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2007 - First Nine Months Results

By Dr. Robert P. Hartwig, CPCU
President
Insurance Information Institute

bobh@iii.org

December 19, 2007

The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 13.1 percent during the first nine months of 2007, unchanged from the first half of the year but down from 14.0 percent for calendar year 2006 and 13.8 percent from last year’s first nine months. The decline in profitability in 2007 is primarily attributable to a marginal deterioration in underwriting performance, which pushed the nine-month combined ratio up to 93.8 compared with 91.5 during the first nine months of last year and 92.5 for all of 2006. Nevertheless, the industry is on track to record what could be one of the top 12 combined ratios since 1920. The results were released by ISO and the Property Casualty Insurers Association of America (PCI). Though profits remain reasonably strong, industry margins could fall short of those realized by the Fortune 500 group of companies, which is expected to turn in an average return on equity (ROE) in the 13 to 15 percent range this year.
    

2007: Surprising Strength in Underwriting Results

The financial performance of the property/casualty insurance industry for 2007 is turning out to be significantly better than was anticipated when the year began. Results through the first nine months are generally excellent and so far have proven surprisingly resilient in the face of an increasingly price competitive environment. But at the same time the nine-month results provide confirmation that the industry is now past its cyclical peak in profitability of 14.0 percent and its cyclical trough in the combined ratio of 92.5, both achieved in 2006. In my commentary on the first quarter 2007 results I presented an analysis suggesting that if the historical trends observed during the past four market cycles hold (dating back some 35 years), the industry can expect ROEs to bottom out in 2011 at about 1 to 2 percent—not reaching another peak in profitability until 2015 or 2016 ( see /financials/2007firstquarter/ ).

The most important question facing the industry today is whether this painful and destructive cycle can be broken and with it the commensurate surge in insurer impairments that invariably occur. History does not imply destiny, of course, and there are some indications that aggressive capital management, expense controls and judiciously timed realization of accumulated capital gains by insurers may be making a difference—leading to a shallower market cycle and a more modest dip in profitability. Insurance CEOs continue to vow that it will be different this time around and 2008 is quickly shaping up to be the year when the industry’s fortunes will be cast.

Shades of Things to Come: As Underwriting Results Slip, Realized Investment Gains Rise

As indicated in my first half 2007 commentary, current results provide a telescopic glimpse into the future ( see /financials/2007firsthalf/ ). It is immediately apparent that insurer profits going forward will become increasingly dependent on investment earnings as underwriting performance steadily deteriorates. It is notable that despite a substantial 25.3 percent ($6.2 billion) drop in underwriting income (the margin by which premium income exceeds claims costs, expenses and policyholder dividends) to $18.1 billion from $24.3 billion a year ago, profits (net income after taxes) actually rose by $3.3 billion, or 7.1 percent, to $49.4 billion during the first nine months of 2007, up from $46.1 billion during the same period in 2006. The increase in profits is entirely attributable to modestly higher investment income—up $2.0 billion (5.4 percent) to $39.5 billion—and a quantum 456.6 percent ($6.7 billion) leap in realized capital gains to $8.2 billion from $1.5 billion a year earlier.

It is important to note that the decision to recognize capital gains is entirely under management discretion. Major stock market indices have been in positive territory every year since 2003 and the Standard & Poor’s 500 Index was up 7.6 percent through September 30 (by December 18, the S&P was up just 2.6 percent, however). While the accumulation of capital gains and volatility in equity markets associated with the current credit crunch have motivated some selling, companies are clearly under pressure to fill the profit void created by shrinking underwriting profits by selling a share of their investment gains accumulated over the past several years. Indeed, the practice of “banking” the majority of accumulated capital gains may well be coming to an end. In 2006, earnings were powered almost entirely by record underwriting profits and insurers realized just $3.4 billion in capital gains throughout the entire year despite a 13.6 increase in the Standard & Poor’s 500 stock index. In contrast, realized capital gains through the first nine months of 2007 are already nearly 2.5 times greater than the $3.4 billion recorded for all of 2006.

Although insurers have accumulated significant unrealized capital gains on their books, they are ultimately a finite resource. In contrast, profits generated through disciplined underwriting are a renewable resource and in a disciplined underwriting and pricing environment provide a stable source of earnings irrespective of the investment conditions. During the late 1990s, bull markets and high interest rates allowed insurers to absorb ever larger underwriting losses. That changed when stock markets collapsed and interest rates tumbled in the early 2000s. The subprime induced market swoon and volatility that began in July and August has persisted through the remainder of the year and looks certain to continue well into 2008. The Federal Reserve has trimmed rates on three occasions for a total 100 basis points (1 full percentage point) since September and is introducing other measures to help stabilize credit markets. The current volatile investment environment and the concern voiced by the Federal Reserve, the Treasury and foreign central banks are reminders of the uncertainty and fragility of investment returns, even in the insurance industry’s very conservatively managed investment portfolio.

Profits: The Key to Rebuilding Claims-Paying Capacity and Reinvestment in the Industry

Continued strong profits in 2007 will allow insurers to make significant reinvestments in the industry. Profits 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 by ratings agencies in the wake of Hurricane Katrina; 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.

From year-end 2006 through September 30, 2007, policyholders’ surplus increased by $35.6 billion, or 7.3 percent, to $521.8 billion. Since September 30, 2006, policyholders’ surplus is up $55.1 billion from $466.7, a gain of 11.8 percent. These significant increases in surplus demonstrate that insurers are reinvesting the majority of their profits (and unrealized capital gains) in the property/casualty insurance industry, bolstering industry claims-paying resources in advance of what are likely to be record-setting catastrophe losses in the relatively near future.

Consumers and regulators can expect that insurers will continue to increase their claims-paying capacity through the fourth quarter of 2007 and into 2008. At the same time, publicly traded insurers must continue to compensate shareholders for the assets they put at risk. With few opportunities for organic growth (such as expanding into new states or branching out into new lines of business) and only a limited number of acquisition targets, insurers can be expected to return capital to shareholders rather than invest it unproductively. Some analysts have estimated that there is as much as $100 billion in excess capital in the industry today. Accumulation of excess capital can also depress returns on equity. Consequently, insurers are returning capital to shareholders in the form of increased dividends and share repurchases. Share repurchase activity in 2007 will shatter all previous records and could constitute a return of 4.5 to 5.0 percent of industry capital to owners. According to Credit Suisse, through the third quarter of 2007, $17.4 billion in share repurchases had been transacted, a figure that is already 133 percent above the previous record of $7.1 billion for all of 2006. It is likely that total share repurchases will exceed $20 billion by year’s end.

Catastrophe Losses: The Worst Has Yet to Come (Though Not in 2007)

When it comes to catastrophe losses, insurers necessarily prepare for the worst and hope for the best. Catastrophe losses during the first nine months were relatively light—at $4.8 billion, compared to $7.8 billion during the first nine months of 2006, according to ISO’s Property Claims Service. This sum is a pittance compared with the record $62 billion in insured losses in 2005, $41.1 billion of which was due to Hurricane Katrina. The 2007 hurricane season was active and produced 15 named storms—the same number as the devastating 2004 season. Yet only one weak hurricane (Humberto) came ashore in the United States on September 13 in East Texas, doing little damage. The most expensive catastrophe of 2007 occurred during the fourth quarter—the wildfires in Southern California. Although official insured loss figures have yet to be released, estimates are in the $2 billion range. Severe wind storms in the Pacific Northwest in December followed by ice storms in the Plains, Midwest and Northeast could further boost total losses for the year. Needless to say, insurers are never out of the woods when it comes to catastrophe losses. The reality is that the 2000s has already established itself as the “decade of disaster,” with record catastrophe losses set in 2001, 2004 and 2005. Insurers and reinsurers today actively plan for a $100 billion event (or sequence of events summing to $100 billion). There are a frighteningly large number of scenarios capable of generating a $100 billion loss, ranging from a repeat of the 1906 San Francisco earthquake, to a strong hurricane striking Miami or New York, to a major terrorist attack.

Not all catastrophe risk is associated with hurricanes. On December 18, with just days to spare before the December 31 expiration of the Terrorism Risk Extension Act, Congress passed a bill that President Bush has indicated he will sign. The bill had been held up by legislative disputes over differences in the House and Senate version of the bill. The proposed bill provides a seven year extension (up from two years from the previous extension) and contains several favorable provisions such as elimination of the distinction between domestic and international acts of terrorism. Insurers will be not required to assume nuclear, biological, chemical and radiological (NBCR) risks, as had been proposed in the original House bill.

Profitability and Pricing

Rising profitability is also intensifying competition throughout most of the property/casualty insurance industry and buyers of insurance are the unambiguous winners when it comes to reaping the benefits of lower insurance premiums. Drivers, homeowners and businesses in most parts of the United States will be left with more cash in their pockets as insurance costs fall in absolute terms, or at least relative to income growth and growth in GDP—the major exception being insurance for property coverages in hurricane-exposed areas. The bottom line is that flat or falling insurance prices are lowering the cost of doing business, driving a car or owning a home for most Americans. For example, countrywide auto insurance expenditures are estimated to have fallen by 0.5 percent in 2007, the first drop since 1999. ( The Insurance Information Institute’s forecast for 2007 auto insurance expenditures is available at /media/updates/press.764681/ ) Early data suggest that average auto expenditures in 2008 will be roughly flat. At the same time the average cost of insuring a non-coastal residence is up by just 2 to 4 percent in many areas and is flat or even falling in others. The cost of insuring the median home is estimated at 0.4 percent of the home’s price in 2008. Businesses too benefited from price declines in 2007 across their entire insurance program. The declines are a continuation of a downward trend in the cost of business insurance that began in earnest in 2004 and are likely to continue into 2008. Commercial insurance prices today stand roughly where they were in late 2001 or early 2002, but are still roughly 30 percent above their late-1999 level. Overall, the share of P/C insurance premiums relative to the overall economy shrank by 2.0 percent in 2006 and will shrink by an estimated 4.9 and 4.3 percent in 2007 and 2008, respectively. Hence, while critics of the industry bemoan insurer profits, the reality is that the cost of insurance for the overwhelming majority of consumers is flat or falling and that insurance costs relative to GDP are falling.

One indicator of increased competition in the insurance industry is advertising expenditures, which rose to a record $3.695 billion in 2006, up 24 percent from $2.975 billion in 2005 and more than double the $1.8 billion recorded in 2001. The increased spending in advertising expenditures is occurring across both commercial and personal lines insurers.
    

Premiums: Zero Growth, But Underwriting Results Remain Healthy

The ISO results indicate that the growth rate in net written premiums was flat (0.0 percent) during the first nine months of 2007, down from a 2.7 percent increase during calendar year 2006, which experienced strong growth in property-related insurance premiums in hurricane-exposed areas. Looking ahead to 2008, the Insurance Information Institute’s Earlybird survey of industry experts calls for slightly negative growth in net written premiums in 2008 of 0.3 percent on average, a very modest deterioration from the zero growth estimate for 2007. ( The Insurance Information Institute’s 2008 Earlybird survey is available at /media/industry/financials/earlybird2008 ) The 0.3 percent decline in premium growth that analysts project for 2008, if accurate, would represent the first decline in aggregate annual premiums since 1943, when premium volume declined by 2.4 percent in the midst of World War II. The zero growth estimate for 2007 is also below the 1.5 percent growth projection in the Earlybird survey in December 2006. Premium growth has decelerated steadily since peaking at 15.3 percent in 2002. This is primarily the result of an across-the-board softening in the personal and commercial lines pricing environment. A weakening economy, leakage of premium to government-operated (re)insurers and strong interest in alternative forms of risk transfer, including various forms of self insurance, captives and catastrophe bonds, are also contributing to the slowdown.

Why Dwelling on Premium Growth May Provide Limited Insights

It is notable that the premium growth estimate for 2008, though slightly negative, represents a leveling out of growth rather than a continuation of the sharp deceleration trend that began in 2003. This suggests that analysts expect pricing discipline to be a key element in the complex dynamics at work in insurance markets in 2008. Historically, the travel time from the cyclical peak of premium growth to the cyclical trough has been 5 to 6 years. Reaching a trough in 2008 would be consistent with historical experience. However, history paints two distinctly different pictures for the years immediately following a trough. During the hard market of the mid-1970s, premium growth peaked in 1975, hit a trough in 1981 and peaked once again in 1985/86. The next trough was effectively reached by 1992, after which the industry experienced very slow growth through the remainder of the decade.

The current drought in premium growth is reminiscent of the soft market of the late 1990s, which presaged some of the worst years in the insurance industry’s history, with combined ratios rising from 102 in 1997 to nearly 116 in 2001. Fortunately, with an expected combined ratio of 93.8 in 2007 and 97.3 in 2008, the comparison—at least so far—appears to be superficial, or at least premature.   

Underwriting Performance: Resilience in the Face of Slowing Growth

The P/C insurance industry’s underwriting results in 2007 remained extraordinarily strong by historical standards. The nine-month combined ratio of 93.8, should it hold for the remainder of 2007, would be among the 12 best since 1920. Last year’s combined ratio of 92.5 was the best since 1949 and ranks as the sixth best result since 1920. The first half combined ratio is up just 1.3 points from the calendar year 2006 figure, though it is up 2.3 points from the first nine months of 2006. The current period of sustained underwriting profits (2004, 2006, 2007 and possibly 2008) is the first in a half century.

It should be noted that while premium growth is below expectations in 2007, the combined ratio estimate of 93.8 from the I.I.I.’s Earlybird survey (coincidentally identical to this year’s nine-month actual result) is materially better than the 97.6 figure predicted a year ago and is up only marginally from the 92.5 combined ratio recorded in 2006. The implication is that the industry’s underwriting performance has not deteriorated as quickly as many had anticipated. Consequently, many insurers delivered strong earnings during the year powered in large part by healthy underwriting profits. Underwriting profits through the first nine months totaled $18.1 billion after policyholder dividends, implying a full-year underwriting profit of $24.2 billion on an annualized basis, which would be the second largest underwriting profit on record after the $31.7 billion earned in 2006. Wall Street has noticed the strong performance. P/C insurer stocks were up 7.1 percent through December 14 (on a market capitalization weighted basis), more than double the 3.5 percent gain of the Standard & Poor’s 500 index over the same period.

Although top line growth has slowed to a standstill, profits (measured in dollar terms) and profitability (as measured by return on equity, or ROE) remain healthy due to a variety of factors including strong across-the-board underwriting results and lower-than-expected catastrophe losses. Net income after taxes (profits) will likely finish the year in the $60 to $65 billion range, roughly unchanged from the $63.7 billion earned in 2006. Another factor contributing to current profitability is investment earnings, which at $47.7 billion through the first nine months, could exceed $60 billion in 2007.

While the survey results indicate fundamentally sound underwriting performances in 2007 and 2008, the anticipated 3.5 point deterioration in the combined ratio over the next year is another indicator of slimmer profit margins in the years ahead. A surge in catastrophe losses could easily push the industry combined ratio to 100 or beyond, too high to generate returns that are competitive with the Fortune 500 group. A combined ratio of 100 means that insurers are paying out exactly the same amount in claims and associated expenses that they earn in premiums. As a stern reminder of the importance of generating substantial underwriting profits in the current low (and getting lower) interest rate environment, the 100.7 combined ratio in 2005 produced an ROE of just 9.4 percent. The virtually identical combined ratio in 1979 of 100.6 contributed to a 15.5 percent return that year, in large part due to much higher interest rates during the late 1970s. The anticipated underwriting profits in 2008 will help insurers earn their cost of capital (the rate of return necessary to retain and attract capital) for just the third time in many years even though industry profitability as a whole—with an expected ROE in the 11 to 12 percent range—will still likely fall short of the Fortune 500 group for the twenty-first consecutive year (every year since 1987). There are, of course, many individual insurers who were able to meet or exceed the Fortune 500 in 2007 and are likely to do so once again in 2008.

Though up substantially in 2006 and (so far) in 2007, insurer profits remain highly volatile. Just six years ago, in 2001, insurers suffered their worst year ever with negative profits for the year. Considering the tremendous risk assumed by investors who back major insurance and reinsurance companies, the returns in most years are woefully inadequate. It is clear that Fortune 500-level ROEs in the neighborhood of 13 to 15 percent cannot be generated consistently going forward without a substantial contribution from underwriting, given the low (and getting lower) interest rate situation going forward and continued stock market volatility. ISO estimates that P/C insurers would needed to generate a combined ratio of 92.6 though the first nine months of 2007 in order to earn a rate of return equal to that of the long-term average for the Fortune 500 group of 13.9 percent, 1.2 points better than the actual result of 93.8.

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.  

Summary

The strong financial and underwriting performance of the P/C insurance industry during the first nine months of 2007 bodes well for the remainder of the year and creates unexpectedly strong momentum for the first part of 2008. The results are primarily attributable to a strong, across-the-board underwriting performance, resulting in one of the best combined ratios in decades. Deteriorating underwriting performance, primarily the result of increasing price competition, will likely lead to a greater share of earnings coming from investment gains going forward—a shift that has already clearly begun.

One major cause for concern is the fact that zero premium growth through the first three quarter of 2007 means that the industry growth has come to a screeching halt and is, in fact, severely 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. To date, insurers have sought to reduce capital primarily through share repurchases. A spate of acquisitions in late 2007 suggests, however, that the pace of consolidation could accelerate in 2008.

A detailed industry income statement for the first nine months of 2007 follows:

Nine-Month 2007 Financial Results*

($ Billions)

  $
Net Earned Premiums $323.3
Incurred Losses (Including loss adjustment expenses) 219.6
Expenses 90.4
Policyholder Dividends 1.2
Net Underwriting Gain (Loss) 18.1
Investment Income 39.5
Other Items -1
Pre-Tax Operating Gain 55.6
Realized Capital Gains (Losses) 8.2
Pre-Tax Income 63.8
Taxes -15.4
Net After-Tax Income $49.4
Surplus (End of Period) $521.8
Combined Ratio 93.8

 *Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.

 

 

 

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