2004 - First Half Results

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

October 18, 2004

The property/casualty insurance industry reported a statutory rate of return on average surplus of 13.1 percent for the first half of 2004, up from 9.7 percent for the first half of 2003 and 9.4 for calendar year 2003, 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).

2004:  Two Halves Won’t Make a Whole

Opposites attract—apparently even in the insurance industry.  Financial results through the first half of 2004 couldn’t have been better—among the best in a half century.  On the other hand, Florida’s quartet of calamities—Hurricanes Charley, Frances, Ivan and Jeanne—assure that the second half of the year will be one of the worst ever.  The four storms left insurers with a tab estimated at somewhere between $22 and $27 billion—effectively wiping out the first half’s net income (after tax profit) of $23.5 billion. 

Taken together, the two halves of 2004 will leave property/casualty insurers feeling something less than whole. After years of disciplined underwriting and pricing, the industry was poised to see its profitability (as measured by return on equity) exceed that of the Fortune 500 for the first time since 1987, at the end of the last hard market.  The first half combined ratio of 94.4, put insurers on a trajectory toward the best underwriting performance since the early 1950s and the year’s underwriting profit seemed destined to reach an all time record of approximately $18 billion (annualizing the 6-month result of $9.0 billion).  The four hurricanes may have dashed any hopes for an underwriting profit in 2004. So rare are underwriting profits in the property/casualty insurance industry that the last one recorded on an industry wide basis occurred more than a quarter century ago, back in 1978, though it amounted to just $1.3 billion ($3.8 billion in current dollars).  It’s important to note, however, that most casualty insurers, property insurers without significant exposure to Florida and monoline auto insurers will still experience excellent results in 2004.

The second half was also impacted by an investigation launched by New York Attorney General Eliot Spitzer.  While it is too soon to tell what financial impact these revelations will have on the industry as a whole, the immediate impact was to cause tens of billions of dollars in lost market capitalization as insurer and broker stocks were dumped by investors immediately following the Spitzer announcement.(1)

Underwriting Discipline: A Multi-Year Effort Finally Bears Fruit

The first half combined ratio of 94.4 proves just how serious insurers had become about improving underwriting and implementing risk-appropriate pricing, but likely marks the zenith in underwriting performance for the current cycle.  Since 2001, insurers have managed to lop more than 21 points off the industry’s combined ratio.  In that year, the industry’s combined ratio peaked at 115.7 and the underwriting loss soared to a record $52 billion, as the 9/11 terrorist attack and $11 billion in adverse reserve development took their toll.

The first half result is far better than what was expected by industry observers earlier this year.  An Insurance Information Institute poll of industry analysts in late January 2004 produced an average estimate for 2004’s combined ratio of 100.0.(2)  Even the most optimistic among the survey respondents forecast a combined ratio of just 97.5.  In the end, the analysts’ prediction of a 100 combined ratio for the year may turn out to be dead-on, but not for the reasons they expected.

It’s important to keep in mind that a combined ratio under 95 should no longer be viewed as a fluke—never to return for another half century. In today’s low interest rate and volatile investment environment, a combined ratio of 93 to 95 is what it takes to generate Fortune 500 rates of return.  The old rule of thumb—that a combined ratio of 100 produces an adequate rate of return—is a property/casualty insurance industry urban legend that just won’t seem to go away.  Last year’s 100.1 combined ratio produced a statutory return on average surplus of just 9.4 percent, compared to a 12.6 percent ROE among the Fortune 500 group.  According to ISO/PCI, insurers would have needed a combined ratio of 94.3 to produce a 15 percent rate in 2003, given prevailing market and tax conditions.   As mentioned earlier, the 94.4 combined ratio through the first half of 2004 equates to an average return on surplus of 13.1 percent.  As we move closer to 2005, maintaining underwriting will remain, by far, the insurance industry’s greatest challenge.

Premiums and Pricing: How Low Will They Go?

Pricing, of course, has been a critical factor in the industry’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. While underwriting discipline remains largely intact, at least for now, current pricing trends are increasingly ominous.

The fact of the matter is that pricing seems to be weakening more rapidly than anyone anticipated.  Net written premium growth came in at just 4.6 percent during the first six months of 2004, well under the 11 percent recorded during the same period last year and less than half the 9.8 percent figure for all of 2003.

The same Insurance Information Institute poll that revealed industry analysts to be too pessimistic in terms of underwriting performance, also revealed excessive optimism when it comes to premium growth expectations.  The average forecast among survey respondents for net written premium growth in 2004 was 7.4 percent, nearly three full points ahead of the first half result; a comparison that is likely to become increasingly ugly as growth continues to decelerate throughout the year.

