2006 - First Half Results

By Dr. Robert P. Hartwig, CPCU
Executive Vice President and Chief Economist
Insurance Information Institute
bobh@iii.org

October 2, 2006

The property/casualty insurance industry reported an annualized statutory rate of return on average surplus of 13 percent through the first six months of 2006, down from 15.6 percent through the first half of 2005. The results were released by ISO and the Property Casualty Insurers Association of America (PCI). Profitability in this range, if maintained, would lead insurers to their best financial performance in nearly 20 years and would put industry margins on par with the Fortune 500 group of companies, which is expected to turn in an average return on equity of about 14.5 percent in 2006. For calendar year 2005—a year of record catastrophe losses—the property/casualty insurance industry recorded a return on average surplus of 10.4 percent, well below the Fortune 500 group’s return of 14.9 percent. The estimated results for full-year 2006, of course, are predicated on the assumption that no major catastrophic loss occurs through year-end, an assumption that appears to be increasingly likely because of below-average tropical cyclone activity.

2006: Profit Peak for the Property/Casualty Insurance Industry

The financial performance of the property/casualty insurance industry during the first half of 2006 was generally excellent and on par with expectations. Although profits (net income) fell $2.9 billion or 9.3 percent to $28.3 billion in the first half from $31.2 billion during the same period in 2005, the industry’s underlying underwriting results were superb, with a first-half combined ratio of just 92, down from 93 and the best result since ISO began recording quarterly figures in 1986. Were the industry to maintain a combined ratio of 92 through the year’s end, it would be the best annual result in more than a half century (1955, to be exact). While Uncle Sam hauled away a big chunk of the industry’s profit in the form of taxes during the first half—$12.3 billion or 20 percent more than in 2005—the major disappointment of the quarter and the principal reason for the decline in first-half profitability was a deterioration in investment performance resulting in a 9.3 percent drop in total investment gain, details of which are discussed below.

Increased profitability due substantially to an ebb in catastrophe losses means that 2006 will be a rebuilding year for the property/casualty insurance industry. Profits will bolster the industry’s policyholder surplus—a measure of claims paying capacity or capital—and provide an additional buffer against the mega-catastrophes that lie ahead. An improved capital position will also help insurers meet the higher capital requirements imposed on them in the wake of Hurricane Katrina by ratings agencies, requirements that oblige insurers to demonstrate an ability to pay claims arising from more than one major catastrophe per year in order to maintain and improve financial strength ratings.

Improved profitability across the property/casualty insurance does not, however, mean that property insurance and reinsurance rates will fall in catastrophe-prone areas. Homeowners insurance, commercial property, business interruption and energy and marine prices are still inadequate relative to the risk insurers and reinsurers are being asked to assume. Consequently rates are likely to continue to rise in 2007. A more detailed discussion of financial reporting and the calculation of insurance industry profitability can be found at: /media/industry/additional/financials/ .

The first half also offered up several red flags and highlighted the major challenges for the remainder of 2006 and into 2007. Unless they are carefully managed, these factors will lead to deteriorating profitability in 2007 and beyond. These factors are classic manifestations of the insurance cycle that historically has been characterized by enormous oscillations in premium growth, underwriting performance and, ultimately, profits. While the cycle itself cannot be avoided entirely, disciplined underwriting and pricing are key to minimizing the often destructive effects.
 
Red flags and the challenges they represent for property/casualty insurers include:

RED FLAG #1: SLUGGISH PREMIUM GROWTH (2.9 Percent in First Half)

