2005 - First Half Results

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

October 5, 2005

The property/casualty insurance industry reported a statutory rate of return on average surplus of 15.3 percent in the first half of 2005, almost certainly the profit peak in the current cycle, up from 10.5 percent during calendar year 2004. The results were released by the Insurance Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI).

2005:  Stellar Start, Frightening Finish

The financial performance of the property/casualty insurance industry during the first half of 2005 was nothing short of spectacular.  With an average return on surplus of 15.3 percent—nearly one full percentage point above the 14.5 percent return on equity expected for the Fortune 500 group of companies this year—the industry was on a trajectory to record its highest level of profitability since 1987.  Yet, as a long-time industry observer, and armed with the knowledge that no good property/casualty deed ever goes unpunished, the author of this Commentary expressed a sense of foreboding in a July 25, 2005 Commentary as follows: 

“It should be noted that the industry’s ability to maintain a 15-plus percent return through the [second half] of the year is anything but certain.  Despite what appears to have been an excellent second quarter, insurers are just entering the disaster-prone third quarter (which many weather experts have predicted is likely to be particularly disastrous)…”

That sense of foreboding would manifest itself in the form of Hurricanes Katrina and Rita, both of which made landfall during the third quarter.  Katrina is almost certain to become the most expensive insured loss in United States and world history, easily ending the 13-year reign of Hurricane Andrew as the most expensive natural disaster (about $21 billion in current dollars) and may even eventually exceed total insured losses from the September 11 terrorist attack (at about $35 billion in current dollars). ISO’s Property Claim Services Unit currently estimates $34.4 billion in insured property losses from Katrina, though it is possible the figures will be revised upward in the months ahead. Catastrophe modeling firms have produced insured loss estimates range as high as $60 billion for Katrina and $7 billion for Rita (1).

Given that net income (profit) after taxes for 2005 was on track to hit $62 billion before the hurricanes (based on $30.9 billion earned through the first six months), it appears that effectively all of the year’s profits were blown away by the two storms.  While reinsurance recoverables and tax credits will lessen the financial blow to some extent, the balance sheets of more than a few insurers and reinsurers will end 2005 awash in red ink.

Why Financial Strength is So Important
The strength of the first half 2005 results serves to illustrate why consistently strong financial performance by property/casualty insurers is so important.  Entering the 2005 hurricane season, several key measures of insurance industry financial strength were at cyclical highs, including overall profitability, underwriting performance, investment returns and claims paying capacity (policyholder surplus).  Thus the industry experienced Katrina and Rita from a position of extraordinary financial strength.  Indeed, the industry is in a substantially better position to handle the claims arising from Hurricanes Katrina and Rita than it was at the time of the September 11, 2001 terrorist attacks (see table below).

Profitability:  Record Profits, Huge Losses

Insurers must operate profitability in order to accumulate sufficient financial resources to pay not only losses from mega-catastrophes such as Hurricane Katrina, but also millions of smaller claims and to compensate investors for putting their capital at risk—extreme risk in some cases.  As discussed previously, the p/c insurance industry posted a 15.3 percent return on average surplus (similar to return on equity) on $30.9 billion in profits for the first half of 2005.  

While insurers have sufficient resources to pay the 1.5 million-plus claims likely to arise from Katrina and Rita, as they did following the 2.1 million claims totaling some $23 billion associated with the four hurricanes that struck the Southeast United States in 2004, it is clear that risk-appropriate profitability in the p/c insurance industry is anything but assured.  For the p/c insurance industry as a whole, the average return on equity over the 15-year period from 1990 through 2004 was 8.8 percent compared to 13.0 percent for the Fortune 500, a difference of 4.2 percentage points.  Focusing on only those years with major catastrophe losses (1992—Hurricanes Andrew and Iniki; 1994—Northridge earthquake; 2001—9/11 terrorist attacks; and 2004—Hurricanes Charley, Frances, Ivan and Jeanne) the difference is much larger at nearly 7 percentage points, with p/c insurers recording an average return in those years of just 4.9 percent compared to 11.8 percent for the Fortune group of companies.  According to ISO/PCI, each $10 billion in net losses from the hurricanes could reduce net income after taxes by $7.4 billion and cut the industry’s annual rate of return by two percentage points, based on tax rates and surplus as of June 30.  Hence, a $60 billion loss from the two storms could theoretically reduce the industry’s annual return from about 15 percent to a mere 3 percent (before accounting for reinsurance recoverables and losses borne by foreign insurers).

The upshot is that profits in the property/casualty insurance industry are usually inadequate.  Years of disciplined underwriting and pricing have dramatically improved operating performance in recent years but those efforts have nevertheless fallen short of the mark for many insurers—in large part because of record catastrophe losses.  Indeed insured catastrophe hit new records in three of the past five years (2001, 2004 and 2005).  Clearly, insurers need to make continued adjustments to their underwriting, pricing and exposure before consistent and adequate profitability become a reality.  

