2000 - First Quarter Results

<b>By Robert P. Hartwig, Ph.D.
Vice President & Chief Economist
Insurance Information Institute</b>
bobh@iii.org

The property/casualty insurance industry reported a statutory rate of return of 7.0 percent (on an annualized basis) during the first quarter of 2000, down from 10.7 percent in same quarter of 1999 but up from 6.6 percent for all of 1999. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

Is the Worst Now Behind Us?

The first quarter 2000 financial results, while far from ideal, provide further evidence supporting the view that the financial performance of the property/ casualty insurance industry may now be passing through a trough with a rebound on the horizon.

Wall Street has already signaled this belief by sharply bidding up the stock price of most property/casualty insurers beginning late in the quarter. Positive developments in the first quarter results included:

<li>the 3.2 percent increase in net written premium (compared to full-year 1999 growth of 1.9 percent)

<li>the 3.0 percent increase in net investment income (compared to a 3.3 percent drop in investment income in calendar year 1999)

<li>the 0.2 percent decrease in surplus from end-1999

Premium Growth

The 3.2 percent increase in net written premium is the result of both strong economic growth and greater pricing discipline on the part of insurers. More risk appropriate pricing in catastrophe prone areas is also a factor.

<b>Pricing</b>

Pricing is critically important to the industry's turnaround. Conning & Company reports that spring 2000 renewals for the commercial segment were up across the board for the first time in years. Workers' compensation, the largest of the commercial lines, led the way with the typical renewal policy seeing a 4.1 percent increase compared to a decrease of 6.6 percent a year ago. The commercial multiperil and general liability lines followed suit with each posting increases of 3.2 percent (compared to decreases of 5.0 percent and 4.4 percent, respectively, a year ago). Commercial auto, commercial property, umbrella and excess and surplus lines also experienced significant improvements.

On the personal lines side, the price war in the personal auto line shows some signs of abating. The Insurance Information Institute estimates that personal auto rates fell 2.8 percent in 1998 and 3.2 percent in 1999 due, in part, to improving fundamentals but also to intense competition between insurers. The price cutting led to huge underwriting losses at many companies with personal lines operations and were a significant factor in the $3.2 billion (108 percent) increase in the first quarter's net underwriting losses. These losses have compelled many insurers to hold the line on further decreases in many states and are compelling them to raise rates in others.

<b>Economic Activity and Exposure Growth</b>

The impact of the economy on the industry's fortunes cannot be underestimated. As noted in the ISO/NAII release, the nation's gross domestic product surged 6.9 percent during the first quarter 2000, compared with the same period last year. In fact, despite rising interest rates, the current economic environment is nearly ideal for insurers. Exposure growth is strong in virtually every commercial lines segment. In the workers' compensation line, for example, aggregate wages and salaries increased by $432 billion last year, reflecting both higher wages and the addition of two million net new workers.

While the auto insurance market remains competitive, auto insurers are also benefiting from the strong economy. Auto manufacturers sold a record 18.3 million new vehicles last year, nearly half of which were relatively expensive light trucks and SUVs, also a record.

The nation's housing boom is also working to the benefit of personal lines carriers. Homeowners continue to build new homes at a record pace, with 927,000 constructed in 1999. New home construction could bring insurers $200 billion in new exposure to this year alone. Improvements to existing homes should add billions more.

Investment Income

The 3.0 percent increase in investment income may at first appear to be unimportant, yet is actually one of the first quarter's significant developments. Rising investment income during the first quarter indicates that the property/casualty insurers are on track to end a two-year slide in earnings on investments, which fell by 3.3 percent last year and 3.9 percent in 1998.

The Federal Reserve's shift toward an anti-inflationary bias in 1999 led to several rate hikes during the second half of 1999 and the first half of 2000. The 3-month Treasury bill at the end of the first quarter was 55 basis points (0.55 percentage points) higher than on December 31.

While the Fed's rate actions have successfully lifted short-term interest rates, longer term rates have in some cases actually declined. Treasury securities with 10 years to maturity were yielding 6.41 percent on December 31, but just 6.03 percent on March 31 and 6.26 percent on June 2.

In fact, the Treasury yield curve is now inverted, meaning that yields on securities maturing in the next few years are actually higher than those maturing in the more distant future. Under normal circumstances, the longer the time to maturity, the higher the yield. As of June 2, the maximum yield along the Treasury yield curve was 6.64 percent-for securities with just two years to maturity! This compares to a yield of only 5.84 percent for the 30-year bond.

The inversion in the yield curve has affected both the industry's optimal investment strategy and the riskiness of the industry's bond portfolio. First, insurers are able to take maximum advantage of higher interest rates by investing in relatively short-term securities. Second, these short-term investments are subject to far less interest rate risk than if insurers had had to invest in long-term securities to lock in high yields. Interest rate risk refers to the fact that changes in interest rates have a relatively large impact on the price of securities with many years to maturity but only a modest impact on shorter-term maturities. Because bond prices and interest rates move in opposite directions, lower interest rate risk means less destruction of capital gains when interest rates rise.

Underwriting Performance

<b>Underwriting Losses</b>

Underwriting losses during the first quarter of 2000 were sharply higher, despite the development of favorable pricing trends and catastrophe losses that were slightly lower than during the same quarter last year. The current high level of underwriting losses is a reflection of the intensely competitive pricing environment over the past few years and the accumulation of losses on underpriced business. The full impact of higher prices for many property/casualty insurance products, which are only now being implemented, will not be felt for several quarters as rate increases take hold. Existing books of business, of course, can be repriced only as policies come up for renewal. There is also a lag between when premium is written and when it is earned.

<b>Combined Ratio</b>

The industry's combined ratio of 107.4 during the first quarter of 2000 is consistent with expectations. The Insurance Information Institute's annual "Groundhog" survey of industry analysts, released in February, produced a consensus estimate of 107.7 in 2000.

The View from Wall Street: Back from the Brink

Wall Street was unkind to the property/casualty insurance industry in 1999. On a market cap weighted-basis, industry stocks lost 25.7 percent of their value, compared to a gain of 21.0 percent for the Standard & Poor's 500 index. Life insurers as a group declined 9.6 percent.

Of course all eyes in 1999 and early 2000 were on the technology-laden Nasdaq. "Old Economy" industries such as insurers, manufacturers and retailers lagged far behind the returns in so-called "New Economy" industries related to the Internet, telecommunications and biotechnology. The Nasdaq began to plummet, however, after reaching its peak of 5048.62 on March 10. During the remainder of that month and through much of the spring, insurer stocks staged a strong comeback. Prior to the comeback, the prices of many insurer stocks were at their lowest levels in years.

By early June, the property/casualty group on a year-to-date basis had recorded a total return of 8.9 percent compared to a decline in the Nasdaq of 4.8 percent. The divergence is far more dramatic when measured from the Nasdaq peak on March 10. Since the bursting of the tech bubble, the Nasdaq has declined by 23.3 percent (though June 9) compared to a gain of 35.2 percent for the property/casualty group, a performance gap of nearly 60 points. The results for life/health insurers are nearly identical since the tech collapse.

The surge in interest in insurance stocks was driven by several factors, including disappointing earnings (or total lack thereof) among the dot-coms, extraordinarily low valuations for insurance stocks and the prospect of investing at a point that could mark a turn in the insurance cycle leading to improved profitability.

Surplus & Capacity

Of lesser concern is the $0.8 billion decline in surplus since year-end 1999. The decline represents just 0.2 percent of industry surplus and does not represent a threat to insurer solvency. Moreover, analysts have estimated the industry's "excess" capital at $100 billion to $125 billion. If insurers are able to grow net income while at the same time reducing surplus, returns on equity will rebound quickly. Some insurers are also working to reduce excess capacity through stock buybacks and large dividend payouts, both of which reduce capacity by reducing surplus.

A detailed industry income statement for the first quarter of 2000 follows:

<i>© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED</i>