2004 - First Nine Months Results

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

December 20, 2004

The property/casualty insurance industry reported a statutory rate of return on average surplus of 9.9 percent through the first nine months of 2004, up from up from 9.2 percent for the first nine months 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: First Underwriting Profit in 26 Years is at Hand (Asterisk Required)

Despite one of the worst quarters ever for disasters, the property-casualty insurance industry in 2004 appears poised to realize its first underwriting profit in more than a quarter century.  This news may be somewhat surprising, given the $21.6 billion in insured catastrophe losses the industry suffered at the hands of Hurricanes Charley, Frances, Ivan and Jeanne during the third quarter.  However, some of the losses will ultimately be borne by foreign reinsurers (and hence recorded in the financial statistics of the country in which that reinsurer is domiciled).  Also, recoveries from the Florida Hurricane Catastrophe Fund, into which insurers have been paying reinsurance premiums since 1993, further reduce losses on a “net” basis.  Finally, the experience of Florida’s state-run high-risk insurer, Citizens Property Insurance Corporation, is not included in the results.  Consequently, ISO/PCI estimate that net losses to the industry after these adjustments are between $10.3 billion and $12.3 billion.  None of these considerations diminish the aggregate financial impact of the hurricanes on the industry or lessen insurers’ obligations to policyholders—insurers will still pay $21.6 billion to roughly 2.2 million claimants.  The difference is due purely to the way losses are treated from an accounting perspective along with non-reporting issues associated with Citizens (and other residual market mechanisms).

With these considerations in mind, the combined ratio for the third quarter was 104.7, significantly lower than it would have been otherwise.  Given that the combined ratio through the first six months of 2004 was a stellar 94.4,  the result through the first nine months was just 97.9, virtually guaranteeing an underwriting profit for calendar year 2004—the first since 1978—when the industry recorded a combined ratio of 97.5.

It’s important to note, however, that the experience of many casualty insurers, property insurers without significant exposure to Florida and monoline auto insurers, will likely be materially better than that of the industry overall.

Catastrophe activity settled down in the fourth quarter, but in October a hurricane of a different sort blew through the insurance industry.  While not directly impacting the operating performance of insurers, 2004 is likely to be remembered by many as the year in which New York State Attorney General Eliot Spitzer initiated an investigation of some insurance industry practices.  The ultimate impact of this investigation, which has resulted in at least two dozen additional probes launched by state attorneys general and insurance departments around the country, is still unknown.  However, insurer (and broker) expenses are certain to rise in 2005 as compliance costs increase as new regulations come online and fines and penalties are levied and paid. (1)

Underwriting Performance: Is 2004 the High Water Mark?

The nine-month combined ratio of 97.9 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 nearly 20 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.

Exceeding Expectations

The nine-month result, despite the four hurricanes, is better than analysts’ expectations from a year ago.  An Insurance Information Institute poll of industry analysts in late January 2004 produced an average estimate for 2004’s combined ratio of 100.0.  Were it not for the four hurricanes, however, this estimate would have proven to be overly pessimistic.  Through the first six months of 2004 the combined ratio was a remarkable 94.4, exceeding expectations by a wide margin.   Another Insurance Information Institute poll taken in December 2004 produced exactly the same combined ratio estimate for 2004, 100.0. (2) But the 100 combined ratio from the more recent survey was not an affirmation of the year-earlier prediction.  Instead, the figure reflected analysts’ belief that the hurricanes would push the industry’s combined ratio well above the first half’s better-than-expected performance.

The same survey projects a 99.0 combined ratio for 2005, little changed from the 100.0 estimated for 2004 and the 100.1 recorded in 2003.  While the survey results show some expected improvement, the bottom line is that the industry will still be paying out almost exactly the same amount in claims and associated expenses as it earns in premiums, thereby increasing the importance of investment earnings.  It also indicates some deterioration in underwriting performance after normalizing for catastrophe losses. Given the current low yield, high volatility investment environment, it is clear that Fortune 500-level returns on equity in the neighborhood of 13 to 14 percent cannot be generated without a major contribution from underwriting.

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. With interest rates still relatively low, 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 97.9 combined ratio through the first nine months of 2004 equates to an average return on surplus of 9.9 percent (down from 13.1 percent through the first half).  In contrast, the nearly identical combined ratio of 97.5 in 1978 (the last time the industry earned an underwriting profit) generated a return of 18.1 percent, in large part because interest rates were much higher during the late 1970s.  As we move into 2005, maintaining underwriting discipline will remain, by far, the insurance industry’s greatest challenge.

Premiums and Pricing: How Low Will They Go?

Premium growth through the first nine months of 2004 slowed significantly to 4.5 percent.  The deceleration is almost entirely due to significant moderation in commercial and personal lines rates (as opposed to sluggish exposure growth).  According to the Council of Insurance Agents and Brokers, 85 percent of commercial property accounts renewed negative during the third quarter, as did roughly half of all casualty risks.  Private passenger auto rates are also moderating.  While increases in the 6 to 8 percent range were common a year ago, many drivers in late 2004 experienced little or no change in their premiums while others began to see the cost of auto insurance fall.

Pricing, of course, has been a critical factor in the industry’s improved performance.  Insurers successfully managed to push insurance prices sharply upward from 2000 through 2003, forging a stronger link between price and risk.  But in 2004, pricing power began to erode.  Because the investment environment remains volatile (interest rates are still relatively low and the stock market in 2004 treaded water until early November), sustained profitability depends increasingly on preserving underwriting discipline. While underwriting discipline remains largely intact, at least for now, current pricing trends portend ominously for 2005.
 
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 4.5 percent during the first nine months of 2004, well under half the 9.7 percent recorded during the same period last year and 9.8 percent increase for all of 2003.  The same Insurance Information Institute polls from a year ago, which revealed industry analysts to be too pessimistic in terms of underwriting performance in 2004, also revealed excessive optimism when it comes to premium growth expectations.  In fact, actual premium growth in 2004 appears to be well below even the most pessimistic of analysts’ expectations from a year ago.  In an I.I.I. survey taken in December 2003, the consensus estimate among analysts was for net written premium growth of 8.1 percent.  Even the lowest estimate among the respondents—at 5.2 percent—appears to have been too optimistic and is 0.7 points above the nine-month result of 4.5 percent.

I.I.I.’s December 2004 survey calls for an increase in net written premiums of 3.4 percent in 2005, down from an estimated 4.8 percent in 2004.

In contrast to previous years, when gains were chiefly the result of higher rates, the sharp weakening in the pricing environment over the past year means that current modest gains are more directly related to increased exposure growth and higher demand associated with the current economic recovery.  Until 2004, exposure growth was concentrated on the personal lines side, as low interest rates propelled new home construction to record levels while at the same time boosting auto sales.  During 2004, however, business investment and hiring finally began to perk up, pushing up demand for commercial insurance.

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 mid-2005 for the first time since 1999.  Through the first nine-months, 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 nine months of 2004, premium growth fell 2.2 percentage points below the 6.7 increase in GDP while during the first nine months of 2003 premium growth outpaced growth in GDP by 5.2 percent points.

Investment Performance: Fed Rate Hikes Help but Stocks Remain Paralyzed

Investment income rose 3.9 percent to $28.7 billion during the first nine months of 2004 compared to $27.7 billion for the same period in 2003.  Realized capital gains also rose during the period, up 15.6 percent to $6.5 billion from $5.6 billion through the first nine months of last year.  As noted by ISO/PCI, however, the sum of realized and unrealized capital gains through the first nine months of 2004 fell sharply (56 percent) from the same period in 2003, reflecting languid market conditions.  The S&P 500 was up a mere 0.2 percent through September 2004, compared with 13.2 percent through September 2003.  Capital gains should recover during the fourth quarter.  As of December 17, the S&P 500 was up 7.4 percent.

Gains in insurer investment performance during the first nine months 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 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 continued to push rates upward in the second half, with a total of five hikes for the year, raising the Federal Funds rate from 1.0 percent in January to 2.25 percent by December.  Through the first half, longer term rates tracked upward with the Fed’s hikes in short-term rates.  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 by September 2004, primarily due to weaker-than-expected economic news.   From October through mid-December, the 10-year yield meandered in a range from roughly 4.0 percent to 4.4 percent.