Critics of the insurance industry as well as trial lawyers seeking clients have distorted and mischaracterized recent insurer profits and claims-paying capital (policyholder surplus) for their own political and financial gain, seeking to extract payments for coverage that is clearly excluded under policies (flood coverage in particular) and for which no premium has ever been received.  This issue is discussed in greater detail in subsequent sections of this Commentary, but at this point it will suffice to say that insurers cannot allow the terms of contracts to be retroactively rewritten.  To do so would permanently destroy the sanctity of contractual agreements, rendering the pricing and sale of insurance effectively impossible.

Policyholder Surplus: Taking a Hit on a Global Scale

Policyholder surplus (PHS), commonly known as owners’ equity or net worth in other industries, rose to a record $412.5 billion during the first half of 2005.  PHS is influenced by contributions from net income (profits), which drop to the PHS account when earned, and also by increases (decreases)  in unrealized capital gains (losses), net new capital raised and the amount of dividends paid out to shareholders (the owners of capital).  Through the first six months of 2005 the vast majority of the $18.7 billion increase in policyholder surplus since December 31, 2004 was associated with $30.9 billion in net income.  Only $2.4 billion in new funds were paid-in to PHS over the same period.  With the S&P 500 index losing 1.7 percent during the first half, insurers experienced $5.4 billion in unrealized capital gains, and an additional $9.2 billion in charges against surplus were principally associated with dividends paid to stockholders.

Hurricanes Katrina and Rita will significantly impact PHS during the third quarter.  Policyholder surplus will likely shrink as insurers are forced to dig deeply into their claims-paying reservoir to pay the tens of billions of dollars of claims arising from the two storms.  Only a fraction of the hit to PHS will be offset by the 3.2 percent increase in stock prices (as measured by the S&P 500) during the third quarter.

It is also true, however, that reinsurance recoverables from foreign reinsurers will soften the blow to US policyholder surplus, though this merely shifts the impact to the PHS account of other nations’ insurance industries.  The more expensive Katrina and Rita ultimately become and the larger the share of losses that originate from commercial lines, the larger the share of losses that will be borne by reinsurers.  The latter observation is due to the fact that some major personal lines insurers (auto and home) make relatively little use of reinsurance despite significant market shares.   Presently, it is likely that reinsurers will pay at least one-third of the storm losses, and possibly much more.  Reinsurers ultimately paid approximately 55 percent of the losses from the September 11 terrorist attacks.  Before the Hurricanes Katrina and Rita, capacity among reinsurers was also at record high, estimated at some $300 billion globally.

Policyholder Surplus: Often Misunderstood, Mischaracterized
Unfortunately, the role of policyholder surplus (PHS) is generally not well understood by people unfamiliar with the insurance industry, including many policymakers and legislators.  As mentioned above, 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.  A number of insurers are under threat of downgrade following Hurricanes Katrina and Rita, though none are expected to become insolvent.

It is also the case that policyholder surplus is not fungible.  In other words, surplus gains that accrue to one segment of the industry or a particular company as the result of improved underwriting and/or investment performance, are generally not available to back-up other types of risk.  For example, surplus accumulated by a workers compensation insurer in Missouri cannot be used to underwrite damaged homes or business property in Louisiana. Likewise, the pre-Katrina surplus accumulated from home and auto operations in Mississippi has absolutely no impact on the ability of the p/c insurance industry to provide coverage against terrorist attacks.

Nevertheless, some politicians and trial lawyers inappropriately cite rising industry-wide capacity and profitability as a justification for ignoring long-standing contract language—every word of which is approved by state insurance regulators—in order to get insurers to pay excluded flood losses.  Similarly, foes of reauthorization of the Terrorism Risk Insurance Act (currently set to expire on December 31, 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.

The reality is that the industry’s policyholder surplus is, in effect, already committed to the risks being underwritten today, both catastrophic and otherwise. 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.  Additionally, capital markets appear to have little or no interest in securitizing terrorism risk.  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.

Will Insurers Be Able to Raise Capital if Needed?
The expense of Hurricanes Katrina and Rita had a significant impact on the policyholder surplus of some companies, particularly some smaller reinsurers.  In several instances, losses from Hurricane Katrina alone consumed more than 30 percent of the company’s claims-paying capital.  In other cases, ratings agencies have threatened downgrades.  In these cases, the (re)insurer will likely need to raise capital. The prospect of high returns in the wake of the two storms in some market segments combined with global financial markets that are awash in capital means that most companies interested in raising cash will be able to do so without great difficultly.  Through October 4, a number of insurers had announced plans to raise a total of $3.8 billion in new capital, sometimes in amounts exceeding Katrina loss estimates.  The ability of insurers to readily raise cash will likely have a tempering affect on pricing.

