2009 - First Nine Months Results

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The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 4.5 percent through the first nine months of 2009, up sharply from 1.1 percent during the same period in 2008. The results provide solid evidence of a substantial and sustained rebound in profitability for P/C insurers in the wake of the financial crisis that began in mid-2007. As recently as the first quarter of 2009 the industry recorded a negative rate of return. Moreover, stable investment market conditions and modest catastrophe losses since the end of the third quarter through late December guarantee that full-year profitability in 2009 will be much higher than the 0.5 percent return recorded in 2008.
 
In another sign of recovery, capacity in the industry (as measured by policyholders' surplus) rebounded for the second consecutive quarter after two years of decline. Policyholders' surplus increased by $27.8 billion to $490.8 billion or 6.0 percent during the quarter, up from $463.0 billion at the end of the second quarter. The gain comes on the heels of a 5.9 percent or $25.9 billion increase to $463.0 billion during the second quarter from $437.1 billion at the end of the first quarter. The reversal is notable and important. P/C insurance industry capacity had plunged by an alarming $84.7 billion or 16.2 percent over the previous five quarters from the pre-crisis peak of $521.8 billion at the end of the second quarter of 2007. The recovery of asset markets, while welcome, is a leading indicator of economic recovery and does nothing to salve the impact of the ongoing six-year-old soft market as well as a significant reduction in demand for insurance driven by a deep global recession that has destroyed property and liability exposure on a worldwide scale. The weak pricing environment and the sharpest contraction in the economy since 1982 sent net written premiums tumbling by 4.5 percent, despite a long awaited return to economic growth. The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
 

A Bottom Line Recovery—But it’s Still Lonely at the Top

Profitability Begins to Recover but Remains Woefully Inadequate

The global financial crisis that sent the world economy into a tailspin over the past two years continued to loosen its grip during the third quarter. The economy grew for the first time in more than a year during the quarter—by 2.2 percent. In the United States, Federal Reserve Chairman Ben Bernanke recently declared in September 2009 that “the recession is almost certainly over.”  While Mr. Bernanke’s declaration is comforting, the fact that the recession is over in a technical sense does not portend a period of unbridled growth and prosperity. As 2009 draws to a close, and the dust from the worst financial crisis since the Great Depression begins to settle, the depth and the breadth of the damage suffered by the U.S. and global economies is only now becoming apparent. Likewise for property/casualty insurers. New growth will sprout from the ashes but only slowly after a fitful recovery. For P/C insurers and reinsurers it will take two to three years simply to replace the exposure that has been lost since the onset of the crisis in mid-2007.
 
It must be understood that the profit recovery in the P/C insurance industry during the second quarter had little to do with improvements in the “real” (i.e., goods and service producing) economy. As stated previously, the swing to positive profits was first and foremost due to an end of the financial panic that sent stock markets into a freefall following the failure of Lehman Brothers in September 2008. The subsequent seizure of credit markets and rising concerns over defaults pushed bond prices down sharply, causing significant realized and unrealized capital losses on insurer portfolios. With two-thirds of invested assets held in the form of bonds, P/C insurer capacity is highly sensitive to changes in credit market conditions.
 
Net income after taxes (profit) during the first nine months totaled $16.2 billion, nearly quadruple the $4.4 billion earned in the year earlier period. The profit was earned entirely in the second and third quarters, more than offsetting the $1.3 billion loss recorded during the year’s first quarter. As mentioned earlier, the impact was to push the industry’s nine-month return on average surplus to positive 4.5 percent, up from negative 1.2 percent during the first quarter. The continued stock market rally and healing of the credit markets during the fourth quarter bode well for insurer profitability during the final three months of 2009.
 
The current profit recovery must be kept in perspective. While net income is once again positive, a 4.5 percent rate of return is woefully inadequate by any standard. The U.S. property/casualty insurance industry’s equity cost of capital stood at approximately 10.5 percent in 2009. This means that there is a 6 percent gap between the actual rate of return and the rate of return that investors in the industry expect to earn given the risks they are being asked to assume. Failure to earn the cost of capital over an extended period of time could result in the exit of capital and, more importantly, difficulty in raising capital after a major “capital event,” particularly in the current capital constrained environment.
 

Top Line Suffers Even as Bottom Line Improves: Premium Growth Declines Accelerate as Insurance Demand Succumbs to Deep Recession

Despite the significant improvement of the bottom line, net written premiums declined by 5.0 percent during the third quarter of 2009, the largest drop since ISO began recording quarterly changes in premium.  Overall the decline during the first nine months was 4.5 percent. The third quarter drop is alarming because it represents a continued acceleration in the pace of premium shrinkage. Premiums dropped by 3.6 percent during the first quarter of 2009 and 4.8 percent during the second quarter. Excluding mortgage and financial guaranty insurers produced a net decline of 4.0 percent, according to ISO. Negative premium growth for all of 2009 is now a certainty and will mark the first three-year sequential decline in premiums written since the Great Depression, when industry premiums fell for four consecutive years (1930 through 1933) after peaking in 1929. Premiums in 2009 were held back in part by continued soft market conditions, primarily in commercial lines, which remained for a fifth consecutive year in 2009. The economy was also a major factor (details below). The nation’s real (i.e., inflation adjusted) gross domestic product (GDP) grew by 2.2 percent in the third quarter but shrank by 0.7 percent during the second quarter after plunging 6.4 percent during the first quarter of the year. Even before 2009 began, the economy had already contracted in four of the previous five quarters going all the way back to 2007.  Fortunately, the economy is expected to continue to grow, albeit modestly. Real GDP growth of between 2.5 and 3.0 percent is expected in 2010, according to Blue Chip Economic Indicators.
 
Softness in commercial insurance pricing remains a persistent problem for insurers. Although the magnitude of price decreases gradually diminished from the 13.8 percent drop recorded in the first quarter of 2008 to a decline of 5.8 percent in the third quarter of 2009, that drop was actually larger than the second quarter decline of 4.9 percent, according to Council of Insurance Agent and Broker data. Auto insurance premiums were up approximately 4.5 percent in the third quarter of 2009 compared with the same period a year earlier, according to Consumer Price Index data. Home insurance prices were up about 3 percent. Nevertheless, whatever modest gains the industry earned from higher rates were more than offset by economic weakness, cutting into the demand for most types of insurance. The weak economy is having a disproportionately large impact on commercial insurers due to rising unemployment (slicing payrolls and eroding the exposure base for workers compensation premiums) and reduced construction and manufacturing activity.
 
While negative premium growth since 2007 primarily reflects soft market (pricing) conditions, the recent acceleration in the decline clearly reflects the corrosive effect of the recession on exposure growth and the demand for insurance. The economic slowdown is taking its toll in a variety of ways in 2009:

 

  • New Housing Starts: Estimated to drop to 570,000 units in 2009, down72 percentfrom 2.07 million units in 2007. The drop affects home insurers and insurers with books of business serving the construction, contracting and home supply industries. 
  • New Car/Light Truck Sales: Expected to drop to 10.3 million vehicles in 2009, down 39 percent from 16.9 million vehicles in 2005; The decline will occur despite the wildly successful “cash for clunkers” program, which sparked the sale of nearly 700,000 vehicles. (Note: the Insurance Information Institute estimates that the program netted auto insurers about $300 million in net new auto premiums).
  • Employment/Underemployment: The average unemployment rate during the first nine months of 2009 was 9.0 percent, up from 5.5 percent a year earlier. By October the unemployment rate had reached 10.2 percent, the highest since August 1983. Nearly 7.5 million jobs have been lost since the beginning of the recession in December 2007. Increases in unemployment SAP payrolls, the exposure base for workers compensation. Underemployment is also a problem. Many people who would like to work full time are working part time. Adding those individuals to the unemployed plus so-called “discouraged workers” (people who have looked for work so long they have stopped searching) reached 17 percent by September, meaning that one in six workers was either unemployed or underemployed.
  • Industrial Production and Capacity Utilization: Industrial production increased by 5.2 percent during the third quarter, the first gain since the first quarter of 2008. The increase comes on the heels of sharp declines of 19.0 percent and 10.3 percent during the first and second quarters of 2009, respectively. Just 69.9 percent of industrial capacity was utilized during the third quarter, according to the Federal Reserve, but recent trends are favorable. Capacity utilization rose from 68.3 percent in June to 71.3 percent in November (though still well below the long-run 80.9 percent average from 1972 to 2008). Weakness in both of these metrics indicates less demand for insurance needed in the production process as well on the goods produced. Nevertheless, continued improvements in these figures should help to increase demand for many types of insurance.

 

Investment Performance: Significant Improvement, But Still a Drag on Profits

The financial crisis continues to affect P/C insurer profitability primarily through reduced investment earnings—one of only two sources of revenue for insurers (the other being premiums). Insurers are among the largest institutional investors in the world, with P/C insurers managing assets totaling some $1.2 trillion as of year-end 2008. Earnings on investments fall into several categories, the largest being investment income (primarily interest generated from bond holdings and dividends from stocks). Capital gains are the second most important source of investment earnings. Net investment income fell 6.3 percent or $2.4 billion to $35.8 billion during the first nine months of 2009 compared with $38.3 billion during the same period in 2008. Despite the recovery in the markets since their March lows (the S&P 500 index was up 17 percent through September 30), net realized capital losses remained very large through the first nine months of the year. Realized capital losses totaled $9.6 billion through the first three quarters, virtually unchanged from losses of $9.7 billion a year earlier. The third-quarter figure represents a significant improvement. For all of 2008, the P/C insurance industry recorded a $19.8 billion realized loss on investments. The $29.4 billion in realized capital losses since the beginning of 2008 is by far the largest in the industry’s history, dwarfing the $1.2 billion loss in 2002 in the wake of the tech bubble collapse and the market crash following the September 11, 2001 terrorist attack.
 
It is worth noting once again, however, that the magnitude of realized losses is diminishing. The industry’s third-quarter realized capital losses totaled $1.1 billion, down from $3.2 billion and $8.0 billion in the second and first quarters, respectively.
 
There are several reasons to believe that the worst might be behind the industry in terms of realized investment losses. First, major stock market indices are well off their March 2009 lows. The S&P 500 Index, for example, was up 64.7 percent through December 21 from its March 9 low (and up 23.3 percent for the year). Moreover, any future plunge in stock markets or loss of value in troubled credit instruments, should they occur, will have a much more muted impact on investment earnings because insurer portfolios have been substantially “derisked” over the past two years. That is because plunging share prices between late 2007 and early 2009 reduced equity exposure. The share of the industry’s portfolio invested in common stock shrank from 17.7 percent at year-end 2007 to approximately 14.9percent as of year-end 2008.

Declining stock prices were not the only reason for the plunge in realized capital gains. Beyond the market swoon is the fact that insurers had to write off or write down billions of dollars in assets. Assets in this case include not only stocks but credit instruments such as bonds and collateralized debt obligations that have lost value. The recovery in credit markets has allowed insurers to take favorable “marks” (record increases in value) on some securities.

Interest rates on the safest of assets plunged in late 2008 and remained low during the first quarter, reducing the ability to generate investment income in the future. The Federal Reserve cut its key federal funds rate on multiple occasions last year. At the beginning of 2008, the federal funds rate was 4.25 percent. On December 16, 2008 the Fed cut rates below 1.00 percent for the first time ever, targeting a range between zero and 0.25 percent, where they remained throughout 2009.

Interest rates are also being held down by subdued inflationary expectations. While there has been concern that the Obama administration’s $787 billion economic stimulus program, combined with the Federal Reserve’s ballooning balance sheet would put inflationary pressure on the economy, there remains no inflation on the horizon. The combination of high unemployment, low factory utilization and the bursting of last year’s energy and commodity price bubble means that there is plenty of slack in the system to absorb growth without sparking inflation. One of the best measures of inflationary expectations is interest rates on intermediate and long-dated Treasury securities. As of mid-December, the yield on U.S. Treasury securities stood at 3.5 percent while the yield on 30-year bonds was 4.4 percent. Neither suggests a great deal of concern on the part of investors about inflation. Moreover, the Federal Reserve is highly cognizant of the riskand is already looking at the timing dimensions for partial withdrawal of its monetary stimulus. It is worth noting, however, that longer-term Treasury yields have been creeping up recently as consensus builds for a more robust economic recovery than was anticipated just a few months ago.
 

What Do Reduced Investment Earnings Mean for P/C Insurers?

The combination of low interest rates, depressed asset prices and smaller dividends means that P/C insurers are earning less from their investment portfolios than in the past. The implications are both profound and immediate because there can be no guarantee of a reversal in these trends. The only guarantee is that insurers will continue to face losses from claims that are as large or larger than in the past. The bottom line, therefore, is that insurers will need to earn more in premium through higher rates to compensate for lower investment earnings. All else being equal, robust investment returns allow insurers to charge less than they would otherwise need to charge. Investment earnings are factored into rate need expectations. Buyers of insurance and regulators will have to accept the fact that insurers will need to charge higher rates in order to meet expected losses that are little changed despite the recession and depressed investment environment. Had a major hurricane struck the coast of Florida during the 2009 hurricane season it would have cost no less, and probably more, than the same storm before the crisis. In the future, more of those losses will necessarily be paid through premiums and less from investment earnings.
 
A very concrete way to see that disciplined underwriting and pricing will be important in the years ahead comes from an historical examination of periods of similar underwriting performance relative to profitability. During the first nine months of 2009, the industry’s combined ratio of 100.7 resulted in a 4.5 percent return on average surplus. In 2005, the identical (full-year) combined ratio produced a 9.6 percent rate of return. Back in 1979, the industry’s combined ratio was 100.6 while the overall return was 15.9 percent. Given that the underwriting performance in each of these years was virtually identical, what explains the radically different profitability figures? The answer is the investment environment and the prevailing level of interest rates in particular. Lower interest rates, which are becoming embedded in insurer portfolios as higher yield bonds mature and are replaced with lower yielding securities, make it extremely difficult, if not impossible, for most insurers to earn a risk appropriate rate of return without improving their underwriting performance through increased rates, lower claims cost or lower expenses or some combination of the three.    

Underwriting Performance and Catastrophe Losses: Discipline, Good Fortune or Both?

Profits during the first half of 2009 were hurt by a modest underwriting loss of $2.3 billion after policyholder dividends on a combined ratio of 100.7. Yet the underwriting performance is much better than the 105.5 recorded during the same period in 2008, which was associated with an underwriting loss of $18.8 billion.
 
Weakness in commercial lines pricing remains the greatest challenge to industry underwriting performance. One break that insurers caught during the first nine months came from notably lower catastrophe losses, which fell by 62 percent to $10.3 billion from $26.8 billion in the year earlier period, according to ISO’s PCS unit.
 

Mortgage and Financial Guaranty Insurers Continue to Distort Results

It is important to bear in mind that the 2009 results remain somewhat skewed by the disastrous performance of many mortgage and financial guaranty insurers. This segment accounts for just 2.0 percent of industry premiums written but ran a combined ratio of 175 during the first nine months. As bad as that result is, it is much improved from 276.2 percent during the first quarter and 237.3 during the first nine months of 2008. According to ISO, exclusion of the mortgage and financial guaranty segment knocks 1.4 points off the combined ratio, leaving it at 99.3 during the first nine months. Because the mortgage and financial guaranty segment so profoundly distorted the nine-month underwriting results, the combined ratio of 99.3 (rather than 100.7) is probably the best to use for comparative purposes as most insurers are not involved in this specialized business. ISO also reports that the exclusion of mortgage and financial guaranty insurers raises the industry’s rate of return to 5.9 percent, compared with 4.5 percent when this segment is included.
 

Impacts of the Economic Crisis on P/C Insurer Policyholders’ Surplus (Capacity/Capital)

Property/casualty insurance is a highly cyclical business. Because the industry’s peak profits in the most recent cycle were achieved in 2006 and 2007, insurers entered the credit crisis and recession from a position of financial strength. Insurers routinely plow back most of their earnings into the business in order to build up their capital positions. The expanded capital cushion not only provides insurers with the necessary resources to pay large-scale catastrophe losses such as Hurricane Katrina ($41.1 billion) or the September 11 terrorist attacks ($32.5 billion), but also helps insurers ride out stock market crashes, credit market turmoil, recessions, inflations and every other sort of economic and financial market disruption.
 
