2002 - First Half Results

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

September 25, 2002

The property/casualty insurance industry reported a statutory rate of return of 3.3 percent during the first half of 2002, up from 1.9 percent during the first half of 2001. The result is also a significant improvement over the worst-ever negative 2.7 percent recorded for all of 2001. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

2002: The Good, the Bad and the Ugly

The good news is that the U.S. property/casualty insurance industry earned $4.6 billion in net income after taxes during the first half of 2002. That’s also the bad news. Although $4.6 billion is a lot better (66.4 percent better, to be precise) than the $2.8 billion earned during the same period last year—it is, amazingly, $700 million less than the $5.3 billion earned during the first quarter of this year. In other words, insurers earned more during the first three months of this year than they did during the entire first half. Accomplishment of this remarkable feat was made possible in part by Uncle Sam, who swallowed $562 million of the industry’s $824 million in pre-tax operating income for the second quarter, as well as by the market swoon sparked by numerous revelations of corporate malfeasance, forcing insurers to realize $909 million in capital losses during the period, producing an overall loss in net income of $647 million in the second quarter. As for the ugly news, the industry’s 3.3statutory rate of return through the first half of this year is barely one-fourth of the industry’s 12 percent cost of capital—the rate of return the industry needs to achieve if its expects to be able to retain and attract capital over the long-run.

And so it is in the property/casualty insurance industry, where no good financial deed ever seems to go unpunished. The truly positive news that net written premium growth accelerated to 12 percent during first half compared to 9.9 percent a year ago is tempered by the fact the investment gains (which consist of investment income and realized investment gains/losses) fell by 28.3 percent. Similarly, excitement over the drop in the combined ratio to 105.0 during through the first half of this year from 111.1 last year is accompanied by concern over the $6.7 billion drop in capacity (surplus) since yearend 2001 to $282.9 billion.

But looks can be deceiving and the industry’s first-half ugliness may run only skin deep. In the final analysis, the industry’s performance through the first six months of 2002 clearly and convincingly indicates that insurers are accomplishing exactly what they set out to do two years ago: put their underwriting houses in order and restore rationality to pricing.  

2002: The March to Profitability Continues

The journey to profitability in the property/casualty insurance industry is made on a long, and bumpy road—and there are no alternative routes or shortcuts. Insurers have been forced to make many very difficult underwriting decisions through the first half of 2002 not only to reduce their exposure to 21st century risks such as terrorism, but also to fix the myriad of woes afflicting their bread and butter personal lines operations, which continue to hemorrhage red ink in many states. Lines as diverse as commercial property, workers compensation, medical malpractice, excess liability, and homeowners insurance have experienced significant withdrawals of capacity in many markets, forcing prices upward and some customers to seek coverage in markets of last resort.  

Closing the Gap: Cost of Capital and Rate of Return

The current hard market for property/casualty insurance has been underway for two years and underwriting performance is clearly improving. But corporate risk managers are growing increasingly impatient with price hikes and consumer advocates accuse the industry of gouging policyholders. Insurance has become a political issue in a number of states in advance of November elections. These observations beg the question--how much longer can the current hard market last?

A good long while is the answer. The duration of a hard market cannot be gauged by how long it has been underway or by the decibel level of carping emanating from the industry’s critics or politicians. Instead, it is reasonable to assume that the hard market will ease once insurers achieve rates of return that are commensurate with their cost of capital—the rate of return the industry needs to achieve if its expects to be able to retain and attract capital over the long-run. Using this measure, the current hard market has a long way to go.

In 2001, the industry’s cost of capital was approximately 12 percent, while p/c insurers as a group earned a rate of return of negative 2.7 percent—a gap of nearly 15 points. While some of 2001’s poor performance was due to the catastrophic losses the industry suffered in the September 11 terrorist attack, the gap would still have been in the neighborhood of 10 percent even if the attack had not occurred. The extraordinary size of this gap—even after removing the impact of September 11—indicates that the root causes of the industry’s profit drought lie not in its exposure to terrorism risk, but throughout the dozens of other coverages offered on the nation’s six million businesses, 90 million homeowners and 150-plus million drivers. In fact, despite the significant improvement in underwriting performance evident in the first half results, the gap between the industry’s rate of return and its cost of capital in 2002 remains an unacceptably-high 8 to 9 points. This gap will not be closed in the second half of 2002, nor is it likely to be closed by the end of 2003, especially if markets continue to swoon.   

Challenges Ahead: Profits, Investments, Geopolitical Instability and Politics

Closing the gap between the industry’s cost of capital and its rate of return is of paramount importance to insurers, investors in the industry, its creditors and ratings agencies. Since 1991, the industry’s rate of return has fallen short of the mark by 6.7 points on average, again underscoring the difficulties that lie ahead.

Stocks sank and bond yields sagged during the second quarter and again in the third quarter of 2002, underscoring the point that virtually all the heavy lifting needed to improve insurer profitability must come from underwriting and pricing. Each basis point shaved off bond yields—which leads to lower investment income on new bonds added to the portfolio—puts additional pressure on underwriting and pricing. For example, Merrill Lynch estimates that the decline in bond yields during the third quarter of this year will depress earnings (of public-traded companies) by 2.2 percent in 2003, forcing insurers to improve their combined ratio by 0.37 points relative to previous expectations to achieve the same financial results. Yields could drop still further if the Federal Reserve lowers rates during the fourth quarter, something it might feel compelled to do in the event the economy weakens further or the United States goes to war with Iraq.

The possibility of war with Iraq is symptomatic of the wider problem of mounting geopolitical instability throughout the world. Such instability depresses financial markets and economic activity on a global scale, reducing investment returns and exposure growth, as new projects are cancelled or deferred.

Perhaps inevitably, the repercussions from the current hard market have spilled into the political arena. Insurers’ very public quest for a federal backstop against terrorism remains stalled in Congress, despite abundant evidence that the lack of terrorism coverage is beginning to have a significant impact on economic activity. At the state level, candidates for various offices have seized upon the pricing and underwriting practices of insurers as a way to curry favor with voters. Insurance fell from the political radar screen during the second half of the 1990s as the price of commercial insurance tumbled and the cost of auto and homeowners insurance remained stable. It is only logical to assume that insurance will come more of a political football in the months and years ahead as prices rise, underwriting continues to tighten and state residual market pools rapidly.   

Insurer Stock Price Performance

Through September 20, property/casualty insurance stocks were down 7.7 percent. While off for the year, the performance nevertheless compares favorably to S&P 500, which was down 25.6 percent over the same period. It is clear that investors are expecting the hard market to deliver healthy profits in the years ahead.

A detailed industry income statement for the first half of 2002 follows: