Financial and Market Conditions
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THE TOPIC
APRIL 2008
Many forces affect the price, availability and security of the insurance product. Some are external, such as changes in interest rates and the stock market, regulatory activity, the number and severity of natural disasters, growth in litigation and rising medical costs. Others are internal, such as the level of competition.
The insurance industry is cyclical. Rates and profits fluctuate depending on the phase of the cycle, particularly in commercial coverages. The profitability cycle may be somewhat different for different types of insurance. While recently the industry has seen record profits, due in part to the respite from major hurricanes, highly profitable years are needed to offset years where profits are minimal or the industry suffers a loss. Losses in 2005 associated with Hurricanes Katrina, Rita and Wilma wiped out the profits of some insurers and forced others to raise additional capital.
The property/casualty insurance market began to harden in 2002, following an unusually prolonged period of soft market conditions in the commercial insurance sector in the 1990s, driven in part by intense competition, where prices barely covered expenses. In 2002, rates began dropping, ushering in the beginning of another soft market in most lines except property in regions prone to natural disasters as reinsurers, hurt by 2005 catastrophe losses and expecting more such losses in future years, raise prices. This, in turn, has exerted pressure on primary company pricing.
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RECENT DEVELOPMENTS
- Full Year 2007 Financial Results: The property/casualty insurance industry reported a statutory rate of return on average surplus of 12.3 percent for the full year of 2007, down from 14 percent for the calendar year 2006. The results were released by ISO and the Property Casualty Insurers Association of America. Though profits remained relatively strong, industry margins are well short of the average return on equity for the Fortune 500 group of companies. The Fortune 500 is expected to produce an average return on equity of 13 to 14 percent in 2007.
- Profits (net income after taxes) fell by 5.8 percent to $61.9 billion, down from $65.8 billion in 2006. The decline in profitability, the first since 2001, is primarily attributable to a marginal deterioration in underwriting performance. Net gains on underwriting, the margin by which premium income exceeds claim costs, expenses and policyholder dividends, fell 38.9 percent to $19.0 billion in 2007 from $31.1 billion in 2006.
- The combined ratio, which does not take account of investment income, deteriorated to 95.6 from 92.4 percent in 2006. The combined ratio reflects the percentage of each premium dollar spent on claims payments, claims reserves and expenses. Despite the deterioration in underwriting results, the 95.6 percent combined ratio is the twentieth best since 1926 while 2006 was tied with 1935 for the fifth best. Indeed, the combined ratios for 2006 and 2007 represent the best back-to-back underwriting performances in more than half a century when the average combined ratio in 1953/1954 was 93.4.
- With underwriting profitability past its peak, industry observers are wondering how many years it will take to reach the bottom. Since 1975 there have been four cyclical troughs in profitability with the lowest and last being a negative 1.2 percent in 2001. The decline can be steep or gradual, lasting on average 4.75 years. If history over the past 35 years provides any guide, the industry can expect returns to bottom out at about 1 to 2 percent in 2011 and another peak in profitability in 2015 or 2016.
- Increased profitability and a two-year lull in disasters have provided the industry with a welcome opportunity to bolster its policyholders’ surplus, which stood at $517.9 billion at year-end 2007, a 6.5 percent increase from $486.2 billion at year-end 2006. Policyholders’ surplus is a measure of claims-paying capacity or capital, providing a financial cushion for megacatastrophes that lie ahead. Additions to surplus come from net income after taxes, unrealized capital gains and new funds raised by insurers. The pace of policyholders’ surplus growth deceleration in 2007 was largely due to declining prices for financial assets. Subtractions from surplus include dividends to shareholders, share buybacks and miscellaneous charges.
- Net written premiums (premiums after reinsurance transactions) declined by 0.6 percent in 2007 from a 4.2 percent increase in 2006, the result of softening prices for all types of insurance, particularly commercial coverages, and slowing economic growth. Overall, the cost of insurance for the overwhelming majority of consumers is flat or falling and insurance costs relative to the nation’s gross domestic product are dropping.
