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2016 - Commentary on first quarter financial results
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Highlights
For the first quarter of 2016, we have good news and bad news. The good news: the property/ casualty insurance industry was profitable and growing in the first quarter of 2016. The bad news is that it was less profitable and growing more slowly in 2016:Q1 than in 2015:Q1.
In the six years since the end of the Great Recession (2010-2015), the first-quarter benchmark for profitability in the property/casualty insurance industry is the first quarter of 2015, when net income after taxes reached $18.1 billion. Profits in the first quarter of 2016, at $13.3 billion, did not reach that lofty mark, thanks in part to a 6.3 percent rise in incurred claims and adjustment expenses—especially claims from catastrophes--little growth in the U.S. economy, and continuing historically low interest rates. In relation to net worth, the industry annualized rate of return on average surplus was a moderate 7.8 percent, down from 10.8 percent for the first quarter of 2015.
Both the insurance and the investment functions contributed to industry profitability. The combined ratio (basically claims and expenses as a percent of premiums) was 97.5 in the first quarter of 2016. Even though this deteriorated from 95.7 in the first quarter of 2015, it still represents profitable underwriting operations. The investment function provided gains of $13.2 billion in 2016:Q1, down from $16.3 billion in the comparable quarter in 2015.
The industry results were released by ISO, a Verisk Analytics company, and the Property Casualty Insurers Association of America (PCI).
Performance Drivers: The Usual Suspects
Overall, the industry’s performance for the first quarter of 2016 was positive. A discussion of the key drivers of the quarter’s performance follows.
Premium Growth: Top Line Growth Continues
Net written premium volume in the first quarter of 2016, at $130.1 billion, grew by 3.2 percent over premium volume in the first quarter of 2015. This is slower than the 3.8 percent net written premium growth in 2015:Q1 and notably below the 4-plus percent growth rate of recent quarters, but it is the 24th consecutive quarter of year-over-year premium growth—a streak that began in the second quarter of 2010, when the economy was barely beginning its recovery from the Great Recession.
There are two main drivers of premium growth in the property/casualty insurance industry: exposure growth and rate. Exposure growth—basically an increase in the number and/or value of insurable interests (such as property and liability risks)—is driven mainly by economic growth and development. But growth in both the U.S. economy and the broader global economy is slowing, which clearly is affecting the growth of the P/C industry.
The traditional measure of economic growth has been the quarterly seasonally adjusted real (inflation-adjusted) Gross Domestic Product (GDP) expressed at an annual rate. Economic growth in the U.S. in the first quarter of 2016 was slight: nominal annualized GDP growth was 3.3 percent. However, two-thirds of that is attributable to inflation; real (that is, inflation-adjusted) GDP in 2016:Q1 rose at an annual rate of 1.1 percent.
Recently some economists have questioned the accuracy of the GDP measurement and instead turned to Gross Domestic Income (GDI) which, in concept, measures the same thing from a different viewpoint. Real GDI in the first quarter of 2016 grew at a seasonally adjusted annual rate of 2.9 percent. Whichever is the more accurate measure, economists expect the economy to grow at a slow rate for the rest of 2016. For the full-year 2016, most forecasts currently see nominal GDP growth (not inflation-adjusted) ranging between 3.0 percent and 3.5 percent, and real GDP forecasts range from 1.7 percent to 2.1 percent.
The industry benefitted from exposure growth in key areas of the economy such as new vehicle sales and construction, but employment and payroll growth shifted to a headwind from what had previously been a tailwind. The U.S. economy added about 587,000 nonfarm jobs in the first quarter of 2016; that rate is slightly better than in 2015:Q1 but considerably below the strong first quarter employment gains in 2012, 2013 and 2014. With the “headline” unemployment rate at 4.7 percent in May, some economists say the economy is close to full employment, although there are other signs that there is still slack in the labor market. For example, if we are at full employment, we would expect to see across-the-board above-inflation-level increases in wages, but that has not been the case. Wages have been rising, but only at or barely above the rate of inflation. Still, with more people working and rising wages, payrolls are expected to continue growing, resulting in rising new premiums written by workers compensation insurers in 2016.
The other important determinant in industry premium growth is rate activity. Rates tend to be driven by trends in claims costs, conditions in the reinsurance market, marketing and distribution costs, and productivity from investments in technology, among other factors. Although it is challenging to foresee the interplay of all of these elements as well as macroeconomic factors, it is certainly possible that, if the first quarter increase in loss costs noted below persists, overall industry growth in net written premiums could keep pace with overall economic growth in 2015.
Besides continued growth in workers compensation premiums, continued growth in premiums related to residential construction is likely. The number of starts of constructed housing units continues to rise each year and, although it has not reached the level attained before the advent of the housing “bubble,” is forecast to continue growing as the millennial generation ages toward the traditional house-buying ages.
Underwriting Performance
Underwriting performance in the first quarter of 2016 was more like 2014:Q1 than 2015:Q1. Net underwriting gains in 2016:Q1 were $2.2 billion, compared to $4.1 billion in 2015:Q1 and $2.4 billion in 2014:Q1.
There are two main drivers of underwriting performance: losses and loss-adjustment expenses, and other underwriting expenses. Losses and loss adjustment expenses grew by $5.2 billion (+6.3 percent) to $87.1 billion—roughly twice as fast as premium growth. Expense growth (at 2.9 percent), on the other hand, was slightly below the premium growth rate.
Underwriting performance in the first quarter of 2016 would have been even better but for catastrophe losses that were higher than last year. ISO/PCI estimates that 2016:Q1 catastrophe losses were $4.9 billion, compared to 2015:Q1 catastrophe losses of $3.4 billion (and $3.2 billion in 2014:Q1). Net losses for non-cat claims also rose by $3.7 billion to $82.2 billion from $78.5 billion.
Reserve releases are generally associated with new estimates of expected costs for claims occurring in past years. Overall inflation continues to be remarkably low, likely contributing to these lower estimates, although prices for some items that comprise claims payouts have been increasing at higher rates. For the first quarter of 2016, the industry reported releases of prior year claims reserves totaling $4.4 billion, compared to releases of $5.7 billion in 2015:Q1, and $5.4 billion released in 2014:Q1.
Driven by the increase in losses and loss-adjustment expenses, but offset to a degree by continuing reserve releases, the industry’s combined ratio for the 2016 first quarter deteriorated to 97.5 from 95.7 in 2015:Q1.
Combined ratios for the major sectors of the industry moved differently. For insurers writing predominantly personal lines, the combined ratio worsened by 3.2 percentage points to 100.8 percent. For those writing mainly commercial lines (excluding mortgage and financial guaranty insurers), the combined ratio improved 0.4 percentage points to 94.3. And those writing balanced books of business posted combined ratios of 96.3 (0.3 percentage points better than in the year-earlier quarter).
Investment Performance: Improvement In Capital Gains And Investment Income
For the first quarter of 2015, net investment gains (which include net investment income plus realized capital gains and losses) were $13.2 billion vs. $16.3 billion in 2015:Q1. The $16.4 billion in net investment gains last year was a record in this category for first calendar quarters, at least since 1986.
In measuring insurance company net investment gains, accounting rules recognize two components: (i) net investment income; and (ii) realized capital gains or losses. Unrealized capital gains or losses are not considered income and affect only surplus on the balance sheet.
Net Investment Income In 2016:Q1
Net investment income itself has basically two elements: interest payments from bonds and dividends from stock. The industry’s net investment income for the first quarter of 2016 was $10.9 billion, down from $11.7 billion in the first quarter of 2015. Most of this income comes from the industry’s bond investments, which are mainly high quality corporates and municipals.
Corporate bond market yields in the first quarter of 2016, as captured by Moody’s AAA-rated seasoned bond index, averaged 3.8 percent, compared to 3.6 percent in the first quarter of 2015. This reflects persistently low (but slightly rising) inflation, weak economic growth and a growing belief that the Federal Reserve Board would hold down short-term interest rates longer into 2016 than was previously anticipated. These lower yields continued to shave income off the industry’s bond portfolio despite its growing size.
Although the U.S. economy is improving slowly, it still is beset by the same forces that have held interest rates down since the Great Recession ended (officially, in June 2009): unused capacity (in both capital resources and some slack in the labor market); cautious consumer and business spending; low near-term future expectations for the economy; and Federal Reserve actions to keep short-term interest rates low. All of these factors contributed to low inflation expectations (and thus, low nominal bond yields).
The other significant source of net investment income (besides bond yields) is stock dividends. Stock dividends have been quite steady lately. Seasonally adjusted, net dividends in the first quarter of 2016 rose by 2.3 percent over the same quarter in 2015.This is about the same rate of growth of net dividends in 2015:Q1 over 2014:Q1. Stock holdings in general represent roughly only about one-sixth of the industry’s invested assets.
Policyholders’ Surplus (Capital/Capacity): Still Exceptionally Strong
Policyholders’ surplus as of March 31, 2016 rose to $676.3 billion, up from $671.9 billion at the end of the first quarter of 2015 (+0.7 percent). According to ISO, a Verisk Analytics company, and PCI, this surplus level is a record for the industry.
Surplus would have been even higher but for $2.1 billion in unrealized capital losses in 2016:Q1. Still, this is an improvement from the same quarter in 2015, when industry balance sheets posted $6.2 billion in unrealized capital losses. Although this was not the only factor affecting surplus, it was an important one.
One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.77, close to its strongest level in modern history. The bottom line is that the industry is extremely well capitalized and financially prepared, if necessary, to pay very large scale losses in 2016 and beyond.
Summary
The property/casualty insurance industry turned in a profitable performance in the first quarter of 2016. In addition, policyholders’ surplus hit a new record high. Despite a considerable rise in claims, weak economic growth and persistently low interest rates, the industry posted another profitable quarter aided by capital gains and reserve releases. Premium growth, while still modest, is now experiencing its longest sustained period of gains in a decade.
Fundamentally, the P/C insurance industry remains quite strong financially, with capital adequacy ratios remaining high relative to long-term historical averages.
To view the full report from ISO and PCI, click here.
A detailed industry income statement for the first quarter of 2016 follows.