MEMBERSHIP
AMPLIFY
EN ESPAÑOL
Connect With Us
- Popular search terms
- Automobile
- Home + Renters
- Claims
- Fraud
- Hurricane
- Popular Topics
- Automobile
- Home + Renters
- The Basics
- Disaster + Preparation
- Life Insurance
June 24, 2008
By Dr. Robert P. Hartwig, CPCU
President
Insurance Information Institute bobh@iii.org
The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 6.4 percent during the first quarter of 2008, down by more than half from 13.2 percent during the first quarter of 2007 and by nearly half from the 12.3 percent return for all of 2007. The sharp decline in profitability is primarily attributable to a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the property/casualty insurance industry. The decline in profitability was led by a substantial deterioration in underwriting performance in those two segments, pushing the first quarter combined ratio up to 99.9, more than 8 points above the 91.7 combined ratio for the same quarter last year and 4.3 points above the 95.6 combined ratio for full-year 2007. Excluding mortgage and financial guarantee insurers reveals declines of a more modest and cyclical nature, with return on average surplus coming in at 9.5 percent. Net written premium growth, which turned negative in 2007 for the first time since 1943 (down 0.6 percent), continued on its negative trajectory, falling 0.9 percent (-0.7 percent excluding mortgage and financial guarantee insurers). Policyholders’ surplus, a measure of capacity, decreased for the second consecutive quarter, down 0.4 percent to $515.6 billion as of March 31 from $517.9 billion at year end 2007. The results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Three key factors drove underwriting performance during the first quarter: the impact of the housing and credit crisis on mortgage and financial guarantee insurers and the resulting spillover into the overall property/casualty insurance industry sector’s financial results; the continuation of soft market conditions through much of the industry, and a surge in catastrophe losses. Each of these factors is discussed in turn below.
The financial performance of the property/casualty insurance industry for 2008 will require more explanation than usual. The credit crisis and ensuing economic downturn combined with falling interest rates, poor equity market conditions, mounting inflationary pressures and resurgent catastrophe losses—all amid a prolonged soft market—mean that each quarter’s results must be examined carefully in order to assess the influences of these factors. Care must be taken to avoid overgeneralizations as the mix and intensity of factors influencing any one sector of the industry or any specific insurer will vary.
The first quarter’s underwriting performance was influenced primarily by significant underwriting losses reported by many mortgage and financial guarantee insurers. While it is not unusual for results in any given quarter to be driven by the experience in a small number of lines or by a specific event (such as home and commercial property coverage after a major catastrophe), it is rare for lines that account for just a sliver of industry premiums to produce large-scale impacts on industry performance. The mortgage and financial guarantee lines—with $2.2 billion in net written premiums during the first quarter—accounted for just 2 percent of the $110.5 billion industrywide total. Nevertheless, according to ISO, this segment’s loss and loss adjustment expenses ballooned to $5 billion—an increase of 570.3 percent—propelling its combined ratio to an unprecedented 266.6 for the quarter compared to 69.6 during the first quarter of 2007. That was enough to add 3.2 points to the industrywide combined ratio, which finished the quarter at 99.9—its highest level in six years.
The second most important factor influencing first quarter underwriting performance was the continuation of the soft market, now in its fourth year. As previously discussed, stripping out the mortgage and financial guarantee insurer results yields a combined ratio of 96.7, up from 92.1 in first quarter 2007 and 95.6 for all of 2007. The deterioration is generally in line with expectations and reflects the effects of a sustained, highly competitive pricing environment for most types of insurance, particularly commercial lines, as well as adverse claim frequency and/or severity trends in some key lines. According to the Council of Insurance Agents and Brokers, commercial renewals for larger brokered accounts were down 13.5 percent during the first quarter. Of course, actual changes experienced by individual insurers can vary substantially and few commercial insurers are actually reporting premium declines of this magnitude. In contrast, pricing in personal auto insurance, which accounts for one-third of industry premiums, appeared to become somewhat more aggressive during the first quarter. According to the US Bureau of Labor Statistics, auto insurance prices averaged 1.1 percent higher during the first quarter of 2008 compared with the first quarter 2007. This compares to an increase of 0.4 percent for all of 2007 relative to 2006. The pace of increase appears to be quickening. Through the first five months of 2008, auto insurance prices averaged 1.5 percent higher than during the same period one year earlier. Pressure on auto insurance rates is driven primarily by rising claim cost severity (average cost per claim) and increasing claim frequency in some coverages in some states. The increases are still well below the general rate of inflation as measured by the Consumer Price Index, which approached a 4 percent annual rate of growth during the first quarter. The issue of rising gas prices and its impact on driving and claim frequency and costs will be discussed below.
Net written premiums declined by 0.7 percent during the quarter. Excluding mortgage and financial guarantee insurers produces a net decline of 0.9 percent. The premium decline is larger excluding mortgage and financial guarantee insurers because of that segment’s 10 percent increase in premiums written during the quarter. The overall decline comes on the heels of a 0.6 percent decline in calendar year 2007. Last year’s decline was the first in 64 years, when premium growth fell in 1943 in the midst of World War II.
As noted by ISO, insured catastrophe losses reached $3.4 billion during the first quarter, their highest level for any first quarter since 1994, when losses from the Northridge earthquake topped $14.5 billion. The losses have continued apace through the second quarter. As of June 24, insurers had sustained an additional $5.5 billion in catastrophe losses, putting the year-to-date total at $8.9 billion—$2.2 billion more than insurers paid for all catastrophes through the entirety of 2007 and just $300 million short of the $9.2 billion in catastrophe losses recorded in 2006. Catastrophe losses during the first half of 2008 are being fueled by record-breaking tornado activity, severe hail and wind losses (apart from tornadoes). During the second quarter, the Midwest suffered its most severe floods since 1993—which cost private insurers $600 million. While flooding is not covered under standard home insurance policies, private insurers do cover flooded motor vehicles (provided the policyholder carries comprehensive coverage) and some businesses do purchase protection on commercial structures as well as business interruption and contingent business interruption losses in some cases. Private crop insurance is also commonly purchased, and losses are expected to be the most significant since 1993, according to National Crop Insurance Services, a trade association representing crop insurers. At the same time, several unique features of crop insurance will limit losses, including a significant amount of federal government reinsurance that caps losses beyond specified loss ratios, offsets to revenue losses sustained by farmers due to high crop prices, and large deductibles (e.g., 25 percent). It is important to note that crop (agricultural) losses are not included in the official catastrophe figures compiled by ISO’s PCS unit.
The first quarter was a very volatile one for investment markets, which were roiled by waves of bad news about credit markets, skyrocketing oil prices and economic weakness. The Standard & Poor’s 500 Index lost 9.7 percent during the quarter (and 10.2 percent through June 23). Approximately 17 percent of p/c insurer invested assets are equities (stocks) while two-thirds are bonds. Bonds, of course, are sensitive to interest rates. The Federal Reserve cut its key federal funds rate on four occasions during the quarter, including twice by 3/4 of a point—the first 75 basis point cut by the Fed since November 1994. By quarter’s end the fed funds rate stood at 2.00 percent compared with 4.25 percent on January 1.
The upshot of the volatility, according to ISO and PCI, is that the industry’s total investment gain slipped by 18.8 percent or $2.8 billion to $12.2 billion from $15 billion during the first quarter of 2007. Investment gains consist primarily of interest earned from the industry’s bond portfolio as well as realized capital gains and losses from investments, especially stocks. Contributing to the decline was a $0.5 billion realized capital loss compared to a $2.1 billion gain during the same quarter last year. Insurers realized $9.0 billion in investment for all of 2007. It is far too soon to estimate realized investment gains or losses for the full year. Markets remain volatile and capital gains (and losses) are realized at the discretion of management. The last time insurers turned in an industrywide realized capital loss for a calendar year was 2002.
