2012 - First Half Results
October 4, 2012
Profitability in the property/casualty insurance industry rebounded during the first half of 2012, propelled chiefly by a sharp drop in catastrophe losses and a marked acceleration in premium growth. According to ISO’s PCS unit, catastrophe losses plunged by 43 percent ($10.6 billion) to $13.8 billion in the first half of this year from $24.4 billion in the first half of 2011—largely the result of a mild winter and diminished tornado activity. The effect: the industry combined ratio fell to 102.2 in the half from 110.5 a year earlier (and 108.2 for full-year 2011) on underwriting losses that shrank by 71 percent to $7.0 billion from $24.1 billion in the first half of 2011. The industry’s bottom line benefited commensurately as overall net income after taxes (profits) surged in the first half by 245.2 percent to $16.4 billion from $4.8 billion in the year earlier period, pushing the industry’s return on average surplus up to 5.9 percent during the first half of 2012, from 1.7 percent in the first half of 2011 (and just 3.5 percent for full-year 2011). Stronger top line growth is also contributing to profitability. Net written premiums were up 3.6 percent in the first half—the best first half performance since 2005—and a full point above the 2.6 percent gain recorded in the year-earlier period. Of course, persistently low interest rates remain a challenge for the industry, with net investment income slipping by $1.1 billion or 4.4 percent during the half. Overall industry capacity remained virtually unchanged from the end of the first quarter to end of the second, off just 0.5 percent from the March 31 record high.
The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Policyholders’ Surplus (Capital/Capacity): Holding Steady
Policyholders’ surplus as of June 30, 2012, stood at $567.8 billion, down 0.5 percent from a record $570.7 as of March 31, 2012, but up $17.5 billion or 3.2 percent from $550.3 billion at year-end 2011. During 2011, policyholders’ surplus actually shrank by 4.6 percent as catastrophes took their toll. The fact that the industry was able to not only fully recoup that loss within a short span of time (six months) and maintain such a strong capital position through the first half of 2012—despite an additional $13.8 billion in catastrophe losses—is further evidence of the property/casualty insurance industry’s remarkable resilience in the face of extreme adversity.
The bottom line is that the industry is, and will remain, extremely well capitalized and financially prepared to pay very large scale losses through the remainder of 2012 and beyond. One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.80, close to its strongest level in modern history.
THE BOTTOM LINE RECOVERY: IS IT SUSTAINABLE?
Ever since plunging by 96 percent during the height of the global financial crisis in 2008, net income after taxes (profit) had been rebounding 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. That was, until Mother Nature got her way in 2011.
So far in 2012, however, Mother Nature has been much less cruel and profits and profitability are once again rebounding as a result. As noted earlier, the P/C insurance industry reported an annualized statutory rate of return on average surplus of 5.9 percent during the first half of the year (6.2 percent after excluding mortgage and financial guaranty insurers), up from 1.7 percent in the first half of 2011 (2.3 percent after excluding mortgage and financial guaranty insurers). Overall net income after taxes (profits) in the first half reached $16.4 billion, up 245.2 percent from $4.8 billion a year earlier.
Looking ahead, catastrophe losses during the third quarter were relatively benign and stock markets surged. Though both developments are highly favorable to the industry, it is impossible to fully anticipate catastrophe loss activity and the investment environment through year’s end. Nevertheless, it is possible that the P/C insurance industry in 2012 could match or even surpass the post-crisis profit peak of $35.2 billion reached in 2010.
While the reduction in catastrophe losses was the dominant factor favorably impacting earnings in the first six months of 2012, the half’s profits were also bolstered by $7.2 billion in favorable prior-year reserve development. Notably, favorable development was down only slightly from $7.3 billion in the first half of 2012—and the addition to earnings is still considerable. 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 2011, prior-year reserve releases actually increased to $11.0 billion from $9.7 in 2010, a gain of 13.4 percent. Despite continued favorable reserve development in the first half of 2012, the contribution to the bottom line from prior-year reserve releases is expected to diminish as the pool of redundant reserves diminishes over time, pushing the combined ratio up. All else being equal, 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, and appears likely to continue that trend through 2012, commercial lines pricing also finally appears to be much firmer than a year ago. According to the Council of Insurance Agents and Brokers (CIAB), the average commercial rate change in the first half of 2012 (obtained by averaging together the first and second quarter results) was +4.4 percent compared with a decline of 1.5 percent in the first half of last year. Gains through the second quarter of 2012 represent the sixth consecutive quarter of positive renewals following 30 consecutive quarters of decline dating back to the start of 2004. Despite recent gains, 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.
It is important to note that the privately insured crop losses associated with the devastating drought throughout much of the nation in 2012 are not yet reflected in the data. These losses will be reflected in the third and fourth quarter financial results reported by insurers.
Top Line Growth Accelerates: P/C Growth Now the Best in Years
Net written premiums were up 3.6 percent though the first half of 2012 compared with 2.6 percent during the same period in 2011. Though growth remains modest, the gain is the best first half result since 2004. The improvement is evidence that personal and commercial insurance renewals are consistently trending positive—and that the property/casualty insurance industry is benefiting even from the frustratingly slow growth in the American economy, which is translating into an increasingly steady stream of additional insurable exposures. On a quarterly basis, net written premiums were up 4.2 percent during the second quarter of 2012, well above the 1.6 percent growth during the same quarter last year. Indeed, second quarter growth was not only the best gain since the end of the financial crisis, it was the best since the fourth quarter of 2006. Premium growth has been positive since the second quarter of 2010 and all indications are that the industry will remain on a modest growth trajectory for the remainder of 2012 and into 2013.
Deconstructing the first half growth of 3.6 percent reveals several interesting trends. Personal lines net premiums written were up 2.9 percent (up from +2.7 percent growth in the first half of 2011). The acceleration reflects both modest increases in rates and the nascent effect of surging new car sales. New car sales will tend to push premium growth upward not only because of an increase in the number of insured vehicles on the road, but because the average premium per vehicle will rise as newer vehicles replace older vehicles. Specifically, owners of new vehicles generally purchase optional coverages such as collision and comprehensive which are often dropped on older models. Auto accounts for approximately 70 percent of personal lines premiums written and one-third of all P/C insurance premiums. Insurers writing predominantly commercial lines (excluding mortgage and financial guaranty insurers) saw growth of 5.6 percent during the first half (double the 2.8 percent growth a year earlier).
Any growth is welcome after three years of decline (2007–2009) and anemic growth (+0.9 percent) in 2010. The figures for 2011 (+3.3 percent)—and thus far in 2012—demonstrate that while growth is likely sustainable through 2012 and possibly several years beyond, the trajectory of growth remains quite modest. Premiums in 2010 and much of 2011 were held back in part by the continued soft market conditions, primarily in commercial lines, which continued to grip the industry through the first half of last year. The economy was also a factor (details below) and remains significant in 2012, though the massive exposure losses that plagued the industry in 2008 and 2009 are much less of a concern 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 3.0 percent, in 2010, the economy grew at a feeble rate of just 1.7 percent in 2011. That weakness continued through the first half of 2012, with GDP growth of just 1.6 percent. In general, 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). As noted above, industry growth now easily exceeds that of the overall economy.
P/C insurers in 2012 continue to see the benefits of exposure growth that began in earnest last year. For example, the value of manufacturing shipments has nearly returned to its pre-crisis peak. Indexes of manufacturing and non-manufacturing activity through September 2012 indicate that expansion was generally continuing, despite economic turmoil in Europe and a slowdown in China. There are also early indications that after years of decline, the construction sector is beginning to show signs of life. Such activity fuels premium growth across many commercial coverages including commercial property, liability, commercial auto and workers compensation. Perhaps most importantly, the private sector created 2.105 million jobs last year, up from 1.423 million in 2010. Through the first six months of 2012, private sector employers added an additional 942,000 workers (and a total of 1,207,000 through August). Overall payrolls, the exposure base for workers compensation insurance, now exceeds its pre-crisis peak. During 2011, the unemployment rate ranged from a high of 9.2 percent in June to a low of 8.5 percent at year’s end. By August 2012, the unemployment—though still high by historical standards—had dropped still further to 8.1 percent.
Despite extreme economic pessimism through much of the past two years, including the past several months of 2012, the economy appears to have successfully avoided a much feared and often discussed “double-dip” recession. Although real GDP growth came in at a disappointing 1.6 during the first half, economic growth is projected to average 1.8 percent in the second half of 2012 and close to 2.0 percent in 2013, according to Blue Chip Economic Indicators.
Importantly, these forecasts assume that the United States in 2013 will not fall off the “fiscal cliff.” The fiscal cliff is a combination of simultaneous sharp tax hikes and federal spending cuts scheduled to take effect January 1, 2013, which, were Congress and the President to fail to agree on a solution, would likely send the economy into recession.
Investment Performance: Investment Gains Shrink
Net investment gains (which include investment income plus realized capital gains and losses) were down by $3.0 billion (-10.6 percent) in first-half 2012 to $25.4 billion, compared to $28.4 billion in first-half 2011.
Net Investment Income
Net investment income during the first half of 2012 was $23.7 billion, compared to $24.8 billion in the first half of 2011. 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 half of 2012 were dismal. Moody’s AAA-rated seasoned bond index yields ranged between 3.77 percent and 3.93 percent in January and February, then rose above 4.0 percent in mid-March. The index yield briefly hit 4.18 percent, then retreated, ending March at 4.04 percent. After April 5 yields dropped below 4.0 percent again and stayed there for the rest of the year’s first half. Yields ranged from 3.87 percent to 3.98 percent during the rest of April and through the first 10 days of May. Then they sank further, mostly to the 3.7 percent area, but touching 3.63 percent on May 16 and again on the last day of May. In June Moody’s AAA-rated seasoned bond index yields ranged from 3.54 percent to 3.71 percent, but were often near the lower end of this range, and ended June at 3.66 percent. 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 2012 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 for the economy, 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.
During the first half yields on the benchmark 10-Year U.S. Treasury note averaged 1.97 percent in January and February, rose to average 2.17 percent and 2.05 percent in March and April, then fell back to 1.80 percent and 1.62 percent in May and June, respectively. Notably, the Federal Reserve announced in September its intention to keep interest rates low through mid-2015—six months longer than originally announced.
The other significant source of net investment income (besides bond yields) is stock dividends. Contrary to the experience of bond yields, dividends grew strongly. Compared to the same quarter in 2011, net dividends in the first quarter of 2012 rose by 6.0 percent and in the second quarter by 8.8 percent. But stock holdings in general represent roughly only one-sixth of the industry’s invested assets.
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 2012 were about half of those of the same period for 2011, at $1.7 billion compared to $3.6 billion in the first half of 2011.
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.
The broad stock market did quite well throughout the first quarter of 2012—the S&P 500 rose 12.00 percent —but it lost 3.29 percent in the second quarter, mostly in May (-6.27 percent). However, it rose by 3.96 percent in June and so ended the first half of 2012 up roughly 6 percent for the year to date.
The outlook for inflation remains quite tame, with the consumer price index expected to remain steady at 2.0 percent in both 2012 and 2013. Low inflation gives the Fed the latitude to pursue an aggressive monetary policy. Relatively high unemployment, remaining underutilized industrial capacity and generally weak consumer demand all continue to point to inflation (and, therefore, interest rates) remaining low for the foreseeable future.
The property/casualty insurance industry turned in a relatively strong performance during in the first half of 2012 in terms of underwriting performance and overall return on average surplus (profitability) compared with the first half of 2011. In addition, policyholders’ surplus remains near an all-time record high as catastrophe losses through first half dropped well below those experienced in the year-earlier period. Although profitability surged amid much lower catastrophe losses this year, investment gains were down. Premium growth, while still modest, nevertheless accelerated to its fastest pace in the post-crisis era. The outlook for the remainder of 2012 is reasonably good, and it appears increasingly likely that some of the industry’s recent momentum could carry through into 2013.
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 first half of 2012 follows.
First Half 2012 Financial Results*