SPECIAL REPORT: Earlybird Forecast 2007

Dr. Robert P. Hartwig, Ph.D., CPCU
Executive Vice President & Chief Economist

December 21, 2006

SURVEY OF ANALYSTS PROJECTS SLOWER P/C PREMIUM GROWTH, BUT UNDERWRITING PROFIT IN 2007

Each year the Insurance Information Institute invites a panel of Wall Street stock analysts and industry professionals to review the prospects for the industry in the year ahead. This year’s survey results indicate that the respite in catastrophe losses in 2006 combined with a strong performance in virtually all other major lines of property/casualty (P/C) insurance will propel the industry to its best underwriting performance since 1955. Analysts expect the industry’s profitability to continue in 2007, albeit with an underwriting performance sufficient to generate a much smaller underwriting profit. However, the poll also shows that analysts uniformly expect premium growth to become even more sluggish in 2007. This apparent paradox of a peak in profits but stalling premium growth is a reminder of the highly cyclical nature of the property/casualty business and the fact that the industry’s financial fortunes are determined by a myriad of factors.

PREMIUM GROWTH: STUCK IN NEUTRAL, BUT INSURANCE BUYERS BENEFIT

The average forecast calls for an increase in net written premiums of just 1.5 percent in 2007, a substantial slowdown from the 2.8 percent estimated for 2006. The 1.5 percent increase in premium growth forecast for 2007 would be the second slowest rate of growth for P/C insurers since 1998, during the depths of the last soft market. It represents a near halving of the estimated figure for 2006. The deceleration in premium growth in 2007 is a direct result of a virtual across-the-board softening in the personal and commercial lines pricing environment, the sole major exception being hurricane-exposed coastal property insurance coverages, as insurers look to charge premiums that are commensurate with the substantial risk assumed.

Premium growth peaked during the most recent cycle at 14.6 percent in 2002 before dropping to 9.8 percent in 2003. It is also worth noting that premium growth in 2006 will come in well below the average analysts’ expectations from a year ago. In last year’s Early Bird survey the consensus estimate was for net written premium growth of 4.7 percent (1).

Buyers of insurance are the unambiguous winners when it comes to reaping the benefits of slowing premium growth. 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 bottom line is that 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 expected to fall 0.5 percent in 2007, the first drop since 1999 (see Auto Insurance Forecast: 2007). Businesses will see declines of 5 percent or more in 2007 across their entire insurance program. Overall, the share of P/C insurance premiums relative to the overall economy will shrink by about 3.5 percent in 2006 and 3.1 percent in 2007.

For insurers, the current premium growth pattern is eerily reminiscent of the soft market of the late 1990s, when the industry recorded growth of 2.9 percent in 1997 and 1.8 percent in 1998. Those years presaged some of the worst years in insurance industry history with combined ratios rising from 102 in 1997 to nearly 116 in 2001. Fortunately, with an expected combined ratio of 97.6 in 2007, the comparison—at least so far—appears to be superficial, or at least premature.

Though top line growth has slowed to a near standstill, profits (measured in dollar terms) and profitability (measured as a return on equity or ROE) are rising due to a variety of factors, including an ebb in catastrophe losses in 2006. The respite in catastrophe losses means that 2006 has been a rebuilding year for insurers who are using the opportunity to restore their claims paying resources and to reinvest in the future of the industry. Indeed, most of the industry’s profits in 2006 will be plowed back into the business. Profits will bolster the industry’s policyholder surplus—a measure of claims paying capacity or capital—and will provide an additional buffer against the mega-catastrophes that lie ahead. An improved capital position also helps 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.

COMBINED RATIO: BEST IN 51 YEARS IN ‘06, STILL STRONG IN ‘07

The combined ratio, which is the ratio of losses and expenses to premiums, for 2007, is projected to be 97.6, a deterioration from an estimated 94.3 in 2006. The 94.3 estimate for 2006, if accurate, would represent the industry’s best underwriting performance since the 94.9 combined ratio recorded 51 years earlier in 1955. If the combined ratio in 2007 comes in under 100 as predicted, it would produce just the third underwriting profit in the property/casualty insurance industry since 1978. The estimate for 2007, of course, assumes another benign year for catastrophe losses. It should be noted, however, that underwriting profits in 2007 will likely fall by approximately 50 percent from 2006 levels. The considerably slimmer margin of underwriting profitability will also be eliminated entirely if CAT losses return to 2004/05 levels.

While the survey results indicate fundamentally sound underwriting performances in 2006 and 2007, the anticipated 3.4 point deterioration in the combined ratio for 2007 begs questions about 2008 and beyond. A similar deterioration in 2008 would leave the industry with a 100 combined ratio, well below what is necessary to generate returns that are competitive with the Fortune 500 group. At that point, the insurers will still be paying out exactly the same amount in claims and associated expenses as it earns in premiums. As a stern reminder of the importance of generating substantial underwriting profits, the 100.7 combined ratio in 2005 produced an ROE of just 10.4 percent. The underwriting profits earned in 2006 will help insurers earn their cost of capital (the rate of return necessary to retain and attract capital) for just the second time in many years, while industry profitability as a whole—with an ROE of about 15 percent—will match that of the Fortune 500 group for the first time since 1987. Though up substantially in 2006, insurer profits remain highly volatile. In fact, just five 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 returns on equity in the neighborhood of 13 to 15 percent cannot be generated consistently without a substantial contribution from underwriting given the murky interest rate situation going forward and continued investment income volatility.

2007: LOOKING GOOD, BUT CHALLENGES LIE AHEAD

What are the biggest potential downside risks for 2007? Still high on the list is exposure to catastrophic loss, which superseded loss of pricing and underwriting discipline as the chief concern in 2005—by far the worst year for catastrophe losses. But the worst is yet to come. With rapid coastal development $40 billion-plus storms are expected to become more common and most in the industry expect a $100 billion CAT year is coming soon.

Analysts’ forecasts for net written premium growth in 2007, which range from 0.4 percent on the low end to just 3.1 percent on the high side, reflect the fact that pricing and underwriting discipline, the industry’s historical nemeses, remain key. Regulators, especially in catastrophe-prone areas, refuse to allow insurers to charge risk-based rates. Most insurers are 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. 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. 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.

Among major external risks, terrorism remains a key concern, despite the two-year extension of the Terrorism Risk Insurance Act signed by President Bush on December 22, 2005. The extension, which has a new expiration date of December 31, 2007, pushed considerably more risk onto private insurers, who have consistently maintained that large-scale terrorism events are not privately insurable. For example, individual company deductibles rose from 15 percent of direct earned premiums in 2005 to 17.5 percent in 2006 and 20 percent in 2007. Likewise, industry aggregate deductibles are raised from $15 billion currently to $25 billion in 2006 and $27.5 billion in 2007. Many insurers now have retentions greater than or equal to their actual 9/11 losses.

Fortunately for insurers, at least some of the momentum built in 2006 will be carried into 2007. That being said, insurers will need to come to grips with a variety of challenges unrelated to catastrophe losses, including increasing price pressure and the slow growth environment that could erode underwriting performance and profitability in the year ahead.

A table containing the estimates and forecasts of the survey participants follows.

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(1) The Insurance Information Institute’s 2006 Early Bird forecast can be accessed at: /media/industry/financials/forecast2006/

(2) The Insurance Information Institute’s Commentary on the six-month results can be accessed at: /media/industry/financials/2006firsthalf/

THE INSURANCE INFORMATION INSTITUTE’S 2007 EARLYBIRD FORECAST