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First-Nine Months 2007 Financial Results*
($ billions)
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$ |
| Net Earned Premiums | $323.30 |
| Incurred Losses (Including loss adjustment expenses) | 219.6 |
| Expenses | 90.4 |
| Policyholder Dividends | 1.2 |
| Net Underwriting Gain (Loss) | 18.1 |
| Investment Income | 39.5 |
| Other Items | -1.0 |
| Pre-Tax Operating Gain | 55.6 |
| Realized Capital Gains (Losses) | 8.2 |
| Pre-Tax Income | 63.8 |
| Taxes | -15.4 |
| Net After-Tax Income | $49.4 |
| Surplus (End of Period) | $521.8 |
| Combined Ratio | 93.8 |
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*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures. |
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Full Year 2007 Financial Results*
($ billions)
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$ |
| Net Earned Premiums | $439.1 |
| Incurred Losses (Including loss adjustment expenses) | 298.6 |
| Expenses | 119.1 |
| Policyholder Dividends | 2.4 |
| Net Underwriting Gain (Loss) | 19.0 |
| Investment Income | 54.6 |
| Other Items | -0.9 |
| Pre-Tax Operating Gain | 72.7 |
| Realized Capital Gains (Losses) | 9.0 |
| Pre-Tax Income | 81.7 |
| Taxes | 19.8 |
| Net After-Tax Income | $61.9 |
| Surplus (End of Period) | $517.9 |
| Combined Ratio | 95.6 |
| *Figures may not add to totals due to rounding. Calculations in text based on unrounded figures. |
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Fourth Quarter 2007 Financial Results*
($ billions)
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$ |
| Net Earned Premiums | $109.8 |
| Incurred Losses (Including loss adjustment expenses) | 79.1 |
| Expenses | 28.6 |
| Policyholder Dividends | 1.3 |
| Net Underwriting Gain (Loss) | 0.9 |
| Investment Income | 15.1 |
| Other Items | 0.1 |
| Pre-Tax Operating Gain | 16.0 |
| Realized Capital Gains (Losses) | 0.8 |
| Pre-Tax Income | 16.8 |
| Taxes | 4.3 |
| Net After-Tax Income | 12.5 |
| Surplus (End of Period) | 517.9 |
| Combined Ratio | 100.9 |
| *Figures may not add to totals due to rounding. Calculations in text based on unrounded figures. |
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- Early Bird Forecast for 2008: Responding to the annual Insurance Information Institute year-end survey, Wall Street stock company analysts and industry professionals forecast slower premium growth in 2008 and a deterioration in the combined ratio, the ratio of losses to expenses.
- The expected decline in premium growth of 0.3, if it occurs, would be the first since 1943 during World War II. In this insurance cycle, premium growth has decelerated steadily since peaking in 2002 at 15.3 percent. The premium growth rate is influenced largely by changes in pricing and to a lesser extent the level of economic expansion, which determines how many more “risks”—vehicles, business and homes—there are to insure. The across-the-board softening in both the personal and commercial lines market, which results in lower prices, combined with a weakening economy, loss of premium to government-sponsored property insurance pools and greater interest in forms of alternative risk transfer such as risk retention groups that now account for $2.7 billion in premium, have all contributed to the slowdown.
- The combined ratio for 2008 is expected to be 97.3, the average forecast of the 10 analysts. It is unusual for the property/casualty insurance industry to make a profit on underwriting. If the 97.3 figure turns out to be correct, the 2008 result would be one of the top 12 best underwriting performances over an 88-year period beginning in 1920. (The 2006 combined ratio was the sixth best over this period.) These forecasts assume so-called normal levels of catastrophe losses. Regardless of underwriting results, insurers’ bottom lines are likely to be affected by the low-interest rate environment that will reduce interest income.
- Rating Agencies Raise Capital Requirements for Catastrophes: Ratings agencies have changed the way they assess the adequacy of an insurer’s capital. Until recently, rating agencies looked at a company’s exposures to losses relative to a catastrophic event that was likely to occur once every 100 years. But events that were once thought to be relatively rare are occurring with increasing frequency. With forecasts of above average hurricane losses for the next decade or so, agencies have raised the threshold for capital adequacy to 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 for building contractors to repair damage after a natural disaster rises. 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. Those that do not may face rating downgrades, which in turn affects their costs of raising capital and, if the downgrades are severe enough, their ability to attract new business.
- Terrorism Coverage: At the end of 2007, Congress passed legislation that would extend the federal reinsurance backstop—the Terrorism Risk Insurance Act (TRIA)—for seven years to 2014. The House had originally passed a bill that would have required the industry to offer nuclear, biological, chemical and radiological coverage as well as coverage for “traditional” acts of terrorism but the President and leading senators opposed this expansion as did many in the insurance industry. The new measure eliminates the distinction between domestic and foreign terrorism that was part of the original legislation passed in 2002.
- A study by the insurance broker Aon suggests that there is increasing demand for stand-alone terrorism insurance, coverage that is purchased separately rather than as part of a property insurance policy. Rates have declined over the past few years and supply has increased. It is now possible to buy $1.5 billion in coverage for a single entity, an increase of about 20 percent since January 2006. But in “terrorism capacity hotspots,” coverage is difficult to obtain.
- Market Conditions: Insurers writing homeowners insurance in hurricane-prone states face significant uncertainties as lawmakers decide how to deal with the continued threat of hurricane losses. In Florida, where officials expanded the reach of Citizens Property Insurance Corporation, the state-run insurer of last resort, and are offering property insurers cheaper reinsurance through the state-run Florida Hurricane Catastrophe Fund, some legislators and state officials are having second thoughts about the amount of reinsurance available through the state, particularly in light of the recent credit squeeze, which would put up the cost of issuing bonds to pay for a megadisaster.
- Policyholders can now switch to Citizens if a homeowners policy from Citizens is 15 percent less than the policy issued by their current insurer. Originally, Citizens’ policies had to be 10 percent higher than the private market but that difference was eliminated. However, a number of new start-up companies are providing coverage, some to specialized markets, such as owners of high-value homes and through a Citizens depopulation program run by the insurance department, increasing number of Citizens policies are being taken over by private companies. In 2007 almost 247,000 policies were assumed by seven insurers, reducing Citizens’ exposure to loss by $68 billion. This process is continuing. As of the end of March 2008, Citizens had some 1.2 million policyholders, about 100,000 less than the month before. About one-third of the total remaining, about 406,800, are in the high-risk account.
- In Louisiana, several insurers have accepted policies from the Louisiana Citizens Property Insurance Corporation under legislation passed in 2007 that offers financial incentives to new insurers entering the state that agree to assume policies from the state windstorm pool. Several states are considering tax credits for homeowners who improve the wind resistance of their homes.
- A 2008 report by the Insurance Research Council shows how auto insurance claim costs and the cost of providing medical care have changed over the past decade. While the number of accidents has dropped significantly, the cost of claims, driven largely by increases in medical care costs per claim, has gone up. Thus on balance, loss costs, or the average cost of claims, have remained relatively stable. Looking at claims from 1990 to 2006, the study found that on an annualized basis, the cost of property damage claims grew by 3.9 percent, bodily injury claims by 1.6 percent and personal injury claims (in no-fault states) by 3.9 percent, compared with inflation as measured by the Consumer Price Index (CPI). The all items CPI rose 2.8 percent over the period and the medical only CPI grew 4.6 percent.
- The cost of medical care in auto injury claims is influenced by the treatment provided. More claimants are going to pain clinics, having expensive diagnostic tests, such as CT (computed tomography) scans and MRIs (magnetic resonance imaging) and using the services of a chiropractor, which typically involve more office visits than using a general practitioner. Meanwhile, the seriousness of injuries is declining due to safer car interior design and air bags. Increasingly claimants are unlikely to report any disability as a result of their injuries.
- Rates for commercial insurance are dropping significantly for most types of coverage, according to a market survey by the Council of Insurance Agents and Brokers, as competition for market share heats up. Large accounts showed the greatest decline. Rates for reinsurance remained flat or fell, due to increased competition from the capital markets (see report on Reinsurance), the tendency for insurers to hold more of the risk themselves, a strategy known as retention, and two years without major hurricanes.
- Regulation: In January 2008, New York’s Commission to Modernize Financial Services said it would consider 1) developing a principles-guided regulatory system, as opposed to the system in the United Kingdom, which is principles-based, and 2) combining regulatory oversight of the various sectors into one regulatory body. In explaining the approach, Commission Executive Director Scott Rothstein said that a principles-guided system would focus on outcomes within the regulatory framework. The principles would help in the interpretation of existing rules and guide the creation of new ones, without sacrificing certainty for the industry or consumer protection.
- In Massachusetts a new system for determining auto insurance rates, known as “managed competition,” is now in effect. Massachusetts had been the only state in which state officials rather than the market set rates for auto insurance. In making decisions about how the new system would function Insurance Commissioner Nonnie Burnes said her aim was to usher in competition, reduce costs and make sure rates are permanently based on motorists’ driving records. The use of factors such as gender and marital status as well as socio-economic data like occupation and education will be prohibited for both rating and underwriting. The commissioner said she has not ruled out the use of insurance scores because credit affects multiple lines of insurance. She will study the issue and make a decision by April 2009, at the end of the year’s transition period. In addition, the commissioner plans to retain the current subsidies for urban drivers. Rates filed by the insurers operating in the state are reviewed by an independent actuarial firm to ensure they comply with requirements.
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BACKGROUND
The insurance industry is cyclical. The cycle of the early and mid-1980s was among the most severe that the industry has experienced. That cycle centered on liability insurance. The hard market that began early in 2001 and peaked in about 2003 is now on a downward trajectory with rates dropping for most types of insurance.
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.
In the 1950s and 1960s, cycles were regular with a three-year period of soft pricing followed by a three-year period of hard pricing in practically all lines of property/casualty insurance. In the 1970s and 1980s, there were only two cycles, one mainly affecting auto insurance in the mid-1970s and the other in the mid-1980s, affecting commercial liability insurance. The commercial liability insurance cycle gave rise to the "liability crisis," when certain types of commercial liability coverages, such as insurance for daycare centers, municipalities, ski resorts and any establishment selling liquor, became difficult to obtain. Since that time, with the exception of the difficulty in obtaining medical malpractice insurance in the early part of this decade, the insurance cycle has had less of an impact on the public.
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 what is taken in premiums. 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, when interest rates were high, business could still be profitable even though the combined ratio was above 100. But so far in the 2000s, interest rates have been low. The industry therefore needs a combined ratio of below 100 to show a profit.
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 interest rates go up, prices decline. 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, about two-thirds 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) accounted for less that 0.1 percent of all bonds owned at the end of 2006, the latest data available.
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INVESTMENTS, PROPERTY/CASUALTY INSURERS, 2002-2006
($ millions)
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Amount |
Percent of total investments |
Investment type |
2002 |
2005 |
2006 |
2002 |
2005 |
2006 |
| Bonds | $566,259.0 | $773,474.3 | $823,126.3 | 67.12% | 68.18% | 67.00% |
| Stocks | 154,193.5 | 208,418.3 | 237,303.3 | 18.28 | 18.37 | 19.32 |
| Preferred | 14,533.7 | 11,517.4 | 16,149.7 | 1.72 | 1.02 | 1.31 |
| Common | 139,659.8 | 196,900.9 | 221,153.6 | 16.55 | 17.36 | 18.00 |
| Mortgage loans on real estate | 2,588.6 | 3,241.1 | 3,801.7 | 0.31 | 0.29 | 0.31 |
| First liens | 2,528.5 | 3,193.9 | 3,787.9 | 0.30 | 0.28 | 0.31 |
| Other than first liens | 60.1 | 47.2 | 13.8 | 0.01 | (1) | (1) |
| Real estate | 9,572.0 | 9,323.2 | 9,711.3 | 1.13 | 0.82 | 0.79 |
| Properties occupied by company | 8,158.4 | 7,869.9 | 8,166.3 | 0.97 | 0.69 | 0.66 |
| Properties held for income production | 1,075.6 | 1,009.1 | 1,069.7 | 0.13 | 0.09 | 0.09 |
| Properties held for sale | 338.0 | 444.2 | 475.3 | 0.04 | 0.04 | 0.04 |
| Cash, cash equivalent and short-term investments | 71,454.0 | 91,497.3 | 98,408.3 | 8.47 | 8.06 | 8.01 |
| Other invested assets | 33,215.3 | 41,567.5 | 51,750.5 | 3.94 | 3.66 | 4.21 |
| Receivable for securities | 2,106.2 | 4,125.3 | 2,115.4 | 0.25 | 0.36 | 0.17 |
| Aggregrate write-in invested assets | 4,235.0 | 2,873.7 | 2,298.8 | 0.50 | 0.25 | 0.19 |
| Total | $843,623.7 | $1,134,520.8 | $1,228,515.5 | 100.00% | 100.00% | 100.00% |
(1) Less than 0.01 percent.
Source: National Association of Insurance Commissioners (NAIC) Annual Statement Database, via Highline Data, LLC. Copyrighted information. No portion of this work may be copied or redistributed without the express written permission of Highline Data, LLC. |
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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 and the payment of a claim can be many years. For example, illness due to exposure to a toxic substance may not be detected until many years after the period during which the person was exposed to the substance. The kinds or "lines" of insurance where this time lag may occur 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.
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. For 1999 and the years leading up to it, the expense ratio was particularly high, rising to 28.0 percent from 26.00 or less, in part because of technology improvements and the cost of preparing for the year 2000.
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.
Policyholders’ surplus is not transferable from one segment of the industry as a result of improved underwriting or investment performance to another. A large increase in surplus for auto insurers, for example, cannot be used by commercial lines companies to provide coverage to corporations against terrorism attacks. Likewise, surplus accumulated by a workers compensation insurer in Mississippi cannot be used to underwrite homeowners insurance in California.
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EXPENSE RATIOS, 1997-2006
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How does an expense ratio of 25.0 percent 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. Some, but not all, of these conceptual problems can be avoided by comparing property/casualty insurers' expense ratios with "similar" industries. As the chart above illustrates, they remain well below those of commercial banks.
Market Conditions
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. A study by AIR Worldwide estimated that the value of insured coastal property exposed to hurricane losses at $6.7 trillion in 2004 or 36 percent of the value of all property in coastal states. In Florida alone, a state with coastal properties that amount to 79 percent of its total property values, insured coastal properties were valued at more than $1.9 trillion. New York was close second.
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 the 2004 and 2005, culminating with Hurricanes Katrina, Wilma and Rita which together caused close to $56 billion in insured property damage according to ISO, have drawn attention to the risks the insurance industry now faces. Sophisticated modeling of disaster scenarios suggest that a major hurricane hitting Miami could cost insurers as much as $80 billion. Before Hurricane Andrew, the outside range of insured damage from a major disaster was thought to be about $8 billion.
Most meteorologists now predict an upturn in hurricane activity over the next few decades and rising losses due to continuing developments of coastal areas. In addition, there is the risk of a major earthquake along the West coast and New Madrid fault in the Midwest.
The buildup in insurable values 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 now require insurers to boost their capital to be able to deal with the higher catastrophe risk they are now seen to be assuming.
In addition to the heightened risk of natural disasters, the insurance industry now faces the risk of terrorist attacks. The Terrorism Risk Insurance Act of 2002 (TRIA) was renewed at the end of 2005 for two years and at the end of 2007 for a further seven years. Rates for terrorism insurance have fallen significantly over the few years, with the result that an increasing portion of businesses are purchasing the coverage.
TRIA authorized the creation of a federal reinsurance program, which is triggered when terrorism losses exceed a predetermined amount. The program enabled the commercial insurance market to function even though the threat of terrorism remains. Under TRIA, individual insurance companies are required to pay a gradually increasing percentage of their earned commercial insurance premium, including workers compensation along with a coinsurance amount. The federal government will pay 85 percent of losses above the per company or overall industry maximum payment level, up to a maximum liability for the total program of $100 billion per year.
During discussions in the House on the specific provisions of the legislation, there was general agreement that some of the payments made by the federal government should be in the form of loans. As a result, if a terrorist act triggers federal funds, a portion of these funds must be recouped through policyholder surcharges. Personal lines insurance companies and reinsurers are not covered by TRIA. In return for the federal backstop, insurers must make terrorism coverage available and conspicuously state the premium charged but policyholders may reject the offer. As of 2007 renewal, the trigger is $100 million.
Distribution Systems: According to the Independent Insurance Agents & Brokers of America, Inc., the number of independent insurance agencies has fallen over the last decade. In 1992 there were 46,000 and in 2006 there were 37,500, as agencies declined in number but grew in size. About two-thirds of commercial insurance is sold by companies that use independent agents and about two-thirds of personal insurance is sold directly or through captive agents that work for a single company.
However, an increasing number of auto insurance companies are experimenting with multiple distribution channels. Several major companies in both personal and commercial lines business now use or plan to use both insurance agents and direct sale methods to reach consumers, including the Internet and phone. New insurance-related entities are springing up on the Internet. Some provide quotes from many insurance companies, others act as a conduit to insurance agents. Employers are also expected to become major distributors of insurance products, offering auto insurance and other coverages through payroll deduction plans. Various organizations also distribute insurance to their members. Affinity sales, or selling through groups, represent a growing distribution channel, according to a study by Conning Research & Consulting. In addition, banks are increasingly selling property/casualty insurance to their banking clients.
The Marketplace: A gradual change is occurring in the property/casualty insurance marketplace. There are fewer multiline companies–those sell both personal lines of insurance (auto and homeowners) and commercial insurance for businesses. Several personal lines companies are now selling products from other sectors of the financial services industry and many banks and some stock brokerage firms are selling insurance products. Some companies that used to distribute their products through their own employees are also using all distribution systems including direct response and independent agents. In addition, many companies, large and small, are directing their attention to specialized market niches. And, as the large commercial lines insurers seek overseas markets, there is a growing divergence between these companies and small insurers with a more regionalized approach.
Sophisticated commercial customers in recent years have turned increasingly to captives and other alternative markets. Overall more than 40 percent of commercial lines premium has now left the traditional insurance market, according to the A.M. Best Co. The recent hard market may have encouraged additional companies to explore other ways of financing risk. Property coverages represent the smallest percentage, in part because of their generally lower cost. Where once only the largest corporations used nontraditional mechanisms, middle-market companies are now joining purchasing or "affinity" groups in an attempt to obtain better terms and prices, or self-insuring some risks.
Federal Taxation of Insurance Companies: Up to the end of 1986 insurance companies paid 46 cents to the federal government on nearly every dollar of taxable income. 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 (see below), 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 federal 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.
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KEY SOURCES OF ADDITIONAL INFORMATION
The I.I.I. Fact Book, Insurance Information Institute, published annually.
I.I.I. Web Site: http://www.iii.org.
© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED
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