2011 - First Half Results
October 7, 2011
The first six months of 2011 have been remarkably violent in terms of catastrophes on a global scale. Megacastastrophes worldwide caused $260 billion in economic losses, surpassing the full-year of record, approximately $55 billion of which was insured—four times the average over the prior decade. In the United States at least $30 billion in economic losses, $19.7billion of which was insured, helped depress the property/casualty (P/C) insurance industry annualized statutory rate of return on average surplus to 1.7 percent during the first half of 2011, down from 6.4 percent from the first half of 2010 and 6.5 percent for all of last year. Profitability receded despite a surprising $1.1 billion or 4.5 percent improvement in investment earnings during the half and a respectable 2.6 percent increase in net premiums written, the strongest first half result since 2006. Perhaps most surprising of all is the fact that that capacity in the U.S. P/C insurance industry ended the catastrophe-wracked, bearish quarter virtually unchanged—down just 1 percent—from the record set just three months earlier. Overall net income after taxes (profits) for the first half plunged by 71.6 percent to $4.8 billion from $16.8 billion in first half of 2010. Indeed, net income through June 30 is actually $3 billion lower than it was as of March 31, largely due to outsized catastrophe losses in April and May. However, some $3billion to $5 billion in loss and loss adjustment expense—almost certainly a record—did wind up on the books of U.S. insurers that cover, reinsure or otherwise assume risk from catastrophic events abroad, including the March 11 Japanese earthquake and tsunami, the February 22 New Zealand earthquake, and severe flooding in Australia in January and February. Hurricane Irene, which caused an estimated $3 billion to $4 billion in insured losses during the third quarter, along with a slew of other catastrophes, will likely push the year-to-date tally above the $25 billion mark. Indeed, through September 30, the federal government issued a record 86 disaster declarations.
In one of the more positive developments for the industry since the end of the financial crisis, premium growth appears to be on a sustained upward trajectory, rising for five consecutive quarters. Although growth remains anemic at just 1.6 percent during the second quarter (2.6 percent in the first half), the very fact that the growth is sustained confirms that the era of mass exposure destruction in the property/casualty insurance industry is now over, with demand for insurance having stabilized and, in fact, growing (albeit slowly) in the aftermath of the “Great Recession.” Underwriting losses, however, skyrocketed during the first half, with the combined ratio for the half rising to 109.4, after excluding mortgage and financial guaranty insurers (110.5 including them), compared to 100.2 a year earlier.
The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Policyholders’ Surplus (Capital/Capacity): Barely Dented Despite Catastrophes
Policyholders’ surplus totaled $559.1 billion as of June 30, 2011, the second highest figure in P/C insurance history. Policyholders’ surplus did decline during the quarter, as expected, but fell by just 1.0 percent or $5.6 billion from the all-time record of $564.7 as of March 31, 2011. The June 30 figure remains 0.4 percent or $2.2 billion above the $556.9 billion in surplus at year-end 2010 (itself a record at the time). While a decline in surplus was all but assured during the second quarter due to high catastrophe losses and poor equity market performance, the small magnitude of the decline is surprising.
One outstanding question is whether the drop in the second quarter is a singular and temporary occurrence caused chiefly by surging catastrophe losses, or whether it is the beginning of a sequence of declines whereby excess capital is expunged from property/casualty insurer balance sheets as core (non-cat) underwriting losses mount and the ability to release prior-year reserves into the earnings stream diminishes. Historically, the latter has presaged a firming of markets whereas the former would suggest that weak market conditions could potentially linger into and possibly through 2012.
The record $559.1 billion in surplus as of June 30, 2011, exceeds the pre-crisis high of $521.8 billion set during the third quarter of 2007 by 7.1 percent—a difference of $37.3 billion. Irrespective of the prospect of further shrinkage in policyholders’ surplus in 2011 following a first-quarter peak, the bottom line is that the industry is and will remain extremely well capitalized and financially prepared to pay very large scale losses, as necessary. One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.78, close to its strongest level in modern history.
THE BOTTOM LINE RECOVERY: 2011 IS A SETBACK
Profit Recovery: Shifting into Reverse?
Ever since plunging by 96 percent during the height of the global financial crisis, net income after taxes (profit) has rebounded fairly steadily and robustly as asset prices recovered, underlying claim frequency and severity trends remained relatively subdued and the release of prior year reserves bolstered the bottom line.
Through the first half of 2011, however, these three factors seem less capable of turbocharging the bottom line than in the recent past. Higher catastrophe losses provided another stiff headwind. As noted earlier, the P/C insurance industry reported an annualized statutory rate of return on average surplus of 1.7 percent during the first half of 2011 (2.3 percent after excluding mortgage and financial guaranty insurers), down from 6.4 percent from the year earlier half and 6.5 percent for all of 2010. Overall net income after taxes (profits) for the half plummeted by 71.6 percent or $12.0 billion to $4.8 billion from $16.8 billion in first half 2010.
While catastrophe losses were the dominant factor adversely impacting profits in the first half, the reduction in prior-year reserve releases also played a role. Indeed, billions in profits over the past several years were actually the result of downward revisions in the estimated ultimate cost of claims occurring in years past. During the first half, prior-year reserve releases fell to $7.3 billion from $9.1 in first-half 2010, a decline of 19.8 percent. The contribution to the bottom line from prior-year reserve releases is expected to continue to decline as the pool of redundant reserves diminishes over time, pushing the combined ratio up. This dynamic will contribute to higher underwriting losses in the future and eventually exert pressure on rates.
Of course, a firming in the pricing environment would help the bottom line on a sustained basis. While pricing in personal lines (which account for approximately half of all premiums written) has been trending positive for several years, commercial lineshad remained in negative territory since 2004. According to the Council of Insurance Agents and Brokers (CIAB), however, the average commercial rate change in the second quarter of 2011 was basically flat for the first time in more than seven years, down just 0.1 percent. This is marked improvement over the 6.4 percent decline noted in the same quarter of 2010. The CIAB survey indicates that commercial renewals have been negative for an astonishing 30 consecutive quarters—dating all the way back to the first quarter of 2004. The overall commercial lines price level today is equivalent to where it was in late 2000. In other words, the cost of insurance sold to businesses today is basically the same as it was more than a decade ago.
Top Line Growth Surprises to the Upside
Net written premiums were up 2.6 percent in first-half 2011. While the current tepid rate does not portend imminent hard market conditions, the improvement is evidence that commercial insurance renewals are no longer uniformly negative and that the property/casualty insurance industry is benefiting even from the miserably slow growth in the American economy, which is translating into a trickle of additional insurable exposures. On a quarterly basis, premium growth has been positive since the second quarter of 2010, placing the industry on a favorable growth trajectory for the remainder of 2011 despite the recent “soft patch” in economic growth.
Deconstructing the first half premium growth of 2.6 percent reveals several interesting trends. Personal lines net premiums written were up 2.7 percent during the first half (down from +3.5 percent growth in first-half 2010) while commercial lines insurers saw growth of 2.9 percent (up from a 3.1 percent decline a year earlier). Insurers with a more diversified book of business experienced growth of 2.2 percent during the first half of this year, up from 1.7 in the first half of 2010.
While any growth is welcome after three years of decline (2007–2009) and anemic growth (+0.9 percent) in 2010, the first-half figures are undeniably a welcome respite and hopefully a positive omen. Premiums in 2010 were held back in part by continued soft market conditions, primarily in commercial lines, which continued to grip the industry for a seventh consecutive year. The economy was also a factor (details below), though the massive exposure losses that plagued the industry in 2008 and 2009 are much less of a factor today. Indeed, the era of “mass exposure destruction” is over as the economy continues to recover—albeit weakly and unevenly. Although the nation’s real (i.e., inflation adjusted) gross domestic product (GDP) actually began to expand during the second half of 2009 and further expanded, by 2.9 percent, in 2010, growth in P/C insurance exposure usually lags behind economic growth by a year or more. This is because the early stages of economic recoveries are always led by productivity gains rather than additions to fixed investment (e.g., plants, equipment) or hiring (which would add to payrolls).
Despite extreme economic pessimism through much of 2010 and the first half of 2011, the economy has so far avoided a much feared “double-dip” recession. Although real GDP growth came in at a disappointing 1.3 percent during the second quarter (on the heels of an even worse 0.4 percent figure in the first quarter), economic growth is expected to rise to about 2 percent in the second half of 2011, according to Blue Chip Economic Indicators.
As discussed in the previous section, softness in commercial insurance pricing remains a persistent, though somewhat less severe, problem for insurers. Lingering economic weakness also remains a problem, restraining the demand for many types of insurance. However, lines such as workers compensation have benefited from the fact that the economy has added 2.6 million private sector workers from January 2010 through August 2011, adding tens of billions of dollars in payroll, which is the exposure base for this large and compulsory line of coverage.
Investment Performance: Muddling Along
Net investment gains (which include investment income plus realized capital gains and losses) were up by $2.6 billion (10.0 percent) in first-half 2011 to $28.4 billion, from $25.8 billion in first-half 2010.
Net Investment Income
Net investment income during the first half of 2011 was $24.8 billion, compared to $23.6 billion in the first half of 2010. Most of this comes from the industry’s bond investments, which are mainly high quality corporates and municipals. Yields on investments in corporate bonds made in the first half of 2011 ranged from 4.9 percent to 5.3 percent, based on Moody’s Seasoned AAA averages. These yields were generally lower than those of older bonds being rolled over, constraining overall net investment income.
The forces that affected interest rates in the first half of 2011 are the same ones that have been at work for the past few years: unused capacity (in both capital resources and high unemployment), slack in the economy and low near-term future expectations leading to an unwillingness to lend/borrow and invest, and Federal Reserve actions to keep both short-term and longer-term interest rates low, all of which contributed to low inflation expectations. Yields on the benchmark 10-Year U.S. Treasury note began the year at 3.36 percent, rose in February briefly to 3.75 percent, then slid fairly steadily to 2.9 percent for much of June 2011.
Realized Capital Gains/Losses
Only realized capital gains and losses affect insurer net income; unrealized capital gains and losses affect policyholders’ surplus. Realized capital gains from the first half of 2011 were $3.6 billion, compared to $2.2 billion in the first half of 2010.
As in the past, the downtrend in interest rates that constrains investment income pushed asset values of older bonds up, providing opportunities for capital gains on those bonds.
Although stock market investments are a modest portion of the invested assets of most insurers (typically in the 10-20 percent range), low returns so far in 2011 are a concern for insurers. The S&P 500 Index, which was up by 5.42 percent through the first quarter, was down 0.39 percent in the second quarter, so that most of the realized capital gains were taken in the first quarter. The S&P 500 fell an additional 12.1 percent in the third quarter.
The property/casualty insurance industry turned in a weak performance during the first half of 2011. Although profitability slumped amid high catastrophe losses, premium growth remained positive, investment earnings were more robust than anticipated and policyholders’ surplus remained near its all-time record high. The outlook for the remainder of the year is a cautious one given continued high third-quarter catastrophe losses, the prospect of high underwriting losses associated with non-cat losses and more uncertainty in the investment markets.
Fundamentally, the property/casualty insurance industry remains quite strong financially, with capital adequacy ratios remaining high relative to long-term historical averages.
A detailed industry income statement for the first half of 2011 follows.
FIRST HALF 2011 FINANCIAL RESULTS*