2003 - First Quarter Results

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

June 23, 2003

The property/casualty insurance industry reported a statutory rate of return of 8.8 percent in the first quarter of 2003, up from a disappointing 1.0 percent in 2002 and the worst-ever negative 2.4 percent recorded in 2001.  The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

2003: The Opening Act

The first quarter of 2003 got property/casualty insurers off to their best start in years, setting the stage for what could become the industry’s first reasonably profitable performance since 1997. Fully three years into the first hard market since 1987, property/casualty insurers find themselves well overdue and in desperate need of some good financial news—and there was plenty of it to be found in the most recent quarter’s results.  Most notably, net income was up 20.6 percent to $6.4 billion from $5.3 billion during the first quarter of 2002.  But the industry’s long profit drought has left the industry battered and bruised and in need of a sustained period of solid earnings to slake its thirst and heal its wounds.  One quarter does not a trend make, and many factors threaten to cut short the profit party short.

In the remainder of this commentary, we provide a detailed discussion of what the most recent quarter’s results mean for the industry in the context of major challenges insurers face today—many of which don’t appear on financial statements.

P/C Insurance: A $400 Billion Business?

Net written premiums during the first quarter totaled $101.3 billion, up a healthy 12.7 percent from the same quarter last year—putting the industry on track to exceed $400 billion in net premiums written for the first time in its history.  While net premium growth during the quarter was undeniably strong, the modest deceleration from 2002’s 14.1 percent rate of growth must be noted.  Nevertheless, even with sequential deceleration in premium growth through the remainder of this year, 2003 will still likely rank as the second-best year in terms of premium growth since 1987.

Losses: A Lost Cause?

Incurred losses and loss adjustment expenses (LAE) rose 10.7 percent during the quarter, to $70.0 billion.  Although the increase in loss and LAE was manageable given that it was more than offset by earned premium growth of 13.6 percent, the magnitude of the increase is disconcerting.  In the current slow growth, low inflation economy, with relatively little net new exposure growth, changes in underlying losses and LAE should be modest.  But the 10.7 percent increase noted in the first quarter was far above either the 3.8 percent increase in nominal (i.e., unadjusted for inflation) GDP during the quarter or the average 2.9 percent rate of inflation during the first three months of the year.  This strongly suggests that there are still underlying problems with claim frequency and severity in many lines of insurance that need to be addressed.  If premium growth rates taper of, as is widely expected, the industry’s underwriting performance will once again deteriorate.

Underwriting Performance:  A 100 Combined Ratio Isn’t What it Used to Be

If you’re an underwriter there was a time not too long ago when hitting a combined ratio of 100 would have earned you a big bonus—today it could get you fired. Why?  Five or six years ago a combined ratio of 100, given the industry’s robust investment returns, would have produced an ROE north of 15 percent. In today’s weak investment environment, you’d be lucky to realize half that.  A combined ratio of 100 still produces big “losses” from the point of view of disappointed investors who could have earned more elsewhere, perhaps with less risk.   After all, if every penny of premium income is paid out for losses and expenses, there’s not a nickel left for anything else—like profits or funds needed to expand the business or offset adverse reserve development.  In the most recent quarter, the combined ratio of 99.5 means that insurers paid out $99.50 for every $100 they earned. That extra 50 cents won’t buy much, but it may eventually buy some respect if results continue to improve, especially considering the fact that as recently as 2001 the industry was paying out nearly $116 for $100 it took in.

What are the odds of holding on to that rarest of all insurance beasts—the underwriting profit—for the full year? Not too good if history is any guide.  The industry’s last underwriting profit was a quarter of a century ago, back in 1978.  The problem is that just too many things can go wrong in the course of 12 months.  The second quarter, for example, suffered setbacks in the form of devastating spring storms, one of which turned out to be the fourth most expensive tornado/wind/hail event in history and at least one large reserve charge by a major company. Presently, we’re just into the opening weeks of what is expected to be a very active hurricane season that won’t reach its peak until late in the third quarter.  Did I mention the West is a tinderbox and that this year’s wildfire season is already off to an auspicious beginning? Nevertheless, continued strong premium growth, “normal” catastrophe activity for the remainder of the year and a reduction in the number of massive year-end reserve charges could maybe, just maybe, be enough to push the industry’s underwriting result into the black for the first time in 25 years.

Investment Income: How Low Can it Go?

