insurance premiums. Drivers, homeowners and businesses in most parts of the United States will be left with more cash in their pockets as insurance costs fall in absolute terms, or at least relative to income growth and growth in GDP—the sole major exception being insurance for property coverages in hurricane-exposed areas. The bottom line is that falling insurance prices are lowering the cost of doing business, driving a car or owning a home for most Americans. For example, countrywide auto insurance expenditures are expected to fall 0.5 percent in 2007, the first drop since 1999.(1) At the same time the average cost of insuring a non-coastal residence is up by just 2 to 4 percent in many areas and is flat or even falling in others. Businesses, too, will see price declines of 5 percent or more in 2007 across their entire insurance program. The declines are a continuation of a downward trend in the cost of business insurance that began in earnest in 2004. Overall, the share of P/C insurance premiums relative to the overall economy shrank by 2.0 percent in 2006 and will likely shrink by another 4 to 5 percent in 2007 and 2008. Hence, while critics of the industry bemoan insurer profits, the reality is that the cost of insurance for the overwhelming majority of consumers is flat or falling.

Improved profitability across the P/C insurance industry does not, however, mean that property insurance and reinsurance rates will fall in catastrophe-prone areas, especially those vulnerable to hurricanes. The risk in those areas remains high. Property catastrophe reinsurance prices are, however, leveling out as competition in the market heats up. One of the greatest threats to affordable property insurance coverage comes from the courts. Adverse court decisions, especially in Mississippi and Louisiana, are putting upward pressure on prices and decreasing availability.

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Premium Growth: Price Competition Takes its Toll on Insurers, is a Boon for Buyers

The ISO results indicate a growth rate in net written premiums of just 0.8 percent during the first quarter of 2007, down substantially from the 4.3 percent increase during calendar year 2006, which experienced strong growth in property-related insurance premiums in hurricane-exposed areas. The first quarter’s slim gains are weaker than the anemic average forecast from the �Ӱ�ԭ�� Information Institute’s February Groundhog survey of industry analysts calls for an increase in net written premiums of just 1.8 percent in both 2007 and 2008.(2) This 0.8 percent increase in premium growth, if maintained through 2007, would represent one of the lowest growth rates for the P/C insurance industry in at least 40 years. The deceleration in premium growth in 2007 is a direct result of a virtual across-the-board softening in the personal and commercial lines pricing environment and a leveling-off in property insurance price increases in many hurricane-exposed areas. Other factors include a general economic slowdown that is negatively impacting exposure growth through declines in home building, new vehicle sales and business investment in new plants and equipment as well as slower wage and salary growth. Actions taken by insurers to reduce their exposure to relatively catastrophe-prone (but rapidly growing) property markets like Florida are also having a negative impact on the outlook for growth as do continued interest by businesses in alternative forms of risk transfer such as captives.

For insurers, the current premium growth pattern is eerily reminiscent of the soft market of the late 1990s, when the industry recorded growth of 2.9 percent in 1997, 1.8 percent in 1998 and 1.9 percent in 1999. Those years presaged some of the worst years in insurance industry history, with combined ratios rising from 102 in 1997 to nearly 116 in 2001. Fortunately, with a first-quarter combined ratio of 91.7 (coming on the heels of 92.4 combined ratio for all of 2006), the comparison—at least so far—appears to be superficial, or at least premature.

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Underwriting Performance: Momentum Continues Into 2007

The P/C insurance industry’s underwriting results in 2007 remained extraordinarily strong by historical standards. The first-quarter combined ratio of 91.7, should it hold for the remainder of 2007, would become the third best since 1920. Last year’s combined ratio of 92.4 was the best since 1949 and stands tied for the fifth best result since 1920. The first-quarter combined ratio is down 0.7 point from the calendar year 2006 result but up 0.6 point from first quarter 2006. The current period of sustained underwriting profits (2004, 2006 and possibly 2007 and 2008) is the first in a half century.

The first quarter’s 91.7 combined ratio implies an underwriting profit after dividends of $8.3 billion. If maintained, 2007 would witness only the third underwriting profit since 1978. The industry’s 2006 underwriting profit totaled $31.2 billion. Despite recent underwriting profits, there remains a cumulative underwriting loss of approximately $390 billion since 1975 (assuming a 2007 underwriting profit of about $30 billion).

The combined ratio is projected to rise to 96.8 in 2007 and 98.7 in 2008, according to the I.I.I.’s Groundhog survey. However, the first-quarter results are better than anticipated, suggesting that a combined ratio of 95 or even lower is possible this year, assuming “normal” catastrophe losses.

While the survey results indicate fundamentally sound underwriting performances in 2007 and 2008, the anticipated 3 to 7 point deterioration in the combined ratio over the next two years is another indicator of slimmer profit margins in the years ahead. A surge in catastrophe losses could easily push the industry combined ratio to 100 or beyond, too high to generate returns that are competitive with the Fortune 500 group. A combined ratio of 100 means that insurers are paying out exactly the same amount in claims and associated expenses that they collect in premiums. As a stern reminder of the importance of generating substantial underwriting profits, the 100.7 combined ratio in 2005 produced an ROE of just 10.5 percent. The underwriting profits earned in 2007 will help insurers earn their cost of capital (the rate of return necessary to retain and attract capital) for just the third time in many years. Though up substantially in 2006 and (so far) in 2007, insurer profits remain highly volatile. Just six years ago, in 2001, insurers suffered their worst year ever with negative profits for the year. Considering the tremendous risk assumed by investors who back major insurance and reinsurance companies, the returns in most years are woefully inadequate. It is clear that Fortune 500-level ROEs in the neighborhood of 13 to 15 percent cannot be generated consistently without a substantial contribution from underwriting, given the murky interest rate situation going forward and continued stock market volatility. According to ISO, P/C insurers would need to generate a combined ratio of 89.6 in 2007 in order to earn a rate of return equal to that of the long-term average for the Fortune 500 group of 13.9 percent.

In the final analysis, insurers will need to find ways to generate adequate rates of return not only to compensate investors for the risk they assume and to preserve their claims-paying capital, but also to maintain their financial strength and credit ratings and to avoid regulatory sanctions. A financially weak insurance industry is of no use to anyone, including policyholders, millions of whom depend on the industry to pay hundreds of billions of dollars in claims each year.

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Investment Returns: Satisfactory Results, Banking Gains for the Future

The industry’s net investment gain increased by $1.1 billion, or 8.3 percent, to $14.7 billion during the first quarter of 2007 from $13.6 billion during the same period in 2006. According to ISO, the net gain consisted of a 10.0 percent increase in net investment income (which consists primarily of interest on bond holdings and stock dividends) and a 2.6 percent drop in realized investment gains. Flat capital gains are consistent with the minimal 0.2 percent gain in the S&P 500 during the first quarter. Moreover, insurers seem content to bank capital they’ve earned in recent years. Realized capital gains fell sharply in 2006, despite the fact that the S&P 500 Index was up 13.6 percent last year. The decision to realize capital gains, of course, is one made by management. By deferring the realization of capital gains, insurers have the option of bolstering future profits, which may come under pressure if underwriting results deteriorate as expected in the years ahead. Looking ahead, while the S&P 500 index was up 5.3 percent through June 27, 2007, it is still far too soon to ascertain the market’s impact on insurer investment gains for the year. It is important to keep in mind, however, that P/C insurers hold just 17 percent of invested assets in the form of common stock, so upside from a rally in stocks is limited.

It is worth noting that the industry’s annualized first-quarter investment gain of $59.0 billion is roughly on par with the $57.9 billion earned in 1998, despite the fact that insurers investment portfolio is much larger today. The inability to match the investment gains of the late 1990s is directly related to higher interest rates on bonds and consistent bullish equity markets during that period of time. This underscores the need for insurers to remain disciplined both in their underwriting and pricing.

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Summary

The strong financial and underwriting performance of the P/C insurance industry during the first quarter of 2007 bodes well for the remainder of the year. The results are primarily attributable to a strong, across-the-board underwriting performance, resulting in one of the best combined ratios in decades. In 2007 insurers face a variety of challenges, including a recurrence of large-scale catastrophe losses and increasing price pressure that could erode underwriting performance.

One major cause for concern is the fact that premium growth in 2007—at just 0.8 percent during the first quarter—is less than one fifth the 2006 growth rate of 4.3 percent and is, in fact, severely negative on an inflation-adjusted basis. Another is the rapid accumulation of capital on insurer balance sheets. The current slow-growth environment means that insurers face very difficult capital allocation decisions over the next several years.

A detailed industry income statement for the first quarter of 2007 follows:

1) The �Ӱ�ԭ�� Information Institute’s forecast for 2007 auto insurance expenditures is available at /media/updates/press.764681/.
(2) �Ӱ�ԭ�� Information Institute survey of industry analysts /media/industry/financials/groundhog2007/.