That being said, no investor will emerge from the current economic crisis unscathed and at the height of the crisis in early 2009 there was a significant impact on insurance industry capacity. Since March the turnaround in stock and bond markets is having a favorable impact on asset prices, bolstering policyholder surplus. As discussed above and noted by ISO and PCI, industry policyholders’ surplus increased by $27.8 billion to $490.8 billion or 6.0 percent during the quarter, up from $463.0 billion at the end of the second quarter. The gain comes on the heels of a 5.9 percent or $25.9 billion increase to $463.0 billion during the second quarter from $437.1 at the end of the first quarter. The reversal is notable and important. Property/casualty insurance industry capacity had plunged by an alarming $84.7 billion or 16.2 percent over the previous five quarters from the pre-crisis peak of $521.8 at the end of the second quarter of 2007. Despite the turnaround during the second quarter, industry capacity remains 5.9 percent below its 2007 peak.
 
The diminution of capital, combined with reduced investment earnings, implies that insurers will need to be very disciplined in their underwriting if they hope to earn risk appropriate rates of return. In effect, this involves a return to the way P/C insurance companies were managed for many decades before the era of high interest rates began in the mid-1970s. Prior to that time insurers managed their operations with the intent of earning underwriting profits every year and were generally successful at doing so. Investment earnings were considered helpful but were certainly not viewed as a reliable source of significant earnings.
 
Despite the erosion of capital over the past two years, the P/C insurance industry ended the nine-month period well capitalized by historical standards. The ratio of annualized nine-month premiums written to available surplus (a simple measure of financial leverage) stood at 0.87 as of September 30. This means that insurers had $1 in capital (surplus) on hand for every $0.87 in premium written. This compares to an average ratio of 1.52 during the past 50 years.
 

Financial Strength: P/C Insurer Financial Strength Remains Strong

Additional evidence of strength and resilience in the property/casualty insurance industry comes from recent data on financial impairments of insurers. According to A.M. Best, seven P/C insurers became impaired in 2008. The corresponding impairment rate is 0.23 percent, the second lowest on record—second only to the record low of 0.17 percent set in 2007. All of the impairments in 2008 were of tiny companies, whose business mix bears little resemblance to that of the industry overall. Among the impaired insurers were three title insurance companies, a Texas-only auto and home insurer pushed over the edge by Hurricane Ike and a risk retention group established to handle the liability risks of a trucking company. Impairment rates have remained low through the first nine months of 2009, compared to an accelerating number of bank failures. Approximately 170 banks will have failed between January 2008 and year-end 2009.
 

Summary

A volatile investment environment and shrinking economy had a significant impact on the financial and underwriting performance of the P/C insurance industry during the first nine months of 2009. A return to profitability and rising capacity during the second and third quarters are primarily attributable to improved investment market performance. At the same time, persistent soft market conditions and a deep recession severely impacted growth. While insurers remain cautious about the economy and financial market conditions, there is guarded optimism that both will continue to improve as the industry moves into 2010.
 
Fundamentally, the property/casualty insurance industry remains quite strong financially, with capital adequacy ratios remaining high relative to long-term historical averages.
 

A detailed industry income statement for the first nine months of 2009 follows.

Nine-Month 2009 Financial Results

($ Billions)

   $
Net Earned Premiums $317.8
Incurred Losses 231.7
     (Including loss adjustment expenses)   
Expenses 90.3
Policyholder Dividends 1.0
Net Underwriting Gain (Loss) -3.2
Investment Income 35.8
Other Items 1.1
Pre-Tax Operating Gain 33.7
Realized Capital Gains (Losses) -9.6
Pre-Tax Income 24.1
Taxes 7.9
Net After-Tax Income $16.2
Surplus (End of Period) $490.8
Combined Ratio 100.7**

*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.
**Includes mortgage and financial guaranty insurers. Excluding these insurers the combined ratio was 99.3.

 

 

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