Financial and Market Conditions
The property/casualty insurance industry had another year of moderate profits in 2015, as measured by a return on average surplus of 8.4 percent, virtually the same as in 2014. Challenged by continuing low interest rates and a slumping stock market, the industry nevertheless posted modest premium growth and a below-100 combined ratio for the fourth straight year. Overall industry capacity (policyholder surplus) slipped slightly to $673.7 billion as of December 31, 2015, but was still extraordinarily strong, as measured by a premium-to-surplus ratio of 0.76—virtually the strongest it has ever been.
The industry results were released by ISO, a Verisk Analytics company, and the Property Casualty Insurers Association of America (PCI).
The industry’s performance in 2015 could be characterized as its “new normal,” neither as profitable as in 2013 nor as affected by catastrophes as in 2011 and 2012. Indeed, in many respects, 2015 looked a lot like 2014.
Net written premiums in 2015 crossed the half-trillion-dollar mark (to $514.0 billion), although the rate of increase slipped slightly to 3.4 percent growth from 4.2 percent in 2014. Net earned premium growth also slowed in 2015 (growing by 3.7 percent) compared to 2014 (4.4 percent growth over 2013).
In 2015 wildfires, winter storms, hail storms and tornadoes all took their toll, but there was no single event that did enormous damage; still, total U.S. catastrophe claims in 2015 were estimated to be $15.2 billion. The industry’s combined ratio rose only slightly to 97.8, compared with 97.0 in 2014.
Favorable development of prior-year claims reserves in 2015 totaled $8.0 billion, a notable decrease from the $11.2 billion in reserve releases in 2014, according to ISO/PCI. Reserve releases are generally associated with lower-than-expected costs for claims occurring in past accident years.
The industry’s net investment income for the full year 2015 was $47.2 billion, compared to $46.4 billion in 2014 (+1.9 percent). Realized capital gains in 2015 were $9.4 billion, compared to $10.3 billion in 2014. Policyholders’ surplus as of December 31, 2015 stood at $673.7 billion, down $1.5 billion or 0.23 percent from year-end 2014.
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FULL-YEAR 2014 FINANCIAL RESULTS*
LIFE/HEALTH INSURANCE INDUSTRY INCOME STATEMENT, 2010-2014
($ billions, end of year)
The Insurance Cycle: The property/casualty insurance industry has exhibited cyclical behavior for many years, as far back as the 1920s. These cycles are characterized by periods of rising rates leading to increased profitability. Following a period of solid but not spectacular rates of return, the industry enters a down phase where prices soften, supply of insurance becomes plentiful and, eventually, profitability diminishes or vanishes completely. In the cycle’s down phase, as results deteriorate, the basic ability of insurance companies to underwrite new business or, for some companies even to renew some existing policies, can be impaired because the capital needed to support the underwriting of risk has been depleted through losses. Cycles vary in their severity.
The insurance industry cycle is not unlike the cycle that occurs in agriculture, for example, in the wheat and beef markets. Demand for the product in both industries is relatively stable and is relatively unresponsive to price changes, while supply can vary from year to year. This means that when supply increases, lowering the price will not instantly "clear" the market of excess supply. If the price of auto insurance is cut in half, people will still buy only one policy, although they may increase the amount of coverage they purchase.
Elements in Financial Results: The combined ratio is a measure of underwriting profitability. It basically reflects what is paid out in losses and expenses compared with the premiums taken in. A combined ratio above 100 means that the industry is losing money on its underwriting operations. Besides underwriting, property/casualty insurance companies have a second source of income—investments. In a period when interest rates are very high, investment income can help offset underwriting losses. In the 1980s, for example, when interest rates were high, business could still be profitable even though the combined ratio was above 100. But for the past decade or more, interest rates have been low. In such an environment, the industry needs a combined ratio of below 100 to show a profit.
