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By Dr. Robert P. Hartwig, CPCU
President
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bobh@iii.org

April 9, 2008

The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 12.3 percent in 2007, down from 14.4 percent in 2006. The decline in profitability in 2007 was expected and is primarily attributable to a marginal deterioration in underwriting performance, which pushed the full-year combined ratio up to 95.6 from 92.4 in 2006. Net written premium growth was down 0.6 percent in 2007, the first such decline since 1943. At the same time policyholder surplus, a measure of capacity, increased 6.5 percent to a record $517.9 billion. The results were released by ISO and the Property Casualty Insurers Association of America (PCI). Though profits remained reasonably strong, industry margins did fall short of those realized by the Fortune 500 group of companies, which turned in an estimated average return on equity (ROE) in the 13 to 14 percent range in 2007.
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2007: Historically Strong, But Signs of Cyclical Strain Emerging

Underwriting

The financial performance of the property/casualty insurance industry for 2007 actually turned out to be quite good in historical terms. From an underwriting perspective, last year was the twentieth best year since 1926, while 2006 was tied for fifth best (with 1935). Indeed, the 92.4 combined ratio recorded in 2006 together with last year’s 95.6 figure represent the best back-to-back underwriting performances in more than a half century, when the average combined ratio in 1953/1954 was 93.4. Likewise, the return on average surplus over the 2006/2007 period—at 13.3 percent—was the best in nearly 20 years (1987/1988). Last year’s results proved to be surprisingly resilient in the face of an increasingly price competitive environment, a weak economy and turmoil in the financial markets. But at the same time the 2007 results provided confirmation that the industry is now well past its cyclical peak in profitability of 14.4 percent and its cyclical trough in the combined ratio of 92.4, both achieved in 2006. In my commentary on the first quarter 2007 results I presented an analysis suggesting that if the historical trends observed during the past four market cycles hold (dating back some 35 years), the industry can expect ROEs to bottom out in 2011 at about 1 to 2 percent, not reaching another peak in profitability until 2015 or 2016.(1) History does not imply destiny, of course, and there are some indications that aggressive capital management, expense controls and judiciously timed realization of accumulated capital gains by insurers may be making a difference—leading to a shallower market cycle and a more modest dip in profitability.

Premiums and Pricing

Net written premiums declined by $2.6 billion or 0.6 in 2007, down from a 4.2 percent increase during in 2006, which experienced strong growth in property-related insurance premiums in hurricane-exposed areas. Last year’s decline was the first in 64 years, when premium growth fell in 1943 in the midst of World War II.

A variety of price surveys and company reports suggest that premiums are likely to decline once again in 2008. This is primarily the result of an across-the-board softening in the personal and commercial lines pricing environment. As in 2007, the declines are more pronounced in commercial (business) lines than in personal lines (auto and home). ISO’s MarketWatch data indicated that commercial renewal premiums during the third quarter of 2007 fell 3.4 percent. Federal statistics indicate auto and home insurance prices rose just 0.4 percent last year. A weakening economy, leakage of premium to government-operated (re)insurers and continued strong interest in alternative forms of risk transfer, including various forms of self insurance, captives and catastrophe bonds, despite lower prices for traditional (re)insurance products are also contributing to the slowdown.

Historically, the travel time from the cyclical peak of premium growth to the cyclical trough has been 5 to 6 years. Reaching a trough in 2008 would be consistent with historical experience (peak growth of 15.3 percent occurred in 2002). However, history paints two distinctly different pictures for the years immediately following a trough. During the hard market of the mid-1970s, premium growth peaked in 1975, hit a trough in 1981 and peaked once again in 1985/86. The next trough was effectively reached by 1992, after which the industry experienced very slow growth through the remainder of the decade.

The current drought in premium growth is reminiscent of the soft market of the late 1990s, which presaged some of the worst years in the insurance industry’s history, with combined ratios rising from 102 in 1997 to nearly 116 in 2001. Fortunately, with last year’s combined ratio of 95.6 and another result below 100 possible in 2008, the comparison—at least so far—appears to be superficial, or at least premature.

Investments

One observation from 2007 is that insurer profits going forward will become increasingly dependent on investment earnings as underwriting performance steadily deteriorates. It is notable that despite a substantial 38.9 percent ($12.1 billion) drop in underwriting income (the margin by which premium income exceeds claims costs, expenses and policyholder dividends) to $19.0 billion from $31.1 billion a year ago, profits (net income after taxes) fell just $3.8 billion, or 5.2 percent, to $61.9 billion in 2007, from $65.8 billion in 2006. The decrease in underwriting profit was substantially offset by modestly higher investment income—up $2.3 billion (4.5 percent) to $54.6 billion—and a 154.6 percent ($5.4 billion) leap in realized capital gains to $9.0 billion from $3.5 billion a year earlier.

It is important to note that the decision to recognize capital gains is entirely under management discretion. Major stock market indices have been in positive territory through 2007, with the Standard & Poor’s 500 Index up 3.5 percent last year (through April 8, 2008 the S&P was down 7.0 percent, however). While the accumulation of capital gains and volatility in equity markets associated with the current credit crunch have motivated some selling, companies are clearly under pressure to fill the profit void created by shrinking underwriting profits by selling a share of their investment gains accumulated over the past several years. In 2006, earnings were powered almost entirely by record underwriting profits and insurers realized just $3.4 billion in capital gains throughout the entire year despite a 13.6 increase in the Standard & Poor’s 500 stock index.

Although insurers have accumulated significant unrealized capital gains on their books, they are ultimately a finite resource. In contrast, profits generated through disciplined underwriting are a renewable resource and in a disciplined underwriting and pricing environment provide a stable source of earnings irrespective of the investment conditions. During the late 1990s, bull markets and high interest rates allowed insurers to absorb ever larger underwriting losses. That changed when stock markets collapsed and interest rates tumbled in the early 2000s. The credit crunch induced market swoon and volatility that began in July and August of last year persists to this day and seems likely to continue for an extended period of time. The Federal Reserve has trimmed rates on six occasions for a total 300 basis points (3 full percentage points) since September and, along with the Treasury Department and other agencies, is introducing other measures to help stabilize credit and real estate markets. The current volatile investment environment and the concern voiced by the Federal Reserve, the Treasury, the President and foreign central banks are reminders of the inherent uncertainty and volatility of investment returns, even in the insurance industry’s very conservatively managed investment portfolio.

Profitability and Capacity

Continued strong profits in 2007 gave insurers the opportunity 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 by ratings agencies in the wake of Hurricane Katrina; 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. Recent turbulence in the financial markets is another reminder of the importance of healthy profits. Insurers must maintain the financial resources to pay record size mega-catastrophe claims no matter how low interest rates fall or how far or fast stock markets plunge.

Net income after taxes (profits) in 2007 fell by $3.8 billion or 5.8 percent to $61.9 billion, down from $65.8 billion in 2006. The decline is the first since 2001. The combination of falling profits and rising policyholder surplus dragged down return on average surplus to 12.3 percent in 2007 from 14.4 percent in 2006, a cyclical peak.

Policyholders’ surplus increased by $31.6 billion, or 6.5 percent, to $517.9 billion at year-end 2007 from $486.2 billion at the end of 2006. The pace of policyholder surplus growth slowed substantially in 2007. Surplus increased by 14.3 percent in 2006, 8.2 percent in 2005, 13.4 percent in 2004 and 21.6 percent in 2003, following declines in 2000, 2001 and 2002. The deceleration in capital accumulation is attributable to several causes, the largest and most obvious being declining prices for financial assets. Consequently, the industry swung from a position of $20.6 billion in unrealized capital gains in 2006 to a $0.5 billion unrealized capital loss in 2007, according to ISO/PCI. Insurers also returned more capital to shareholders through dividends and share buybacks, as discussed below.

The significant increase in surplus in recent years demonstrates that insurers are reinvesting the majority of their profits in the property/casualty insurance industry, bolstering industry claims-paying resources in advance of what are likely to be record-setting catastrophe losses in the relatively near future, not to mention the financial market volatility of today.

Consumers and regulators can expect that insurers will continue to increase their claims-paying capacity through into 2008. At the same time, publicly traded insurers must continue to compensate shareholders for the assets they put at risk. With relatively few opportunities for organic growth (such as expanding into new states or branching out into new lines of business) and only a limited number of acquisition targets (M&A activity remains well below what it was a decade ago), insurers can reasonably be expected to return capital to shareholders rather than invest it unproductively. Accumulation of excess capital can depress returns on equity. Consequently, insurers are returning capital to shareholders in the form of increased dividends and share repurchases. Share repurchase activity in 2007 shattered all previous records and constituted a return of 4.4 percent of average industry capital. According to Credit Suisse, share repurchases increased by 214 percent to a record $22.3 billion, and are more than four times the $5.3 billion peak recorded in the midst of the last soft market in 1999. Dividend payouts to shareholders increased by $7.3 billion or 29.3 percent last year to $32.0 billion, up $24.7 billion in 2006.
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The Weak Economy and Credit Crunch: Implications for Insurers

The credit crunch that began with the subprime mortgage meltdown in mid-2007 has precipitated a broader economic crisis in the United States (and abroad) that has challenged every industry in ways that were not foreseen a year ago—insurers included. Indeed, the economy may have sunk into recession during the first half of 2008. A steady stream of bad economic news, from slumping home prices and sales to record oil prices to rising unemployment have begun to take their toll on the wallets and confidence of consumers and the businesses that depend on them. Some of the key impacts of the economic downturn for insurers are reviewed in the sections below.

The reality is that throughout its nearly 200 year history in the United States, the property-casualty insurance industry has endured every conceivable economic circumstance and crisis and managed to persevere. Financial panics, deep recessions and war plagued the country throughout the nineteenth century and well into the first half of the twentieth. Since then inflation, stagflation, stock market bubbles and gyrating interest rates have made their presence known, but ultimately insurers have managed their way through each of these challenging periods. Experience has demonstrated that insurers, unlike banks, rarely run into deep financial trouble because of poor economic conditions. Instead, it is deficient loss reserves and inadequate pricing that historically account for the lion’s share of insurer impairments.

Has the industry ever experienced the combination of a soft market and recessionary economy? Yes, it has—most recently during the economic downturn of 1990/1991. Over that two year span, premium growth averaged 3.4 percent while return on equity averaged 9.2 percent.

Exposure Impacts

While property/casualty insurers are by no means immune from the effects of the current economic downturn, the impacts in terms of growth and profitability will be somewhat muted. In terms of revenue, property/casualty insurers are distinct from more economically vulnerable sectors such as homebuilders or carmakers. This is because approximately 98 to 99 percent of insurer exposure growth (measured in units) is tied to renewal business. In contrast, 100 percent of a homebuilder’s growth, for example, comes from new business. The relationship between insurance and the overall economy is actually more akin to that of the utility sector or the consumer staples segment. �Ӱ�ԭ�� is, in effect, an economic necessity, not a discretionary purchase. Homes, cars, businesses and workers all need to be insured irrespective of the state of the economy. To be sure, the precipitous 53 percent decline in new home construction from 2.07 million units in 2006 to an estimated 0.98 million units in 2008 will hurt growth prospects for homeowners insurers, but only on the margins. The reality is that the aggregate stock of housing grows by less than two percent annually even in the best of times. Likewise, the 8.3 percent drop in new car and light truck sales from 16.9 million in 2005 to about 15.5 million this year will have little impact on the total number of insured vehicles on the road, as older cars are simply kept on the road a bit longer. Again, the influence is at the margins: slightly fewer cars on the road with somewhat lower average premiums than would otherwise be the case if the economy had not soured. Other marginal impacts include workers compensation, where the combination of rising unemployment and minimal wage gains will stunt payroll growth (and therefore premium growth) in 2008, as was the case during the last recession in 2001. The economy has already shed 232,000 jobs this year (January through March) compared to total job losses of 2.7 million between January 2001 and August 2003. Despite the job losses over that 32 month period, workers compensation premium growth never declined. Premiums were flat in 2001, grew very slightly in 2002 and began to accelerate in 2003.