Causes

• Price Weakness: A virtual across-the-board softening in the personal and commercial lines pricing environment, with the exception of hurricane exposed property and property catastrophe reinsurance is in progress. The average commercial account renewed down about 3 percent during the first half of 2006 (though commercial property was up sharply in hurricane prone areas), while auto premium growth was stagnant and homeowners insurance premiums outside hurricane zones rose by little more than the pace of inflation.
• Rate Suppression: Regulators, especially in catastrophe-prone areas, refuse to allow insurers to charge risk-based rates. Some insurers may also be paying more for reinsurance, which causes them to report lower “net” written premium growth figures if they cannot fully recoup those costs at the retail level.
• Slowing Economy: A deliberate, Federal Reserve engineered cooling of the economy that is shrinking exposure growth in the home, auto, commercial property and workers compensation lines—which collectively account for more than 70 percent of all premiums written—is adversely impacting exposure growth. New home starts, for example, are expected to decline by 18 percent between 2005 and 2009, according to Blue Chip Economic Indicators. Similarly, rising interest rates will dent new car sales, as will still-high gas prices.
• Premium “Leakage”: Increased interest by traditional commercial insurance buyers in alternative forms of risk transfer, especially captives, self-insurance arrangements and large deductibles is causing significant leakage of premiums from the system. Also, insurer pullbacks from coastal areas are resulting in the ceding of significant premium to state-run residual market mechanisms, often in states that otherwise offer significant growth opportunities.

Challenge
The consequences of slowing/sluggish premium growth can be sobering if not appropriately handled. Management may be tempted to engage in price-based battles for market-share while CEOs may feel increased pressure to make potentially ill-fated acquisitions.  The challenge is to avoid a significant sacrifice of margins on existing business lines while seeking out growth opportunities that leverage off current company strengths. The flip side to growth is retention. Improvements in customer retention rates for many insurers will produce benefits that exceed those achieved through growth.

RED FLAG #2:  RAPID CAPITAL ACCUMULATION (9.0 Percent over the Past Year)

Causes

• Increase in Profits and Value of Invested Assets: Growth in net income and recovering asset prices over the past four years has contributed to growth in policyholder surplus (PHS), the industry’s basic measure of capacity, which reached a new record of $445.5 billion as of June 30, 2006. Since bottoming out in 2002, PHS has increased by 56 percent or approximately $60 billion. While an improved capital position can bolster financial strength ratings, excess capital can lead to reduced returns on equity.
• Dearth of New Growth Opportunities: The property/casualty insurance industry is saturated. Most people with homes, cars and businesses are already insured. While efforts to promote insurance-to-value, new products and expansion into new lines and territories result in the productive deployment of limited amounts of capital, those initiatives have so far been unable to keep pace with new accumulation. Many growth opportunities exist, but they involve increased risk or expansion and/or modification of many insurers’ current operating models.
• Limited Opportunities for Mergers and Acquisitions: M&A activity within the property/casualty insurance sector remains limited. Normally, a period where growth expectations are limited that is accompanied by an accumulation of capital would spark a trend toward consolidation, as was the case during the mid-to-late 1990s. Obstacles to increased M&A activity today include the fact that a significant share of the industry’s capital accumulates on the books of mutual insurers and therefore cannot be considered “in play.”  Also, acquirers may be concerned about slow growth potential even for the merged entity, limited opportunities to trim expenses, rising share prices among the limited number of possible acquisition targets (making the deal much more expensive than if executed just a few months ago) and large, as-of-yet unknown liabilities that could require substantial reserve charge-offs in the future.
• Ratings Agency Requirements: In the wake of the record-breaking hurricane seasons of 2004 and 2005, ratings agencies are requiring insurers to carry more capital just to maintain the same rating.
• Entry of New Capital: Approximately $25 to $30 billion in new capital has entered the property/casualty insurance and reinsurance industries in the year since Hurricane Katrina came ashore. Approximately $10 billion was raised by existing insurers and reinsurers while somewhat more than $10 billion was raised by start-ups, mostly operating as property catastrophe reinsurers out of Bermuda. Additionally, several Lloyd’s syndicates expanded their North American capacity while insurers and reinsurers established numerous “sidecar” facilities.  Securitization deals have also increased. Despite the significant inflow of new capital, the amount raised still falls short of the 2005 after-tax losses to the industry which were in the $37 to $40 billion range. Importantly, virtually none of this capital has reached the homeowners insurance markets in states like Florida, where rate suppression makes capital infusions non-economical.
• Increased Risk Aversion: Insurers remain chastened by the nearly $100 billion in insured catastrophe losses they have suffered since 2004 and can understandably be expected to err on the side of caution when it comes to how much capital to keep on the books—even a bit of hoarding might be in order. Additional uncertainty for insurers arises from a variety of sources, especially the tort system. While the U.S. tort system has arguably improved over the past several years, challenges remain, including attempts by trial lawyers and the attorney general of Mississippi to force insurers to pay billions of dollars of excluded flood losses to policyholders whose homes were damaged or destroyed by flood and storm surge. The looming expiration of the Terrorism Risk Insurance Extension Act at the end of 2007 also exposes commercial insurers to billions of dollars of potential loss.
• Measured Return of Capital:  Given the omnipresent specter of mega-catastrophes, determining when “excess” capital exists on the books and can safely be returned to shareholders or policyholders is a difficult management decision. Nevertheless, while many stock insurers have stock buyback programs in place today, these programs are likely to be ramped-up in the year ahead. Stock dividends may also increase, but at a measured pace that is sustainable over the long run. Some mutual companies pay dividends to policyholders and others may consider it going forward. Indeed, through the first half of 2006 policyholder dividends rose 17 percent, or about $90 million over their 2005 level.