Investment gains come largely from interest on bonds, stock dividends and realized capital gains. When investment income is high, companies have an incentive to bring in more cash, and, in the competitive marketplace, they attempt to do this by cutting rates to attract new business. As investment income goes up, prices may decline. However, ultimately the combined ratio increases because what is coming in—premium revenue—is declining, or growing at a very slow rate, while what is going out—claims payments and expenses—is either unchanged or rising. When interest rates and stock market earnings drop, there is less investment income to offset underwriting losses. The insurance industry is one of the largest institutional investors.
Property/casualty insurers hold a large percentage of their investments in the form of bonds to protect their assets against precipitous stock market declines. Typically, more than 60 percent of total investments are in bonds and about one-fifth are in common stock. The exact figure fluctuates according to stock market trends. The asset quality of the industry’s investments is high. Bonds in or near default (Class 6) generally account for a tiny percentage (much less than 1 percent) of all bonds owned by insurers.
A critical element in the relationship between investment and underwriting results is the time lag that sometimes exists between premium payment and the ultimate payment of claims, which enables insurers to earn interest income on the cash inflow from premiums before losses are paid. This is particularly important in liability insurance, where the time lag between the occurrence of an insured event or accident, such as exposure to a toxic substance and the harm that it causes, can be many years. The illness may be developing in the body but may not be detected until long after the person was exposed to the substance. The kinds or "lines" of insurance where this time lag may occur, such as product liability insurance, are known as long-tail lines. Lines of insurance where the time lag between payment of premium and payment of a loss is short are known as short-tail lines. Fire insurance, where claims are filed almost immediately after a fire occurs and generally within the policy period, is an example of a short-tail line, as are most other property damage coverages.
Policyholders’ Surplus: Policyholders’ surplus is essentially the amount of money remaining after an insurer’s liabilities are subtracted from its assets. Policyholders’ surplus is a financial cushion that protects a company’s policyholders in the event of unexpected or catastrophic losses. In other industries it is known as “net worth” or “owners’ equity.” It is a measure of underwriting capacity because it reflects the financial resources (capital) that stand behind every policy written by the insurer. A weakened surplus can lead to ratings downgrades and ultimately, if the situation is serious enough, to insolvency.
Expense Ratios: Every industry's profitability is affected by the cost of doing business. In the property/casualty insurance industry, expenses are made up of commissions and other expenses such as salaries, rent and the cost of utilities. The expense ratio is calculated by dividing expense items (before federal taxes) by written premiums. Expense ratios tend to fluctuate with premium growth. While commissions move with changes in premiums, other expenses are fixed. Thus, when premiums are flat, fixed expenses tend to push up the expense ratio.
How does an expense ratio in the property/casualty industry compare with other industries? Because industries differ, there are conceptual and technical problems in comparing expenses across industries. For example, in hairdressing, which is a basic service business, expenses are close to 100 percent of sales since all costs are in the expense area. By contrast, expense ratios for crude oil production are usually low. Once a well is pumping, very little expense is incurred in storing and transporting the oil to market.
The insurance industry is conservative. A conservative approach permeates almost every aspect of the business from statutory accounting practices, which emphasize a company’s present solvency, see report on Insurance Accounting, to the requirement that the risk assumed in issuing insurance contracts (policies) is in line with the insurer’s capital or surplus account.
Three hallmarks of insurance company risk management separate the insurance industry from other financial services. First, in general insurers do not borrow to make investments or pay claims. So when some investments perform poorly, the effect is not magnified as it is when investments are highly leveraged. Second, insurers use historical experience and sophisticated modeling techniques to match risk to price and, as mentioned above, they limit the aggregate amount of risk they assume to the capital they have on hand. Third, insurers keep the risk they assume on their own books. Even when they lay off some of the risk to reinsurers, typically the reinsurer will require the primary company to keep a portion of the risk. Having “skin in the game” acts as a strong incentive to underwrite carefully. Inattention to underwriting can lead to reduced profits.