Asset and Investment Impacts

The hallmark of the current economic crisis is the collapse of the credit bubble. By definition, the bursting of any financial bubble implies asset price deflation. Tumbling home prices are generating the most headlines and concerns among consumers and could ultimately drop by as much as 20 percent according to Standard & Poor’s. But insurers hold very little in the way of direct investments in real estate. In fact, as of year-end 2006, just 0.13 percent of industry assets fell into the category of properties held for income or sale. An additional 0.31 percent of industry assets were invested in mortgage loans on real estate. While it is true that some insurers have some exposure to certain categories of mortgage-backed securities, most have little to no such exposure. Some insurers also have exposure to various credit-related financial instruments including derivatives. In some instances some insurers have had to recognize or write-down losses on some of these investments (irrespective of the performance of the underlying asset). In cases where these instruments were owned by an entity within the insurer’s holding company structure but not by a property/casualty insurer, they are not included in the financial results reported here.

Of greater immediate impact to insurers are the traditional asset market impacts associated with economic downturns—declines in stock markets and lower interest rates. The Standard & Poor’s 500 Index, as noted by ISO/PCI, was up just 3.5 percent in 2007 and down 9.9 percent through the first quarter of 2008 (7.0 percent through April 8). Yet the effects on property/casualty insurers are tempered by the fact that equities (common stock) account for just 18 percent of invested assets.

The Federal Reserve’s campaign to jump start the economy by slashing interest rates is reducing bond yields and will inevitably reduce the average yield on the industry’s bond portfolio—which accounts for two-thirds of invested assets—as new cash is invested at rates below that of maturing bonds.

Catastrophe Losses: The Worst Has Yet to Come

When it comes to catastrophe losses, insurers necessarily prepare for the worst and hope for the best. Catastrophe losses during 2007 were relatively light—at $6.7 billion, compared to $9.2 billion during 2006, according to ISO’s Property Claims Service. This sum is a pittance compared with the record $62 billion in insured losses in 2005, $41.1 billion of which was due to Hurricane Katrina. The 2007 hurricane season was active and produced 15 named storms, the same number as the devastating 2004 season. Yet only one weak hurricane (Humberto) came ashore in the United States on September 13 in East Texas, doing little damage. The most expensive catastrophe of 2007 occurred during the fourth quarter—the wildfires in Southern California. According to the state of California, insured losses from all fires totaled approximately $2.3 billion. Needless to say, insurers are never out of the woods when it comes to catastrophe losses. The reality is that the 2000s has already established itself as 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 frighteningly 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.

Unfortunately, 2008 is already off to an inauspicious beginning, with catastrophe losses for the first quarter exceeding $3 billion, the highest first quarter total in many years.
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Summary

The strong financial and underwriting performance of the P/C insurance industry in 2007 creates unexpectedly strong momentum for the first part of 2008. The results were primarily attributable to a strong, across-the-board underwriting performance, resulting in one of the best combined ratios in the past 80 years. Deteriorating underwriting performance, primarily the result of increasing price competition, will likely lead to a greater share of earnings coming from investment gains going forward—a shift that has already clearly begun. Insurer underwriting performance and profits were also aided by reserves releases, which knocked 1 to 2 points off the combined ratio for many insurers.

One major cause for concern is the fact that negative premium growth in 2007 means that the industry growth has come to a screeching halt 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. To date, insurers have sought to reduce capital primarily through share repurchases. A spate of acquisitions in late 2007 suggests, however, that the pace of consolidation could accelerate in 2008.

A detailed industry income statement for 2007 follows:

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