How low can investment income go?  Not much lower, fortunately.  With short-term interest rates hovering around 1 percent and the Federal Reserve widely expected to cut its overnight lending rate for banks (the federal funds rate) to just 1 percent or less when it meets this week, there’s clearly little room for interest rates—which presently stand at 45-year lows—to fall any further.  In fact, after falling four out of the past five years, investment income was down just 0.3 percent during the first quarter, perhaps signaling that a trough is at hand.

Investment income could rise in future quarters for a variety of reasons:

• Cash flow is improving.  Even with no help from higher interest rates, the increase in investable funds should begin to turn the tide in favor of greater  (though still not great) gains.  Investment income also includes dividends paid on common stock.  The S&P 500 dividend yield today is about 1.9 percent compared to 1.5 percent not long ago.  Improved corporate earnings and the reduction in the tax on corporate dividends, which makes dividend paying stocks more attractive, could help keep yields high and will allow insurers to keep more of their earnings on an after-tax basis.
• President Bush’s tax cut earlier this year will force the federal budget into deficit for the foreseeable future, leading to the largest deficits in the nation’s history and record borrowing by the federal government.  The Congressional Budget Office is currently projecting a record $246 billion deficit for fiscal year 2003.  Most economist view that figure as wildly optimistic, with many predicting deficits in excess of $300 billion and approaching $400 billion if the economy fails to recover robustly.  State governments, looking to close yawning budget gaps, are also borrowing heavily.  Contrary to recent political rhetoric on this issue, deficits do matter.  Large deficits, all else equal, increase the demand for borrowed funds thereby forcing the price of those funds (interest rates) higher.
• Economic recovery in the second half of 2003 or in early 2004 will increase the demand for debt, pushing interest rates upward.  Real GDP growth is estimated at 2.1 percent for the first half of this year, 2.5 percent during the second half and 3.6 percent in 2004 (Blue Chip Economic Indicators, June 2003).
• The stock market recovery that began in March will likely drain away assets from the bond markets as investors seek higher yields in equities, pushing bond prices down and yields up.

What About Wall Street?

Major U.S. stock markets were down in 2000, 2001 and 2002 and continued to fall until the middle of March 2003.  The current rally on Wall Street was barely underway by the time the third quarter ended and the S&P 500 index was still down by 3.6 for the year at that point.  As noted in the ISO release, the second quarter has been a banner one for stocks, with the S&P 500 up 13.2 percent through Friday, June 20 (although p/c insurer stocks were up just 9.9 percent over the same period). While the recent rally is a welcome respite from the markets’ dreadful performance over the past three years, it is unlikely to have a significant impact on insurer earnings anytime soon.  First, it is unclear if the current bull market has staying power—the economy remains fundamentally weak.  Second, only about 21 percent of the industry invested assets are in stocks while 66 percent are invested in bonds.  The minority interest in stocks helped insurers weather the fury of the recent bear markets, but also limits their ability to capitalize on the current run-up in share prices.  Nevertheless, the increase in stock prices is welcome news to the industry and will provide insurers with more opportunities to realize investment gains on portfolios.

Surplus and Capacity

Surplus expanded by 1.4 percent or $3.9 billion during the quarter to $289.2 billion.  Unless the bottom falls out the stock markets during the second half of this year or the industry is rocked by well-above losses or reserve charges clobber balance sheets more than usual, surplus for the year will likely expand for the first time since 1999.  While increases in surplus are almost universally heralded as good news, there is a downside risk.  Specifically, if capacity expands in what is an otherwise moribund economy, then capacity will expand faster than exposure growth.  New exposures (like terrorism) can absorb some of the increased capacity, but most will seek a home with traditional property and casualty-type risks.  In other words, there will be too much money chasing too little exposure.  For example, 2.5 million fewer people are employed today than 2 ½ years ago, pushing the unemployment rate in May up to 6.1 percent—the highest it’s been in nearly 9 years.  Workers compensation exposure growth is suffering as a result.  Commercial property exposure is likewise hurt by the continuing malaise in capital investment by businesses, which continued its slide into the first quarter of 2003.

Summary

The first quarter of 2003 represents the first truly good quarter the property/casualty insurance has seen since the current hard market began 12 quarters ago.  The fact that the industry statutory return on surplus was just 8.8 percent despite a combined ratio of just 99.5 is a stark reminder that additional improvements in underwriting are needed if the industry hopes to generate Fortune 500 rates of return in the 12 to 15 percent range anytime soon.  A weak investment environment, sluggish exposure growth in the midst of increasing capacity and reserve overhangs are just a few of many areas of concern that will be interesting to watch as the remainder of 2003 unfolds.

A detailed industry income statement for the quarter follows: