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Robert P. Hartwig, Ph.D., CPCU
Senior Vice President & Chief Economist
Insurance Information Institute
bobh@iii.org
December 27, 2005
The property/casualty insurance industry reported a statutory rate of return on average surplus of 9.5 percent through the first nine months of 2005, marginally below the 10.5 percent average return recorded during calendar year 2004. The results were released by the Insurance Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI).
The financial performance of the property/casualty insurance industry during the first nine months of 2005, while falling well short of what insurers had been hoping for, nonetheless provided stunning proof of the resilience of the property/casualty insurance industry in the face of unprecedented adversity. Rocked by record catastrophe losses approaching $50 billion, the industry broke even from an underwriting perspective with a combined ratio coming in at an uncanny and surprisingly low 100 even. This means that effectively every dime of premium income that came in the door through the first nine months of 2005 exited in the form of claims payments, claims reserves and expenses—with nothing left over for profit. All was not lost, however, as insurers benefited from rising interest rates and modest stock market gains to generate $40.7 billion on their investment portfolio, enough to tip the balance toward a 9.5 percent return on average surplus. Granted, the 9.5 percent return through the first nine months is a far cry from the 15.3 percent return posted through the first half of 2005, but is much better than expected, and a reasonable fourth quarter (Hurricane Wilma notwithstanding) should push overall profitability for 2005 into the 10 to 11 percent range, roughly on par with the 10.5 percent return in 2004. It must be noted, however, that profitability in the industry is still disappointing low, coming in well below the expected 14 percent return for the Fortune 500 group of companies this year. Prior to Hurricane Katrina the industry was on a trajectory to record its highest level of profitability since 1987.
The ability of property/casualty insurers to weather record catastrophe losses exceeding $55 billion in 2005 fresh on the heels of record losses of $27.5 billion in 2004 derives from four main sources:
Each of these factors is discussed below both in context of the nine-month 2005 results and the prospects for the industry going forward.
The property/casualty insurance industry entered the 2005 hurricane season from an extraordinarily strong underwriting position. Indeed, the industrywide combined ratio was just 92.7 through the first six months of the year, down from 98.3 in (calendar year) 2004, 100.1 in 2003, 107.2 in 2002 and 115.7 in 2001. Thus in less than four years, 23 points had been lopped off the combined ratio.
The improvement in underwriting over the past several years is the result of a painful but necessary across-the-board effort by insurers to reassess risk that has led to a much better match between risk assumed and price charged as well as a general tightening in the terms and conditions of coverage. The fruits of this effort led in 2004 to the industry’s first underwriting profit (i.e., combined ratio under 100) in 26 years. That same discipline remained in place in 2005. Even with record catastrophe losses, insurers are likely to record a modest underwriting profit for the year because fundamental underlying performance remains strong.
Another strong underwriting performance is expected in 2006. Preliminary results from the Insurance Information Institute’s Earlybird Survey of industry analysts indicates an expected combined ratio of 97.9 for the year ahead, leading to a third consecutive underwriting profit for the first time in decades.
Many major insurers, particularly those with significant commercial lines operations, cede 10 to 30 percent of their premiums to reinsurers. Smaller insurers often cede much more. Cession rates for catastrophe-prone business can be even higher. These facts came together in 2005 to produce a significant benefit to primary insurance companies with exposure to the hurricane ravaged Gulf and Southeast Atlantic coasts, with some insurers having upwards of 60 percent of their gross losses covered by reinsurance. While painful for reinsurers, the global spread of risk through the use of reinsurance (and retrocessional markets) is the principal means by which large-scale catastrophes are financed. It is likely that reinsurers will ultimately bear more than half the losses associated with Hurricane Katrina as they did in the wake of the September 11, 2001 terrorist attacks. ISO estimates that foreign reinsurers alone, who account for the bulk of reinsurance protection sold in the United States, along with residual market mechanisms reduced gross catastrophe losses of $47.6 billion through the first nine months of 2005 to somewhere between $27 billion and $32 billion, implying a net decrease of up to 43 percent. Inclusive of domestic reinsurers and given the likelihood that the year’s catastrophe losses will develop upward (with the majority of those losses falling to reinsurers) and the fact that large offshore energy losses (which are not included in the ISO catastrophe loss figures) tend to be heavily reinsured, reinsurers’ total share of 2005 catastrophe losses will almost certainly rise. Fitch ratings estimates that the global reinsurance sector lost $18 billion to $20 billion in equity (surplus) due to 2005’s record catastrophe losses, which equates to roughly 5 to 6 percent of the sector’s year-end 2004 surplus.
Reinsurers’ combined ratio for 2005 will likely exceed 130. The significant hit suffered by reinsurers suggests reinsurance prices will rise in 2006, though large increases will generally be confined to property catastrophe reinsurance backing residential and commercial property lines exposed to East Coast hurricane risk as well for energy and marine coverages. In addition to raising prices, many reinsurers are raising additional capital to patch holes created by this year’s storms and other catastrophes abroad. Moreover, a number of new reinsurers have been formed in the wake of Hurricane Katrina in order to capitalize on higher prices, short supply and strong demand. The issue of capital raising and start-ups will be addressed in the section on capacity below.
As noted by ISO, policyholder surplus—the broadest measure of claims paying capacity—actually rose slightly during the quarter, from $412.5 billion on June 30 to $414.3 as of September 30. The increase was not expected. In fact, most analysts expected policyholder surplus for the whole of 2005 to remain roughly flat or increase only slightly from the year-end 2004 level of $393.8 billion. The majority of the $20.4 billion increase (a gain of 5.2 percent) through the first nine months is associated with $28.8 billion in after-tax profits (net income) and $6.3 billion in new capital. These inflows were partially offset set by $9.6 billion in shareholder dividends, $4.7 billion in miscellaneous charges against surplus and $0.4 billion in unrealized capital losses on investments. Again, the figure reflects the broad spread and syndication of risk through heavy use of reinsurance, much of it foreign. Consequently, a significant share of the impact on surplus associated with the storm season of 2005 will ultimately wind up on insurance industry balance sheets in countries like Switzerland, Germany, Great Britain, France and Bermuda. Nevertheless, a recent report by Merrill-Lynch suggests that global reinsurance capacity will rise by 7 percent in 2005 despite the storms.
Of great interest in the wake of Hurricane Katrina was the ease and rapidity with which many insurers and reinsurers were able to raise capital. As of December 1, 19 existing insurers announced plans to raise $10 billion in fresh capital. Additionally, the “Class of 2005” was born with 12 new insurers and reinsurers being formed with an initial capitalization of $8.7 billion. Eleven of the twelve start-ups will be domiciled in Bermuda while one will take-up residence in the Cayman Islands. Lloyd’s syndicates in London have also announced billions in new capacity for 2006. Altogether, it is likely that about $23 billion dollars in new capital will be raised, or roughly 60 percent of the after-tax losses suffered by the industry overall during the 2005 storm season.
This is an extraordinary sum to be raised so quickly and will have a material impact in terms of muting the return of significantly harder market conditions in some segments. Most of the start-up entities hope to be writing by January 1 and have indicated interest in the property catastrophe reinsurance markets as well as the energy and marine segments. Relatively little of this capital will make its way directly into homeowners insurance markets in catastrophe-prone areas, which will continue to experience acute supply and demand imbalances and rising prices in 2006. The source of capital varies and including traditional equity capital as well as private equity and hedge fund money.
Investor interest in the property/casualty insurance and reinsurance industries is high because certain insurers (existing and start-up) and some industry segments offer the prospect of attractive returns going forward. Investments in the insurance sector are particularly attractive to non-tradition sources of capital such as hedge funds because insurance risk is generally uncorrelated with traditional financial risks. For example, the frequency/severity of hurricanes is uncorrelated with interest rates movements or fluctuations in foreign exchange rates assumed by hedge funds, making them attractive investments because they lower the volatility of the hedge fund portfolio while providing potential high rates of return. These sources of capital also tend to be less risk averse than traditional investors.
Wall Street certainty has high expectation for insurers in the wake of record catastrophe losses during each of the past two years. Property/casualty insurer stocks on a market cap weighted basis were up nearly 10 percent for the year as of December 19 compared to only about 4 percent for the S&P 500 index.
Some regulators, legislators and insurers have cited the 2004 and 2005 storm seasons and the prospect of more mega-sized natural disasters in the future as a reason why the federal government should play a role in the financing of natural disaster in the future. The property/casualty insurance industry’s financial performance over the past two catastrophe-wracked years is likely to feed into this debate.
Proponents of a more active federal role argue that such events are only likely to become more frequent and more expensive over time and are already reaching the limit of insurers’ ability to offer insurance in disaster-prone areas. The National Association of Insurance Commissioners (NAIC) has formally unveiled a plan that calls for a layered approach to financing natural disaster losses. Within the context of an “all-risks” policy offered by private insurers (i.e., including flood and earthquake), the NAIC proposes a layered approach. The first layer would attempt to maximize the resources of the private insurance and reinsurance industries. The second layer would consist of a system of state or regional catastrophe funds while the third layer would be a federal reinsurance mechanism. Several bills have been introduced into Congress that what authorize the federal government to sell or auction off reinsurance to state catastrophe plans. The proposal also calls for changes to US tax law that would allow insurers to accumulate catastrophe reserves on a tax-preferred basis (presently the IRS only allows for post-event reserving) and would encourage individuals to establish tax-free personal catastrophe savings accounts.
Opponents to a more active federal role believe there is sufficient private sector capacity for even very large catastrophes and fear the federal government will crowd out private capital and stifle innovative private sector solutions for managing catastrophic risks.
Investment income rose by 14.6 percent after adjusting for special dividends (25.9 percent before adjusting) during the first nine months of 2005 relative to the same period in 2004. This compares to unremarkable growth of 2.4 percent for all of 2004. Growth in investment income (which consists primarily of interest income generated from the industry’s substantial bond portfolio) had been tepid (or even declined) despite stronger cash flow because of declining interest rates over the past several years and which remained low throughout 2004. Indeed, the average yield on 10-year Treasury securities during the first nine months was 4.22 percent, not significantly different from calendar years 2003 and 2004, at 4.01 percent and 4.27 percent, respectively, which were the lowest in 40 years. Given recent tightening by the Fed and strong economic growth, insurers, like most institutional investors, believed that long-term rates would have headed higher many months ago. They didn’t. Instead the yield curve simply flattened as short-term yields rose in response to the Fed’s actions while long-term rates stayed flat or declined—a phenomenon Fed Chairman Alan Greenspan famously labeled a “conundrum” in testimony in February.
Thirteen rate hikes by the Federal Reserve since June 2004 have pushed the federal funds rate up by 3 ¼ points to 4.25 percent (the highest level since May 2001) from 1.00 percent (a 46-year low), forcing money market rates and rates on short-term securities upward. The last two hikes occurred during the fourth quarter, pushing rates up by a total of 50 basis points (0.5 percentage points). Ordinarily, such an increase would have only a marginal impact on insurer investment earnings, but insurers have been accumulating significant assets with very short maturities in a bid to minimize interest rate risk and because the flat yield curves afforded virtually premium for investing long. A special Insurance Information Institute analysis of the industry’s current investment portfolio estimates that 10 percent of the industry’s invested assets in 2004 were held as cash or short-term securities compared to 4.1 percent in 1999. Over the same period, the proportion of the industry’s bond portfolio with maturities ranging from 10 to 20 years fell from 21 percent to and estimated 15 percent.
