2003 - Year End Results

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

The property/casualty insurance industry reported a statutory rate of return of 9.4 percent in 2003, up from a disappointing 1.1 percent in 2002 and the worst-ever negative 2.3 percent recorded in 2001.  The results were released by the Insurance Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI).

2003:  A Parting of the Sea of Red Ink

The sun shone brightly on the property/casualty insurance industry in 2003.  Profitability approached reasonable levels for the first time in years as higher premium revenues, improved underwriting and a turnaround in the equities markets had their predicted effect on the industry’s bottom line.  Last year’s 9.8 percent increase in net written premiums, 85 percent reduction in underwriting losses, and $8.1 billion positive swing in realized capital gains propelled the industry to a 9.4 return on average surplus, its best performance since 1997.  The fact that policyholder surplus, the industry’s primary measure of capacity, reached a record high $347 billion at year-end 2003—up $61.6 billion or 21.6 percent from $285.4 in 2002 is also of note as this figure will become the number of record in the upcoming debate over reauthorization of the Terrorism Risk Insurance Act (TRIA) currently scheduled to expire at the end of 2005. 

While celebrating the industry’s return to a reasonable level of profitability in 2003 is tempting, it is generally ill-advised and inappropriate for two reasons.  First, the results—while much improved—do not meet most generally-accepted benchmarks for profitability, falling well-short of the Fortune 500’s return of 12.6 percent last year.  Second, the 2003 results in general are likely to be misinterpreted, misconstrued and misused by the industry’s critics and some regulators to make a wide array of spurious, actuarially unsupported and in some cases politically motivated arguments detrimental to insurers and ultimately policyholders.  In particular, some will seize upon the figures to suggest that insurers are making “excessive” profits, that rising profitability is a sign that rates are too high, that rate rollbacks should be considered, that tort reform is unnecessary and, as mentioned previously, that the Terrorism Risk Insurance Act should not be reauthorized.  All of these arguments are bogus and putting the industry’s profit and capacity figures in perspective is the key to better understanding the true financial state of the insurance industry and to refuting arguments likely to damage the industry’s still-fragile recovery.

Profitability: Much Improved, But P/C Insurance Still Comes Up Short

Last year’s 9.4 percent return on average surplus was viewed within the insurance industry as nothing short of phenomenal.  As mentioned earlier, the 2003 result is more than 8 points better than the 1.1 percent ROE figure in 2002 and nearly 12 percentage points better than 2001’s worst-ever negative 2.3 percent ROE.  That 2003 appeared phenomenal to many industry observers is hardly surprising, given the industry hemorrhaged $137 billion in underwriting losses in the prior three years (2000 through 2002).  However, the industry’s long-awaited return to profitability last year seemed to underwhelm the investor community and ratings agencies, as p/c stocks lagged behind the major market indices and downgrades continued to outpace upgrades by a wide margin.  This was a clarion call to all insurers:  your work is not done—more improvement is necessary.

Improving—not just maintaining—profitability necessarily remains job number one with the vast majority of p/c insurance CEOs.  While quite a few insurers managed to hit profit targets in 2003, the industry overall continues to underperform, extending a trend that has now spanned the better part of two decades.  For an amazing 17 consecutive years, in fact, p/c insurance industry profitability has trailed the Fortune 500.  The 12.6 percent ROE chalked up by America’s largest corporations in 2003 leaves p/c insurers to ponder a 3.2 point profit deficit in a year in which strong premium growth and tough underwriting should have propelled the industry to a standout performance.  Insurers are almost certain to underperform the Fortune 500 once again in 2004.

Regulators and others need to recognize that last year’s 9.4 percent ROE comes on the heels of several of the worst years in the industry’s history.  Many of the factors that gave rise to the insurance industry dark ages—the years from 1999-2002—are still in place and threaten the economic well-being of insurers on a daily basis. These include:

• the potential for enormous terrorism-related losses
• mega-scale natural disasters
• rapidly escalating tort costs (exacerbated by the failure of class action, asbestos and medical malpractice reform)
• high medical cost trends
• potential for additional adverse reserve development
• newly emerging/unforeseen risks
• possible drop in equities market prices
• continuation of  near record low interest rates

Underwriting Discipline: The Mantra of the New Millennium

Last year’s combined ratio of 100.1, down sharply from 107.3 in 2002, was much better than expected.  Indeed, the 2003 result was the best since the 100.6 combined ratio recorded way back in 1979.  Even seasoned industry observers were surprised.  An Insurance Information Institute poll of industry analysts in late January 2003 produced an average estimate for the 2003 combined ratio of 103.2 while the consensus estimate from the same poll conducted one year later was 101.4.(1)   The magnitude of the improvement clearly caught many industry analysts off guard—11 of the 12 analysts responding to the survey provided estimates above the 100.1 figure (one hit it right on the mark).  That being said, analysts will be forgiven for maintaining a pessimistic bias.  As recently as 2001 the combined ratio was 115.7.  In terms of dollars, insurers managed to shrink their underwriting losses from $30.8 billion in 2002 to $4.6 billion last year—a decline of 85 percent.  The Insurance Information Institute’s most recent poll (referenced above) projects a 2004 combined ratio of 100.0, implying an underwriting loss of zero.

It’s also important to keep in mind that combined ratio in the neighborhood of 100 isn’t what it used to be.  The industry’s 100.6 combined ratio in 1979 resulted in a 15.5 percent ROE for the industry, in large part because of much higher interest rates at that time. According to ISO/PCI, insurers would have needed a combined ratio of 94.3 to produce a 15 percent rate of return last year, given prevailing market and tax conditions. The average yield on the 10-year Treasury notes in 1979 was 9.43 percent, compared to just 4.01 percent in 2003. 

Pricing, of course, is a critical factor in last year’s improved performance.  Insurers have successfully managed to push insurance prices sharply upward over the past four years, forging a stronger link between price and risk.  But as pricing power continues to wane in the aging hard market and the investment environment remains volatile, sustained profitability depends increasingly on maintaining underwriting discipline. At investor conferences, CEOs are routinely grilled by analysts over their commitment to underwriting discipline.  The upshot is that no CEO today could credibly argue for any substantial broadening of terms and conditions—without a corresponding substantial premium charge—and not expect a swift, negative reaction from investors and ratings agencies. The lesson learned from the 1990s is that in the long run it is smart underwriting that separates truly successful companies from the pack.  Elite underwriters benefit not only from higher ROEs but also a high degree of financial flexibility that allows them to seize new opportunities through expansion, acquisition and new product innovation.  These insurers can also more easily meet their obligations when the unexpected happens—such as when major disasters strike or reserves develop adversely—and thereby remain in the good graces of Wall Street and ratings agencies.

Investment Performance: Encore of 2003 Unlikely

Last year’s 26.4 percent gain in the S&P 500 was a welcome change from the double-digit declines posted over the three prior years.  The increase allowed insurers to realize $6.9 billion in capital gains in 2003 compared to a realized capital loss of $1.2 billion in 2002.

The extreme volatility on Wall Street over the past several years and the continued low interest rate environment (the 10-year Treasury note reached a 45-year low in 2003) underscore the fact that all the heavy lifting in terms of further improving performance in the p/c insurance industry will fall to strategies that emphasize disciplined underwriting and pricing.  Through the first quarter of 2003, the S&P 500 was up just 1.3 percent while the average yield on 10-year Treasury securities was 4.02 percent, essentially unchanged from the 4.01 average for all of 2003.

Why There’s No “Surplus” in Policyholder Surplus

Policyholder surplus reached a record high $347 billion at year-end 2003—up $61.6 billion or 21.6 percent from $285.4 in 2002 and surpassing its previous high of $339.3 billion achieved in the second quarter of 1999.   Replenishment of the industry’s capital base has been a priority for insurers in the wake of enormous losses over the last several years, including record losses stemming from the September 11 terrorist attack.

Unfortunately, the role of policyholder surplus (PHS) is generally not well understood by people unfamiliar with the insurance industry, including many policymakers and legislators.  PHS is insurance nomenclature for what is referred to as “net worth” or “owners’ equity” in other industries.  It is a measure of underwriting capacity because PHS is a measure of the financial resources (capital) that stand behind every policy underwritten by an insurer.   A weakened surplus position can lead to downgrades and, if the drop is steep enough, regulatory actions or insolvency.

While the policyholder surplus figure for year-end 2003 increased substantially, it stands just 2.3 percent higher than in mid-1999.  Over the same period, the US economy expanded by 23 percent and the demand for insurance along with it.  The industry’s capital base is therefore stretched more thinly than it was in the late 1990s.  In addition, a wide variety of new risks have emerged, all relying on this same, limited pool of capital; these include: terrorism, toxic mold, the medical malpractice crisis and the crisis in corporate governance—none of which were major issues in 1999.  The combination of economic growth and greater demand for insurance along with new and emerging risks illustrates the fact that the industry’s policyholder surplus is fully committed.  Increasing the size of that pool is necessary in order to finance the insurance needs of a growing US economy as well as claims arising from a virtually unlimited array of new and existing risks.

In 2004, the finances of the property/casualty insurance industry will come under close scrutiny from state regulators, insurance departments, the federal government as well as the industry’s perennial critics.  Some will inappropriately cite rising capacity and profitability to call for rate roll backs while others will try to derail tort reform efforts, citing favorable loss trends.  Of course, foes of reauthorization of the Terrorism Risk Insurance Act, or even individuals and government agencies trying to make an honest assessment of industry resources, may misinterpret last year’s 21.6 percent increase in policyholder surplus and wrongly assume that the gain means that insurers are financially able and willing to underwrite full-limit terrorism coverage.

It means no such thing.  As discussed earlier, the industry’s policyholder surplus is, in effect, already committed to the risks being underwritten today.  Moreover, because potential losses from a terrorist attack or sequence of attacks are potentially unlimited, no amount of policyholder surplus is sufficient to cover the full range of attack scenarios.  Even the federal government, with theoretically unlimited resources, caps its own liability under TRIA at $100 billion.  Insurers, with far more limited resources than Washington, and no ability to meaningfully reinsure terrorism risk will, in many cases, be forced to walk away from the policyholders in the event TRIA is not reauthorized.

Summary

In 2003 the property/casualty insurance industry had its best year since 1997.  But the fact that the industry’s average return on surplus was just 9.4 percent despite a combined ratio of just 100.1 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 and volatile investment environment, a variety of regulatory concerns, efforts to thwart tort reform, reserve overhangs and the TRIA reauthorization debate are just a few of many areas of concern that will be interesting to watch as 2004 unfolds.
 
A detailed industry income statement for the quarter follows:

(1) Insurance Information Institute Groundhog Forecast, February 2004: /media/industry/financials/forecast2004/.