As in any other industry, the price and availability of insurance are governed by insurers' assessments of profitability. However, unlike most other industries, this assessment is also governed by the regulatory climate and geographical considerations.
Catastrophes: As commercial and residential development along the Atlantic and Gulf coasts mushroomed in the 1980s, insurers' exposure to hurricane losses soared. The buildup of property values coincided with a lull in hurricane activity. But Hurricane Andrew (1992) and the Northridge Earthquake (1994) and an unusually high number of major hurricanes in 2004 and 2005, culminating with Hurricanes Katrina, Wilma and Rita in 2005, which together caused more than $50 billion in insured property damage, according to ISO, have continually drawn attention to the risks the insurance industry faces. Sophisticated modeling of disaster scenarios suggest that a major hurricane hitting Miami could cost insurers more than the 2005 storms combined. Before Hurricane Andrew, the outside range of insured damage from a major disaster was thought to be about $8 billion.
The buildup in insurable values in coastal states together with predictions of greater losses is causing insurance companies and their reinsurers to reassess the magnitude of their loss exposure in these areas and to limit growth in geographical markets where their exposure to loss is too great. They are also requiring policyholders in the riskiest parts of the country to share more of the loss through larger deductibles, generally a percentage of the insured value of the dwelling. In addition, the price of property insurance along the Atlantic seaboard is increasing as reinsurers, the insurers of insurance companies, raise their prices for coverage and primary companies reassess their risk exposure in light of new information on potential losses.
Also contributing to rising prices are new demands from the rating agencies that assess insurance companies’ financial health. Rating agencies require insurers to hold enough capital to be able to deal with the catastrophe risk they assume. Rating agencies typically require insurers to have sufficient capital to handle an event that is expected to occur once in 250 years. In addition, they are looking at potential losses from catastrophes in the aggregate—two megadisasters in quick succession, for example—and requiring a company’s estimates of its probable maximum loss to include such items as demand surge. Demand surge in this context is the increase in the cost of labor and materials as demand rises for building contractors to repair damage after a natural disaster. This pushes up the size of claims. Not surprisingly, since the 2005 hurricane season, many insurers have adopted more conservative approaches to managing their exposure to catastrophic losses. Rating agencies can downgrade companies that, in their estimation, may have issues responding to a catastrophe. The downgrade can affect their ability to attract new business.
Federal Taxation of Insurance Companies: Under the current tax code, insurance companies are taxed at a rate of 35 cents on the dollar, the basic rate for all businesses. Because property/casualty companies have significant interest income from tax-exempt state and local government bonds, taxable income usually is lower than net income as reported in financial statements. A variation between taxable income and net income is not unique to the insurance industry. Indeed it is not unique to corporations, as taxpayers will recognize from experience in filling out their income tax forms.
In property/casualty insurance, the basis for computing income for tax purposes is the statutory Annual Statement, submitted annually to the state insurance departments. While maintaining statutory accounting for most purposes, the 1986 Tax Reform Act made several changes in the way taxable income is computed for federal income tax assessments. These include discounting loss reserves; reducing the size of unearned premium reserves, thus increasing income; taxing a portion of interest from otherwise tax-exempt bonds; and eliminating some previous provisions that helped reduce the impact of catastrophic losses for mutual insurance companies. Statutory accounting as it is now, which is more conservative than GAAP accounting, is likely to undergo some changes in the years to come as insurance accounting globally undergoes more standardization, see report on Insurance Accounting.
State Premium Taxes: In addition to federal taxes, insurers pay taxes to each state based on premiums paid by policyholders. Premium taxes totaled $17.4 billion in 2013. On a per capita basis, this works out to $55 for every person living in the United States. Premium taxes accounted for 2.0 percent of all taxes collected by the states.
KEY SOURCES OF ADDITIONAL INFORMATION
The I.I.I. Fact Book, Insurance Information Institute, published annually.
I.I.I. Website: http://www.iii.org
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