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, though by early December the yield was approaching 3 percent.

Storm Clouds: Monetary and Fiscal Policy, Deficits & the Dollar

Insurers are among the largest institutional investors in the world.  Assets under management by all sectors of the U.S. insurance industry totaled $4.8 trillion in 2003.  Virtually all of these invested assets are influenced by U.S. monetary and fiscal policy.  Over the past year, in a bid to prevent inflation from taking root, the Federal Reserve has moved to tighten-up monetary policy by raising interest rates.  Accelerating inflation is bad for insurers for several reasons.  First, claims costs rise faster than rates due to regulatory and recognition lags—rate inadequacy is the result.  Second, unanticipated inflation renders prior-year reserves deficient because claims cost more to service than expected.  Third, were inflation to suddenly accelerate, interest rates would rise.  Sharp spikes in interest rates would push down the price of (lower-yielding) bonds in insurers’ portfolios (bonds account for two-thirds of p/c insurer invested assets) and produce an immediate reduction in capacity.  The benefit of higher rates in terms of improved investment yields would take much longer to work its way to the bottom line.

While the Fed is currently working to nip inflation in the bud, current U.S. fiscal policy is moving in the opposite direction.  The combination of higher federal spending and tax cuts pushed the federal budget deficit to a record $422 billion in FY2004, roughly 4.5 percent of GDP.  Just three years earlier, the government ran a surplus totaling $127 billion.  Current expectations are for the U.S. to continue to run deficits indefinitely. Moreover, most economists do not believe the Administration’s stated commitment to halving the deficit within five years to be credible.  Consequently, massive borrowing by the federal government will continue—a policy that will ultimately lead to higher inflation and higher interest rates.

Because Americans save very little and are burdened by record debt of their own, much of the capital used to fund the federal budget deficit—and the deficits of ordinary Americans—must be imported.  Foreigners have the capital to invest in the U.S. because of the enormous current account deficit the U.S. runs with most of its major trading partners.  Attracting evermore foreign capital will become more difficult in the future as nations that are net savers, like China, look to diversify their portfolio.  The only way to attract more capital at that point will be to raise interest rates still further.

The large current account deficit, combined with years of loose monetary policy, are contributing to a virtual freefall in the value of the dollar.  The lower value of the dollar effectively imports inflation, as goods (such as oil) and services produced abroad cost more in dollar terms.  The fall of the dollar is also problematic for large segments of the U.S. insurance industry.  Many of the largest players in the U.S. insurance market are foreign (or foreign owned) making repatriation of profits difficult as dollar profits are reduced due to depreciation of the dollar relative to currency of the insurer’s country of domicile.

Why There’s Still No “Surplus” in Policyholder Surplus

Policyholder surplus rose by 6.3 percent, or $22 billion, to $369.4 billion during the first nine-months of 2004, compared to $347.0 billion at the end of 2003, but virtually unchanged from the six-month figure of $370.4 billion.  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 8.8 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.” Others seem to believe that because the four hurricanes that struck during the quarter didn’t bankrupt large numbers of insurers, the industry has ample capital and does not need to adjust underwriting and pricing.  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 nine-months of 2004 was quite good, considering the magnitude of third quarter catastrophe losses.  Cumulative catastrophe losses through the first nine months totaled some $25.8 billion according ISO’s PCS unit, wiping out a large proportion of industry profits, even after adjusting for reinsurance and other factors.

On a catastrophe-adjusted basis, 2004 is likely to represent the zenith in the current cycle in terms of underwriting and profit performance.  Combined ratios are likely to rise in 2005 as 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 nine months of 2004 is well below expectations, with real growth in net written premiums likely to turn negative by 2005.  The fact that the industry’s average return on surplus is an estimated 9.9 percent, despite a combined ratio of just 97.9 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 nine months follows:

(1) A detailed discussion on broker/agent compensation is available at:  /media/hottopics/insurance/brokercompensation

(2) 2005 Early Bird Forecast, Insurance Information Institute; Available at:  /media/industry/financials/forecast2005/.