One explanation for the faster-than-expected decline in top line growth is the faster-than-expected improvement in financial performance.  With insurers hitting price, profit and underwriting targets more quickly than they expected, the market has turned price-competitive sooner than would otherwise be the case.  Justified or not, the combination of rising inflation and slower premium growth could plunge the industry into a negative real growth situation by late this year or early 2005 for the first time since 1999.  Through the first half, real premium growth was approximately 2 percent.

As noted by ISO/PCI, a negative spread between written premium growth and economic (GDP) growth has re-emerged.  During the first half of this year, premium growth fell 2.3 percentage points below the 6.9 increase in GDP while during the first half of 2003 premium growth outpaced growth in GDP by 6.9 percent.

Investment Performance: Fed Rate Hikes Help but Stocks Remain Paralyzed

Investment income rose 4.1 percent to $19 billion during the first half of 2004 compared to $18.3 billion for the same period in 2003.  Realized capital gains also rose during the period, up 11.1 percent to $5 billion from $4.5 through the first six months of last year. 

Gains in insurer investment performance during the first half were driven by a combination of higher interest rates, small gains in the stock market, the realization of accumulated capital gains from prior periods and by an increase in invested assets  boosted by improved cash flow.

Fed Tightens, Rates Rise—Then Fall

Interest rates rose through the first half of 2004 as stronger economic growth, modestly higher inflation and the first in a series of Fed rate hikes was pushed through (the Fed increased rates again in August and September, increasing the Federal Funds rate by a total of 3/4 of a point by the end of the third quarter).  In June 2004, the 10-year U.S. Treasury note yielded 4.72 percent, up 159 basis points (1.59 percentage points) from 3.13 percent recorded in mid-June 2003—a 45-year low.  Yields have become less attractive since then, falling back to 4.13 percent in September 2004, primarily due to weaker-than-expected economic news.

Some insurers appear to be shortening the duration of their bond portfolios (which account for two-thirds of all invested assets) in order to reduce the interest rate risk inherent in the Fed’s policy shift.  The downside of this strategy is that it confines insurers to short-end of the yield cure and its miserly returns.  The average yield on one-year Treasury bills in both June and September 2004 was 2.12 percent.

Stock Block

It is painfully apparent that U.S. stock markets will come nowhere near their standout performance in 2003, which included a 26.4 percent gain in the S&P 500 index.  Through June 30, the S&P 500 was up a mere 2.6 percent and then proceeded to forfeit even this meager increase.  By the end of the third quarter on September 30, the index was up just 0.24 percent and was down 0.3 percent through October 15.  Should stocks finish in negative territory for the year, it would be the third decline in the past four years.  More importantly for insurers is the fact that realized (and unrealized capital gains) will likely shrink going forward, negatively impacting net income.

Why There’s No “Surplus” in Policyholder Surplus

Policyholder surplus rose by 6.8 percent, or $23.4 billion, to a new record high of $370.4 billion during the first half, compared to $347.0 billion at the end of 2003.  Prior to that, the previous high for policyholder surplus was $339.3 billion during the second quarter of 1999.

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 growth has been substantial over the past few quarters, it stands just 9.2 percent higher than in mid-1999.  Over the same period, the U.S. economy expanded by approximately 25 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, mold, the medical malpractice crisis and the crisis in corporate governance—none of which were major issues in 1999—not to mention this year’s record natural disaster losses.  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 U.S. 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 are coming under close scrutiny from state regulators, insurance departments, the federal government as well as the industry’s perennial critics.  Some have inappropriately cited rising capacity and profitability to call for rate roll backs while others will try to derail tort reform efforts, citing favorable loss trends.  Predictably, some have already endeavored to offer their unenlightened commentary to the media, characterizing the industry as “rolling in dough.” Of course, foes of reauthorization of the Terrorism Risk Insurance Act (currently set to expire at the end of 2005), or even individuals and government agencies trying to make an honest assessment of industry resources, may misinterpret the significant increase in policyholder surplus since the end of 2002 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

The financial and underwriting performance of the property/casualty insurance industry during the first half of 2004 was nothing short of outstanding.  Unfortunately, total insured catastrophe losses in 2004 could approach $30 billion, wiping out a substantial portion of the industry’s profits.  Aside from this year’s unusual catastrophe losses, results are quite good, though combined ratios are likely to rise sequentially in future quarters as lower rates through much of the commercial sector and increasingly in private passenger auto begin to squeeze underwriting profits.  Price competition in the industry is not yet “destructive” and terms and conditions remain relatively firm. 

Ominously, top line growth during the first quarter of 2004 is well below expectations, with real growth in net written premiums likely to turn negative by early 2005.  The fact that the industry’s average return on surplus is an estimated 13.1 percent, despite a combined ratio of just 94.4 during the first half, is a stark reminder that a renewed commitment to underwriting and pricing discipline are needed if the industry hopes to maintain Fortune 500 rates in 2005.
 
A detailed industry income statement for the first half follows:

(1) A more detailed discussion on this issue is available at /media/hottopics/insurance/brokercompensation

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