Challenge
The primary consequence of rapid capital accumulation is to produce lower returns on equity, a problem that is exacerbated in an economic environment with limited opportunities for organic or merger driven growth. On the other hand, it is important that insurers remain well capitalized in this era of mega-catastrophes and hyper-vigilant ratings agencies. Capital allocation and pricing decisions made by management over the full 24 months will determine whether the industry rides out the soft phase of the insurance cycle with reasonable levels of profitability and modest-to-slow growth or with plunging profits and negative premium growth.

Underwriting Performance: Best in a Generation (or Two)

With the usually noisy third quarter nearly over and virtually catastrophe free, the stellar underwriting performance of the first half of the year is quite likely to carry through to year’s end. If so, the property/casualty insurance industry will realize its best underwriting result in nearly 51 years, besting the 94.9 combined ratio recorded in 1955. In 2005 insurers were clobbered by a record $61.2 billion in catastrophe losses arising from more than 3.3 million claims, of which 95 percent had been settled by the first anniversary of Katrina in August 2006, leaving just 2 percent in dispute (1).  Bouncing back with a first-half combined ratio of 92 provides tangible proof of the resilience of the industry in the face of unprecedented adversity in 2004 and 2005.  Insured catastrophe losses during the first half of 2006 were a modest $5.3 billion. With the peak of the hurricane season past us, it appears that insurers could see the lowest toll from catastrophe losses since the $5.9 billion recorded in 2002. Nevertheless, commercial and residential property (homeowners and condo) pricing for insurance will remain firm in 2007 because of the expectation of above-average hurricane activity for the next 10 to 20 years. Reinsurance prices on coastally exposed structures will remain firm as well.

A combined ratio of 92 means that for every dollar of premium income that insurers earned during the first half of 2006, $0.92 exited in the form of claims payments, claims reserves and expenses. The remaining 8 cents is an underwriting profit—an exceedingly rare occurrence in the property/casualty insurance industry. In fact, the industry recorded just two full-year underwriting profits over the past 28 years (1978 and 2004). This suggests that something usually happens during the year that puts a combined ratio under 100 out of reach.  In 2005, for example, the industry was on track for a record underwriting profit after turning in an impressive combined ratio of 92.2 for the first quarter, but wound up finishing the year with a combined ratio of 101 and a multi-billion dollar underwriting loss.  Mother Nature was to blame, of course, and her fury—at least in terms of hurricanes—so far remains unexpectedly muted. In fact, as of September 26, just eight named storms have formed in the North Atlantic basin; as of the same date in 2005 19 storms had formed. According to the well-known hurricane forecaster Dr. William Gray, there is just a 14 percent chance of a hurricane landfall in the United States during October 2006 and just a 4 percent chance of a major (Category 3, 4 or 5) storm making landfall. The bottom line is that with a $15.1 billion underwriting profit during the first half of 2006 and a mild hurricane season, an underwriting profit in the range of $30 billion for the full year is within reach.