Fed rate hikes are expected to continue into 2006 but are also widely expected to end, perhaps as soon as the January 31 meeting of the Federal Reserve Open Market Committee. That meeting, the last for outgoing Federal Reserve Chairman Alan Greenspan, could see the federal funds rate rise to 4.5 percent. It is unlikely that the Fed will chart a radically different course under incoming Chairman Benjamin Bernanke, whose confirmation hearing is expected to go smoothly in early 2006.
Insurers’ investment return was bolstered by $4.3 billion in realized capital gains through the first nine months of the year, though the figure represented a 32.6 percent decrease from the same period in 2004. The S&P 500 index was up just 1.4 percent through September 30, but was up about 4 percent through December 23. Higher stock prices mean that insurers will have the opportunity to boost earnings by realizing gains on their portfolio during the fourth quarter. Looking ahead, 2006 could be a good year for Wall Street. Energy and hurricane induced inflationary pressures should ease and the Fed’s push toward higher rates should end early on, while the overall economy is expected to remain healthy.
Aside from record catastrophe losses, the major disappointment in the nine month results was extremely sluggish growth in net written premiums, which according to ISO increased by just 1.3 percent after adjusting for $6 billion in premiums and loss and loss adjustment expense ceded from one insurer to its foreign parent (and actually declined by 0.5 percent before the adjustment). The growth is the slowest since the 1.5 percent increase posted during the heart of the last soft market in 1999. The figure is well below the preliminary estimate from the Insurance Information Institute’s Earlybird Survey of industry analysts, which estimated 2.5 percent growth for full-year 2005. The survey does, however, predict that in the aftermath of 2005’s active hurricane season and the likelihood of another in 2006, the pace of premium growth will nearly double to 4.9 percent as prices firm.
In mid-December the US Congress passed a two-year extension of the Terrorism Risk Insurance Act, which had been scheduled to sunset on December 31, 2005. President Bush signed the bill, without ceremony, on December 22. Extension of TRIA is a positive for the insurance industry despite the fact that the government significantly reduced its own exposure at the expense of private insurers and reinsurers. The extension of the Act will help to stabilize insurance markets in the event of another major terrorist attack on US soil.
Major features of the legislation are summarized below:
The financial and underwriting performance of the property/casualty insurance industry during the first nine months of 2005 was much better than expected. Although buffeted by record catastrophe losses, insurers managed to break even from an underwriting perspective, suggesting that 2005 will conclude with an overall underwriting profit, only the second since 1978. The surprisingly good results suggest imply that insurers are doing a good job of spreading risk on a global scale, largely through extensive use of reinsurance. At the same, the industry remains attractive to investors, who have poured more than $20 billion into new and existing platforms post-Katrina and pushed stocks to their 2005 highs.
The storms of 2005 were not solvency-threatening to the industry as a whole, nor did they cause a net reduction in claims paying capacity. However, record catastrophe losses in 2004 and 2005 did take their toll on profitability. Return on equity in both years would have been in the 13 percent to 15 percent range each year—on par with the Fortune 500 group—had catastrophe losses been anywhere near “normal.” On a catastrophe-adjusted basis, 2005 is likely to represent the peak in the current cycle in terms of underwriting and profit performance. Combined ratios, however, are likely to rise in 2006 if catastrophe activity subsides even modestly.
One cause for concern overshadowed by recent events is the fact that top line growth through the first nine months of the year was just 1.3 percent and is, in fact, negative on an inflation-adjusted basis. There are likely to be price impacts on residential, commercial property and property catastrophe reinsurance prices in the aftermath of this year’s hurricanes that will push net written premium growth upward, but the affects will be focused on the Southeast and Gulf coast areas.
A detailed industry income statement for the first nine months of 2005 follows:
First Nine Months of 2005 Financial Results*
($ billions)
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*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.