Should the Federal Government Be Involved in the Financing of Natural Disaster Risk?
Some insurers have cited Hurricanes Katrina and Rita and the four storms that struck the Southeast United States in 2004 and the prospect of more mega-sized natural disasters in the future as a reason why the federal government should play a role in the financing of natural disaster in the future.  Proponents of a more active federal role argue that such events are only likely to become more frequent and more expensive over time and are already reaching the limit of insurers’ ability to offer insurance in disaster-prone areas.  A number of options have been proposed, including formation of a national or regional pool and/or changes in tax law that allow insurers to accumulate reserves before an event occurs on a tax deferred basis (presently US tax law only allows for post-event reserving).

Underwriting: Where the Money is Made and Fortunes are Lost

Property/casualty insurers typically lose money on underwriting.  In fact, 2004 was the first time the industry managed an underwriting profit in 26 years—a slim $5 billion dollars resulting from a combined ratio of 98.3.  In contrast, the industry accumulated $459 billion in underwriting losses between 1979 and 2003 with an average combined ratio of 108.5.  The good news from the first half of 2005 was that the industry was on track to turn in another underwriting profit in 2005.   Indeed, the first half combined ratio of 92.7 led to an underwriting profit of $13.2 billion—beating the full-year 2004 record underwriting profit by a factor of nearly three in just six months. 

Aside from catastrophe losses, underwriting results during the second half of 2005 are likely to remain fundamentally strong.  Growth in non-catastrophe related losses and loss adjustment expenses was a negligible 0.4 percent during the first six months of the year while net written premiums rose by 2.4 percent.

Investment Performance: Fed Rate Hikes Boost Conservative Portfolios

Investment income rose by 16.5 percent after adjusting for special dividends (32.7 percent before adjusting) during the first half of 2005 relative to the first half of 2004.  This compares to unremarkable growth of 2.4 percent for all of 2004. Growth in investment income (which consists primarily of interest income generated from the industry’s substantial bond portfolio) had been tepid (or even declined) despite stronger cash flow because of declining interest rates over the past several years and which remained low throughout 2004. Indeed, the average yield on 10-year Treasury securities during the first half was 4.23 percent, not significantly different from calendar years 2003 and 2004, at 4.01 percent and 4.27 percent, respectively, which were the lowest in 40 years.  Given recent tightening by the Fed and strong economic growth, insurers, like most institutional investors, believed that long-term rates would have headed higher many months.  They didn’t.  Instead the yield curve simply flattened as short-term yields rose in response to the Fed’s actions while long-term rates stayed flat or declined—a phenomenon Fed Chairman Alan Greenspan famously labeled a “conundrum” in testimony in February.

Eleven rate hikes by the Federal Reserve since June 2004 have pushed the federal funds rate up by 2 ¾   points to 3.75 percent from 1.00 percent, forcing money market rates and rates on short-term securities upward.  The last two hikes occurred during the third quarter, pushing rates up by a total of 50 basis points (0.5 percentage points).  Ordinarily, such an increase would have only a marginal impact on insurer investment earnings, but insurers have been accumulating significant assets with very short maturities in a bid to minimize interest rate risk and because the flat yield curves afforded virtually premium for investing long.  A special Insurance Information Institute analysis of the industry’s current investment portfolio estimates that 10 percent of the industry’s invested assets in 2004 were held as cash or short-term securities compared to 4.1 percent in 1999.  Over the same period, the proportion of the industry’s bond portfolio with maturities ranging from 10 to 20 years fell from 21 percent to and estimated 15 percent.

Fed rate hikes are expected to continue through the end of 2005.  It is quite likely that the federal funds rate will rise to 4.00 percent by December.

Summary

The financial and underwriting performance of the property/casualty insurance industry during the first half of 2005 was the best in decades and is unlikely to be repeated for many years.  The magnitude of the third quarter losses will mask an operating performance that is fundamentally strong.

On a catastrophe-adjusted basis, 2005 is likely to represent the peak in the current cycle in terms of underwriting and profit performance.  Combined ratios are likely to rise in 2006 and beyond as the effects of an intensification in price competition through much of the commercial sector and increasingly in private passenger auto begin to trickle down to the bottom line.  But price competition in the industry is not yet “destructive” and terms and conditions remain relatively firm. 

One cause for concern overshadowed by recent events is the fact that top line through the first half of the year was just 2.4 percent and is, in fact, negative on an inflation-adjusted basis.  There are likely to be price impacts on residential, commercial property and property catastrophe reinsurance prices in the aftermath of this year’s hurricanes, but the affects will be focused on the Southeast and Gulf coast areas.
 
A detailed industry income statement for the first half of 2005 follows:

(1) As of October 1, 2005, insured loss estimates for Hurricane Katrina range from $14 billion (lower end of Eqecat range) to $60 billion (upper end of RMS range).  The latter figure includes up to $25 billion in privately insured flood losses (mostly commercial), excluding NFIP policies.  The lower estimate contains no estimate of privately insured flood loss.  Hurricane Rita estimates range from $2.5 billion to $7 billion.