While still deeply in the red following the record catastrophe losses of 2004 and 2005, property insurance and reinsurance companies will realize their first profit from coastal business since 2003. An Insurance Information Institute analysis indicates that the cumulative underwriting loss on Florida homeowners insurance from 1990 through 2005 was $13 billion.

Catastrophe losses are not the sole factor influencing underwriting performance. As discussed previously, insurers face mounting competitive pressure which is taking the form of falling prices across a broad spectrum of commercial and personal lines coverages, a slowing economy and regulatory rate suppression. Insurers may also use the fourth quarter of the year, as they often do, to take reserve charges, which could amount to several billion dollars across the industry.

In the final analysis, insurers will need to find ways to generate adequate rates of return not only to compensate investors for the risk they assume and to preserve their claims-paying capital, but also to maintain their financial strength and credit ratings and to avoid regulatory sanctions. A financially weak insurance industry is of no use to anyone, including policyholders, millions of whom depend on the industry to pay hundreds of billions of dollars in claims each year.

Investment Returns: Is the Sky Really Falling?

The industry’s net investment gain dropped by $2.6 billion or 9.3 percent to $25.4 billion during the first half of 2006 from $28 billion during first half 2005. According to ISO, the loss consisted of a 3.5 percent decline in net investment income (which consists primarily of interest on bond holdings and stock dividends) and a 66.4 percent drop in realized investment gains. Fortunately, the deterioration in realized capital gains during the first half is likely a temporary setback. The S&P 500 Index, which was up just 1.8 percent as of June 30, performed well during the third quarter with a year-to-date gain of 7.0 percent as September 30. The markets have been reacting favorably to the Fed’s decision this summer to at least temporarily halt the series of rate hikes initiated in June 2004, as well as to falling energy prices. It is important to keep in mind, however, that property/casualty insurers hold just 17 percent of invested assets in the form of common stock, so upside from a rally in stocks is limited.

The interest rate situation going forward is somewhat murky for insurers. The direction of interest rates is critically important for property/casualty insurers because 68 percent of all invested assets are held in the form of bonds. The average yield on 10-year US Treasury notes was 5.07 percent during the second quarter of 2006, but slipped back to just 4.65 percent as of September 21, almost identical to the 4.73 yield in June 2004 (when the Fed began to raise rates). Indeed the yield curve has once again become inverted. While short-term interest rates are much higher than they were at the beginning of the Fed’s campaign to raise rates (the 3-month T-bill yielded 1.29 percent in June 2004) the yield as of September 21 was 4.92 percent, 27 basis points above the yield on the 10-year note. Indeed, the 30-year Treasury bond on the same date yielded just 4.78 percent. This situation leaves insurance company chief investment officers with a difficult choice—lock in long-term rates now lest they fall further or stick with shorter-term instruments because of the higher yield. The decision to go long is fraught with interest rate risk. It is easy to envision situations (such as an oil-induced inflation shock or a war) that drive interest rates sharply higher in the years ahead, a development that would push the price of bonds down. On the other hand, rates could trend down further, perhaps for years. If the yield curve also returns to its normal shape, then going long today is the right strategy.

Securities investors appear to be sending a signal that they expect intermediate and long-term interest rates to decline. The traditional explanation for this is an expectation of economic weakness in the months and years ahead.

Summary

The financial and underwriting performance of the property/casualty insurance industry during 2006 is expected to be strong, aided substantially by catastrophe losses that will in all likelihood be far below those experienced in 2004 and 2005. Insurers, however, face a variety of challenges unrelated to catastrophe losses, including increasing price pressure that could erode underwriting performance and profitability in the quarters ahead.

One cause for concern is the fact that top line growth in the first half of 2006 was less than 3 percent and is, in fact, negative on an inflation-adjusted basis. Another is the rapid accumulation of capital on insurer balance sheets. The current slow growth environment means that insurers face very difficult capital allocation decisions over the next several years.

A detailed industry income statement for the first half of 2006 follows:

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(1) Insurance Information Institute special survey conducted in August 2006.  The full study can be accessed at /media/updates/press.760032/ .