Strong profits over the past several years gave insurers the opportunity to make significant reinvestments in the industry. Profits bolster the industry’s policyholders’ surplus—a measure of claims-paying capacity or capital—and provide an additional buffer against the mega-catastrophes that lie ahead. The improved capital position also helped 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. Recent turbulence in the financial markets is another reminder of the importance of healthy profits. Insurers must maintain the financial resources to pay record size mega-catastrophe claims no matter how low interest rates fall or how far or fast stock markets plunge.
Net income after taxes (profits) during the first quarter fell $8.0 billion or 49.4 percent during the first quarter of 2008 from $16.2 billion during 2007’s first quarter. The decline is attributable to the previously discussed deterioration in underwriting and investment performance. The net income figure is not adjusted for the impacts of mortgage and financial guarantee insurers.
Because profits fell more quickly than policyholders’ surplus, return on average surplus declined to 6.4 percent during the first quarter, down from 13.2 percent during the same period one year earlier and 12.3 percent for all of 2007. Excluding mortgage and financial guarantee insurers yields a return on average surplus of 9.5 percent.
Policyholders’ surplus decreased in the first quarter by $2.3 billion, or 0.4 percent, to $515.6 billion from $517.9 billion at year-end 2007. The decline is the second consecutive quarterly drop in policyholders’ surplus, which recently peaked at $521.8 billion during the third quarter of 2007. Surplus increased by 6.2 percent in 2007, 14.3 percent in 2006, 8.2 percent in 2005, 13.4 percent in 2004 and 21.6 percent in 2003, following declines in 2000, 2001 and 2002. The return to negative capital accumulation is attributable to several causes, the largest and most obvious being declining prices for financial assets. As mentioned previously, the industry swung from a position of $2.1 billion in unrealized capital gains in 2007’s first quarter to a $0.5 billion unrealized capital loss in the first quarter of 2008, according to ISO/PCI. Some insurers also continue to return capital to shareholders through dividends and share buybacks. Share buybacks reached a record $23.2 billion in 2007.
The credit crunch that began with the subprime mortgage meltdown in mid-2007 has precipitated a broader economic crisis in the United States (and abroad) that has challenged every industry in ways that were not foreseen a year ago—insurers included. While the economy may have averted sinking into an official recession during the first half of 2008 (defined as two consecutive quarters of negative real GDP growth), a steady stream of bad economic news, from slumping home prices and sales to record oil prices to rising unemployment have begun to take their toll on the wallets and confidence of consumers and the businesses that depend on them. Some of the key impacts of the economic downturn for insurers are reviewed in the sections below.
The reality is that throughout its nearly 200 year history in the United States, the property-casualty insurance industry has endured every conceivable economic circumstance and crisis and managed to persevere. Financial panics, deep recessions and war plagued the country throughout the nineteenth century and well into the first half of the twentieth. Since then inflation, stagflation, stock market bubbles and gyrating interest rates have made their presence known, but ultimately insurers have managed their way through each of these challenging periods. Experience has demonstrated that insurers, unlike banks, rarely run into deep financial trouble because of poor economic conditions. Instead, it is deficient loss reserves and inadequate pricing that historically account for the lion’s share of insurer impairments.
Has the industry ever experienced the combination of a soft market and recessionary economy? Yes, it has—most recently during the economic downturn of 1990/1991. Over that two year span, premium growth averaged 3.4 percent while return on equity averaged 9.2 percent.
While property/casualty insurers are by no means immune from the effects of the current economic downturn, the impacts in terms of growth and profitability will be somewhat muted. In terms of revenue, property/casualty insurers are distinct from more economically vulnerable sectors such as homebuilders or carmakers. This is because approximately 98 to 99 percent of insurer exposure growth (measured in units) is tied to renewal business. In contrast, 100 percent of a homebuilder’s or car manufacturer’s growth, for example, comes from new business. The relationship between insurance and the overall economy is actually more akin to that of the utility sector or the consumer staples segment. Insurance is, in effect, an economic necessity, not a discretionary purchase. Homes, cars, businesses and workers all need to be insured irrespective of the state of the economy. To be sure, the precipitous 54 percent decline in new home construction from 2.07 million units in 2006 to an estimated 0.96 million units in 2008 will hurt growth prospects for homeowners insurers, but only on the margins. The reality is that the aggregate stock of housing grows by less than two percent annually even in the best of times. Likewise, the 11.2 percent drop in new car and light truck sales from 16.9 million in 2005 to about 15.0 million this year will have little impact on the total number of insured vehicles on the road, as older cars are simply kept on the road a bit longer. Again, the influence is at the margins: slightly fewer cars on the road with somewhat lower average premiums than would otherwise be the case if the economy had not soured. Other marginal impacts include workers compensation, where the combination of rising unemployment (up to 5.5 percent in May) and minimal wage gains will stunt payroll growth (and therefore premium growth) in 2008, as was the case during the last recession in 2001. The economy has already shed 277,000 jobs this year (January through May) compared to total job losses of 2.7 million between January 2001 and August 2003. Despite the job losses over that 32 month period, workers compensation premium growth never declined.
Economic downturns can impact frequency and severity trends in addition to exposure growth. According to the National Council on Compensation Insurance, for example, lost time workplace injury incidence rates declined during each of the past four economic downturns.
Apart from the subprime and credit crises, most of the discussion related to the economy, especially in recent months has centered on record high oil prices and rising inflation. Historically both have had significant impacts on the industry.
Americans have a love affair with the automobile and it takes a lot to keep them from getting behind the wheel. It seems that $4 per gallon of gasoline was the straw that broke the camel’s back for many car owners. As gasoline breached that record price late in the first quarter and into the second, miles driven in the United States began to decline for the first time in 30 years.
In 1973/1974 and again in 1979/1980, oil shocks sent gasoline prices to record highs—if it was available at all. People drove less and consequently were involved in fewer motor vehicle accidents. According to ISO Fast Track data records for the period coincident with the Arab oil embargo of 1973/1974, personal auto claim frequency for collision, property damage liability and bodily injury coverages fell by 7.7 percent, 9.5 percent and 13.3 percent, respectively. After the embargo was lifted and gas prices began to fall, claim frequency rebounded almost immediately, reaching pre-crisis levels within 2 to 3 years.
Claim severity, in contrast, tended to increase after the oil shocks. The reason is that the increase in oil prices drove inflation for most goods and services higher, pushing up repair, replacement and labor costs. Medical costs and ultimately tort costs were also driven higher.
The analogy between the energy price shock today and the 1970s is not a perfect one. Gasoline is available today, whereas that was not always the case during the supply crises of the 1970s. Congress also lowered the speed limit to 55 miles per hour in 1974 as part of the Emergency Highway Energy Conservation Act (authority to regulate speed limits on highways was returned to the states in 1995). The Act contributed to the reduction in accident frequency. No such legislation is currently before Congress.
Economic turbulence has had an impact on the financial and underwriting performance of the P/C insurance industry during the first quarter of 2008. The sharp decline in profitability is primarily attributable to a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the property/casualty insurance industry. Excluding this segment reveals a much more modest decline in profitability more in keeping with the pace normally associated with cyclical downturns. Volatile investment markets also contributed to the decline. One continued cause for concern in 2008 is that premium growth remains in negative territory and is, in fact, severely negative on an inflation-adjusted basis.
Fundamentally, however, the property/casualty insurance industry remains quite strong financially, with policyholders’ surplus close to all-time record highs.
A detailed industry income statement for the first quarter of 2008 follows: