INSURANCE TOPICS

Financial and Market Conditions

THE TOPIC

MAY 2009

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. 

In 2008 industry financial results were affected by a broad, rapid and steep deterioration in financial markets on a global scale as well as by a four-year long soft market, huge losses from Hurricane Ike and other natural disasters, and the impact of a deep recession.  

Fortunately, insurance companies run their businesses conservatively as if every day might bring some new disaster, so despite current economic and financial conditions, the industry has been able to function normally. Unlike banks, insurers are not highly leveraged (they generally do not borrow to make investments or to pay claims); they limit the amount of risk they assume to the capital they have on hand; and because they do not sell the risks they assume to another party—they have some “skin in the game”--they must underwrite carefully or suffer the consequences. 

2008 financial results as a whole have not been good, they been negatively affected by the mortgage and financial guarantee segments of the business, which in turn have been hurt by the bursting of the housing bubble and the collapse of the credit markets. 

RECENT DEVELOPMENTS

• Full Year 2008 Financial Results: The property/casualty insurance industry reported an annualized statutory rate of return on average surplus of 0.5 percent in 2008, down sharply from the 12.4 percent of 2007, and a 96.2 drop in net income. The substantial decline in profitability is primarily due to the deterioration in financiall market conditions around the globe. The combination of higher catastrophe losses, the cyclical deterioration in underwriting performance and severe stress in the mortgage and financial guaranty segments of the industry pushed the combined ratio for 2008 up to 105.1. (The combined ratio is the percentage of each premium dollar spent on claims and expenses.) The results were released by ISO and the Property Casualty Insurers Association of America (PCI).
• Excluding the results for the mortgage and financial guaranty segments produces a smaller change in profitability, more in line with what might be expected in a soft market, with a return on average surplus of 4.2 percent and a combined ratio of 101.0 percent, according to ISO.
• Net written premium growth, which turned negative for the first time since 1943 in 2007, continued on its downward path. Net written premiums declined by 1.4 percent, or 1.5 percent when mortgage and financial guaranty insurance is excluded.
• Catastrophe losses for 2008, at $26.2 billion, were 64 percent higher than the total for the years 2006 and 2007 combined ($15.9 billion) and the fourth highest on record, behind 2005, 2004 and 2001. Hurricane Ike caused $10.655 billion in losses, making it the fourth most expensive hurricane on record in the United States. Record-breaking tornado activity and severe hail and windstorm losses also pushed up the total.
• Due to volatility in the securities markets, the industry's net investment gains—the sum of net investment income and realized capital gains or losses on investments—fell 50.9 percent to $31.4 billion from $64 billion in 2007.
• Net income after taxes fell 96.2 percent to $2.4 billion from $62.5 billion for 2007.

• Market Conditions: Although the financial markets are in turmoil, insurers’ balance sheets remain fundamentally strong. The crisis at American International Group, formerly one of the largest U.S. insurers, was due to the failure of a financial unit that was regulated by federal agencies. The company’s insurance units, regulated by the states in which they do business, are not in danger. They continue to have adequate resources to pay claims.
• Property/casualty insurers are entering the end of the soft part of the insurance cycle, according to most analysts. Rates for commercial insurance are dropping less or leveling off, according to a market survey by the Council of Insurance Agents and Brokers. Rates for reinsurance remained flat or rose as the credit crisis and catastrophes during the past 12 months pushed pricing upwards along with increased competition for reinsurance protection in this uncertain financial environment. The economic slowdown is also affecting insurers as the number of new houses and new cars purchased reduces growth in personal lines. Drivers in at least 19 states have seen their auto insurance rates drop over the last six months, Insurance.com reported in April.
• Hurricane Ike hit the Texas coast on September 6, 2008 as a strong Category 2 storm with a Category 4 surge, according to the Texas Windstorm Association (TWIA), which took the largest hit as the insurer of most homes and businesses in coastal counties. Ike destroyed many structures in low lying areas. The TWIA expects claims payments to be between $2.1 and 2.4 billion, somewhat less than originally forecast. Insurers doing business in the state have been assessed $430 million to pay claims after the wind pool’s reinsurance payments and cash on hand are exhausted. Another assessment will follow if this amount proves insufficient. Texas lawmakers are now struggling with how to reform TWIA funding in the current market and how to apportion the cost of windstorm damage between coastal and inland counties.
• In auto insurance, claims costs are increasing due to rising medical care charges. Some observers assume that claims will drop as Americans drive less to offset the soaring price of gasoline, but insurers say that this trend has not resulted in significantly fewer accidents or claims. However, more people are using motorcycles or scooters.
• In an effort to reduce the number of miles driven to lower greenhouse gas emissions, some states are encouraging insurers to offer drivers the opportunity to save when they drive significantly fewer miles. Miles driven can be measured by a device inside the car or by checking the car’s odometer. Currently, premiums are calculated based on drivers’ own estimate of the number of miles they drive each year.
• 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.
• In Florida, many new insurance companies are entering the homeowners market as national insurers cut back on coverage in coastal areas of the state. Some 40 local companies have taken policies out of Citizens Property Insurance Corporation, the state’s insurer of last resort, have been established over the past two years.
• Regulation: New York has been looking into the possibility of reviving the New York Insurance Exchange, which opened in 1980 in the expectation that it would become something akin to a U.S. Lloyd’s of London, a centralized marketplace. It closed seven years later with many of its syndicates insolvent. State officials believe that new interest on the part of the capital markets, advances in technology and the ability to make deals more transparent could revive the exchange. The legal and statutory structure for an exchange to function is still intact, according to New York’s Superintendent Eric Dinallo, who foresees a revived exchange as a place for large-scale transactions and complex reinsurance deals.
• 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.

BACKGROUND

The insurance industry is cyclical, particularly in the area of commercial coverages. 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 most recent hard market, which began early in about 2001 and peaked in early 2004, is now on a downward trajectory. Rates have dropped for most types of insurance and are now beginning to flatten out, depending on the type of business and coverage.

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.

Investment gains come largely from interest on bonds, stock dividend 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 go 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, 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 0.4 percent of all bonds owned at the end of 2007, the latest data available.

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 26.0 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.

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.

Risk Management

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 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.

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 $8.9 trillion in 2007 or 38 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 $2.4 trillion. New York was a 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. 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. As a result, 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 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. 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.

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 past 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 the TRIA 2007 renewal, the trigger is $100 million.

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 2007 measure eliminates the distinction between domestic and foreign terrorism that was part of the original legislation passed in 2002.

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. In 2005, banks accounted for 7 percent of commercial insurance sales and 3 percent of personal insurance sales.

The Marketplace: A gradual change is occurring in the property/casualty insurance marketplace. There are fewer multiline companies—those that 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 hard market at the beginning of the decade 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, 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.

State Premium Taxes: In addition to federal taxes, insurers pay taxes to each state based on premiums paid by policyholders. Premium taxes totaled $15.3 billion in 2007 and accounted for 2.0 percent of all taxes collected by states in that year. This amounted to a per capita payment of $51 for every person living in the United States.

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.

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