2004 - First Quarter Results

By Robert P. Hartwig, Ph.D.
Senior Vice President & Chief Economist
Insurance Information Institute
bobh@iii.org

June 29, 2004

The property/casualty insurance industry reported a statutory rate of return on average surplus of 11.3 percent for the twelve months ending March 31, 2004, up from 9.4 for calendar year 2003, 1.1 percent in 2002 and the worst-ever negative 2.3 percent recorded in 2001. The annualized statutory rate of return on average surplus for the first quarter was 15 percent.  The results were released by the Insurance Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI).

2004:  Keeping the Industry’s New-Found Profitability in Perspective

Some events in the insurance world are so rare or so extreme they might occur only once or twice in a career.  In other cases, perhaps just once in a lifetime. While this is a good thing when it comes to large-scale natural disasters or major terrorist attacks, it’s quite another when it comes to achieving robust levels of profitability.  Consequently, 2004 should be a time for introspection—a time to reflect on why profitability remains so elusive and fleeting in our industry, rather than a time to revel in its arrival.

Yes, the 11.3 percent return on average surplus over the 12 months ending March 31 is a welcome departure from the disappointment of negative and single digit returns that have come to characterize the property/casualty insurance industry over the past 15 years.  But even more exciting is the prospect of a 15 percent return for 2004.
 
If you’re wondering when the property/casualty insurance industry last achieved a rate of return in the neighborhood of 11 percent, you’ll need to travel back to 1997 when insurers registered an 11.6 percent return on equity.  But that year’s good fortune owes itself largely to a meteorological fluke—the lowest level of catastrophe losses in at least the past 15 years.  If you’re wondering when the industry last generated a return anywhere near 15 percent, you’ll have to go all the way back to 1988, at the tail end of the last hard market.  In that year the industry posted a 14.1 percent return—and marked the last time the industry earned its way to profitability through underwriting and pricing discipline.  One year earlier, in 1987, the p/c insurance industry outperformed the Fortune 500 group—a feat that has not been repeated in the 16 years since.  If all goes well in 2004, that miserable streak of underperformance will come to an end, with p/c insurers nudging out the Fortune 500 group by a point or so.

Underwriting Discipline: A Multi-Year Effort Finally Bears Fruit

The first quarter combined ratio of 93.3 proves just how serious insurers have become about improving underwriting and implementing risk-appropriate pricing.  Since 2001, insurers have managed to lop more than 22 points off the industry’s combined ratio, turning that year’s record $52 billion underwriting loss into an estimated record underwriting profit of $21 billion this year (based on annualized first quarter net underwriting profits of $5.36 billion).

The current quarter’s result is far better than what was expected by industry observers.  An Insurance Information Institute poll of industry analysts in late January 2004 produced an average estimate for the 2004 combined ratio of 100.0.(1)  Even the most optimistic among the survey respondents forecast a combined ratio of just 97.5.

The prospect of a combined ratio under 100 makes for some interesting historical comparisons.  The last time the industry ran a full-year underwriting profit was more than a quarter of a century ago—in 1978—when the combined ratio sank to 97.5 following the hard market of the mid-1970s.  The last time the industry experienced a full-year combined ratio better than 2004’s first quarter result of 93.3 was more than a half century ago, in 1953!  Prior to 1960, underwriting profits in the industry were the norm.  In fact, stock p/c insurers experienced underwriting profits in 30 of the 40 years from 1920 through 1959.  Among the 10 years with a combined ratio exceeding 100, three occurred during the Great Depression, with a peak combined ratio of 104.9 in 1932.

It’s also important to keep in mind that a combined ratio in the neighborhood of 93 should no longer be viewed as a fluke—not likely be seen again for another half century. In today’s low interest rate and volatile investment environment, a combined ratio of 93 to 95 is what it takes to generate Fortune 500 rates of return.  The old rule of thumb—that a combined ratio of 100 produces an adequate rate of return is a property/casualty insurance industry urban legend that just won’t seem to go away.  Last year’s 100.1 combined ratio produced a statutory return on average surplus of just 9.4 percent, compared to a 12.6 percent ROE among the Fortune 500 group.  According to ISO/PCI, insurers would have needed a combined ratio of 94.3 to produce a 15 percent rate of return last year, given prevailing market and tax conditions.

Premiums and Pricing: Sinking Beneath the Waves?

Pricing, of course, has been a critical factor in the industry’s improved performance.  Insurers have successfully managed to push insurance prices sharply upward over the past four years, forging a stronger link between price and risk.  But as pricing power continues to wane in the aging hard market and the investment environment remains volatile, sustained profitability depends increasingly on maintaining underwriting discipline. While underwriting discipline remains largely intact, at least for now, current pricing trends are increasingly ominous.

The fact of the matter is that pricing seems to be weakening more rapidly than anyone anticipated.  Net written premium growth came in at just 4.5 percent during the first quarter, barely one-third the 12.7 percent pace recorded during the same quarter last year and less than half the 9.8 percent figure for all of 2003.

The same Insurance Information Institute poll that revealed industry analysts to be too pessimistic in terms of underwriting performance also reveals excessive optimism when it comes to premium growth expectations.  The average forecast among survey respondents for net written premium growth in 2004 was 7.4 percent, nearly three full points ahead of the first quarter result, a comparison that is likely to become increasingly ugly as growth continues to decelerate throughout the year.

One explanation for the faster-than-expected decline in top line growth is the faster-than-expected improvement in financial performance.  With insurers hitting price, profit and underwriting targets more quickly than they expected, the market has turned price-competitive sooner than would otherwise be the case.  Justified or not, the combination of rising inflation and slower premium growth could plunge the industry into a negative real growth situation by late this year or early 2005 for the first time since 1999.

Investment Performance: Encore of 2003 Increasingly Unlikely

What a difference a year makes.  The 26.4 percent gain in the S&P 500 in 2003 was a welcome change from the double-digit declines posted over the three prior years.  The increase allowed insurers to realize $6.9 billion in capital gains in 2003 compared to a realized capital loss of $1.2 billion in 2002.  This year, the S&P 500 rose only about       1 percent during through the first quarter and was up barely 2 percent through late June.  Stocks so far this year appear to be paralyzed by the prospect of the Federal Reserves stated intent to raise interest rates, in steps, throughout the second half of 2004.  Expectations are that the Federal Funds rate will be lifted from 1 percent (its level through most of the first half) to 2 percent by year’s end.

Some insurers appear to be shortening the duration of their bond portfolios (which account for two-thirds of all invested assets) in order to reduce the interest rate risk inherent in the Fed’s policy shift. This appears to have been a wise strategic maneuver given that the yield on the 10-year Treasury note, which fell to a 45-year low of         3.13 percent on June 13, 2003, rose more than 160 basis points to 4.75 percent by late June 2004.

Nevertheless, interest rates during the first quarter were generally quite low, leading to a mere 2.1 percent increase in investment income for the first quarter.  Much of the increase in investment income came from an increase in the industry’s invested assets which, as noted by ISO/PCI, rose by 13.9 percent to $950.2 billion.  Insurers were also able to realize capital gains in their portfolios to the tune of $3.4 billion during the quarter.

Why There’s No “Surplus” in Policyholder Surplus

Policyholder surplus rose by 4.1 percent, or $14.2 billion, to a new record high of $361.2 billion during the first quarter, surpassing the previous record high of $347.0 billion set during the final quarter of last year.  Prior to that, the previous high for policyholder surplus was $339.3 billion during the second quarter of 1999.

Unfortunately, the role of policyholder surplus (PHS) is generally not well understood by people unfamiliar with the insurance industry, including many policymakers and legislators.  PHS is insurance nomenclature for what is referred to as “net worth” or “owners’ equity” in other industries.  It is a measure of underwriting capacity because PHS is a measure of the financial resources (capital) that stand behind every policy underwritten by an insurer.   A weakened surplus position can lead to downgrades and, if the drop is steep enough, regulatory actions or insolvency.

While the policyholder surplus growth has been substantial over the past few quarters, it stands just 6.5 percent higher than in mid-1999.  Over the same period, the U.S. economy expanded by 25 percent and the demand for insurance along with it.  The industry’s capital base is therefore stretched more thinly than it was in the late 1990s.  In addition, a wide variety of new risks have emerged, all relying on this same, limited pool of capital; these include: terrorism, mold, the medical malpractice crisis and the crisis in corporate governance—none of which were major issues in 1999.  The combination of economic growth and greater demand for insurance along with new and emerging risks illustrates the fact that the industry’s policyholder surplus is fully committed.  Increasing the size of that pool is necessary in order to finance the insurance needs of a growing U.S. economy as well as claims arising from a virtually unlimited array of new and existing risks.

In 2004, the finances of the property/casualty insurance industry are coming under close scrutiny from state regulators, insurance departments, the federal government as well as the industry’s perennial critics.  Some have inappropriately cited rising capacity and profitability to call for rate roll backs while others will try to derail tort reform efforts, citing favorable loss trends.  Predictably, some have already endeavored to offer their unenlightened commentary to the media, characterizing the industry as “rolling in dough.” Of course, foes of reauthorization of the Terrorism Risk Insurance Act (currently set to expire at the end of 2005), or even individuals and government agencies trying to make an honest assessment of industry resources, may misinterpret the significant increase in policyholder surplus since the end of 2002 and wrongly assume that the gain means that insurers are financially able and willing to underwrite full-limit terrorism coverage.

It means no such thing.  As discussed earlier, the industry’s policyholder surplus is, in effect, already committed to the risks being underwritten today.  Moreover, because potential losses from a terrorist attack or sequence of attacks are potentially unlimited, no amount of policyholder surplus is sufficient to cover the full range of attack scenarios.  Even the federal government, with theoretically unlimited resources, caps its own liability under TRIA at $100 billion.  Insurers, with far more limited resources than Washington, and no ability to meaningfully reinsure terrorism risk will, in many cases, be forced to walk away from the policyholders in the event TRIA is not reauthorized.

Summary

The financial and underwriting performance of the property/casualty insurance industry during the first quarter of 2004 was nothing short of outstanding.  The results bode well for a year that is likely to be among the best in the past half century in terms of underwriting performance and the best since 1987 in terms of profitability, barring unusual catastrophe losses in the second half.  Much of the strength in 2004, however, is derived from rating and underwriting actions taken in previous policy years that are only now bearing fruit.  Ominously, top line growth during the first quarter of 2004 is well below expectations, with real growth in net written premiums likely to turn negative by year’s end.  Moreover, the fact that the industry’s average return on surplus is an estimated 15 percent, despite a combined ratio of just 93.3, is a stark reminder that a renewed commitment to underwriting and pricing discipline are needed if the industry hopes to maintain Fortune 500 rates of return beyond the next four to five quarters.
 
A detailed industry income statement for the quarter follows:

(1) Insurance Information Institute Groundhog Forecast, February 2004: /media/industry/financials/forecast2004/.