2008 - First Nine Months Results

Financial Crisis: Impacts on the Insurance Industry

Insurers and all other segments of the financial services industry have been adversely impacted by the current economic and financial conditions. While the impact of turmoil in the financial markets affects individual insurers differently, the insurance industry, as a whole, remains fundamentally strong. Moreover, the basic function of insurance—the orderly transfer of risk from client to insurer—continues without interruption. This means that insurers today continue to sell and renew policies, pay claims and develop new products to protect people’s property, businesses and lives, and help support their retirements. The bottom line is that unlike banking, insurance markets are functioning normally.

It is important to recognize that the insurance industry is not suffering from a credit or liquidity crisis. Unlike many of the banks and other financial companies that have struggled, insurance companies, in general, do not borrow to make investments. Nor do they borrow to pay claims. So, even when some investments perform poorly, the effect is not magnified as it is when investments are highly leveraged.

It is true, however, that investment losses incurred by a non-insurance financial products subsidiary of one of the nation’s largest insurers have resulted in it receiving some $150 billion in federal assistance. Its insurance operations remain solvent and continue to operate normally. It is also true that several predominantly life insurance companies have indicated their desire to receive federal funds as well. Other insurers have stated they have no need for federal assistance and do not intend to seek it.

Insurance companies are regulated by state insurance departments that closely monitor the financial strength of insurers domiciled or doing business in their states. State regulators have repeatedly stressed that the insurance system is financially sound. Independent rating agencies also closely scrutinize the financial strength of individual insurance companies and make their rankings available to the public.

Throughout its nearly 200-year history in the United States, the insurance industry has endured every conceivable economic circumstance and crisis and managed to persevere. These include not only events like the Great Depression and numerous economic recessions, but also stock market crashes, gyrations in interest rates and inflationary spikes.

Impacts of the Economic Crisis on P/C Insurer Investment Earnings

The economic crisis has so far affected property/casualty profitability primarily through reduced investment earnings—one of only two sources of revenue for insurers (the other being premium income). Insurers are among the largest institutional investors in the world with P/C insurers managing assets totaling some $1.3 trillion as of year-end 2007. 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. Both are down through the first nine months of 2008. Given the 20.7 percent decline in the Standard & Poor’s 500 index through September 30, it is no surprise that the opportunity to realize net capital gains on stock holdings has effectively vanished. As noted by ISO/PCI, realized capital gains were nonexistent in the quarter—with the industry instead turning in a realized capital loss of $8.6 billion compared to a $4.0 billion gain in the same quarter a year earlier. The cumulative realized capital loss through the first nine months was $9.7 billion compared to a gain of $8.2 billion in 2007—an unprecedented 12-month swing of $17.9 billion. Continued market deterioration in the fourth quarter (the S&P 500 was down 40.9 percent through December 15) assures that the industry’s realized capital losses in 2008 will be the largest in 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 interesting to note that realized losses are much larger in 2008 than they were in 2002 for several reasons—but not because the markets were down more through the first nine months of 2008. In fact, the S&P 500 was down substantially more in 2002—off 29.0 percent through September 30 compared with 20.7 percent in 2008. Beyond the current market swoon is the fact that insurers are having 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 subprime mortgage crisis that began in mid-2007 began to seep into other sectors of the economy late in that year. Indeed, the National Bureau of Economic Research recently announced that the U.S. economy fell into recession in December 2007. During the third quarter of 2008 the crisis had exploded into a global credit catastrophe.

Property/casualty insurers, in general, maintain a fairly conservative investment profile. Insurers invest two-thirds of their assets in highly rated bonds (credit sensitive investments). While the actual default rate on most credit instruments remains low, mark-to-market requirements have forced prices down on some assets held by some insurers. The International Monetary Fund estimates that the credit crisis cost financial institutions worldwide $706 billion through September 2008 with insurers (globally) absorbing $106 billion or 15 percent of those losses.

Although stocks in 2008 will record their first losing year since 2002, when the S&P 500 Index lost 23.4 percent of its value, it is important to note that only 17 percent of P/C insurer invested assets are equities (stocks) while two-thirds are bonds. Nevertheless, the weak economy has taken a toll on the stock prices of almost every publicly traded firm and their investors have suffered along with them.

It is also worth noting that stock markets in the United States have experienced unprecedented volatility in 2008. The VIX Volatility Index, also known as the “Investor Fear Index” published by the Chicago Board Options Exchange reached record highs during the year. The index value is typically between 15 and 20, implying low volatility. Values greater than 30 signify extreme volatility. By September, the index value had reached 30.2 and new records were set in both October and November when the index soared to 61.2 and 62.6, respectively.

Interest rates on the safest of assets are headed down, reducing the ability to generate investment income in the future. The Federal Reserve had cut its key federal funds rate on four occasions by the end of March, including twice by three quarters of a point—the first 75 basis point cut by the Fed since November 1994. By the end of the first quarter the fed funds rate stood at 2.00 percent, compared with 4.25 percent on January 1, where it remained through the second and third quarters. Mounting evidence of a rapid deterioration in the economy compelled the Fed to cut the federal funds rates twice in October, to 1.00 percent, the lowest level since early 2004. On December 16, the Fed cut rates below 1.00 percent for the first time ever, targeting a range between zero and 0.25 percent. Because the Fed has now lowered the interest rates it controls effectively to zero, it has essentially reached the limits of what it can do to stimulate the economy by reducing borrowing costs, the traditional antirecessionary policy prescription administered by the Fed for decades. The Fed has not been rendered impotent, however. Chairman Bernanke has indicated that the Fed will engage in “quantitative easing” which means that it will likely purchase agency debt (such as debt issued by Fannie Mae and Freddie Mac) as well as longer-dated Treasury securities. Both efforts would have the effect of pushing down longer-term interest rates in an effort to stimulate mortgage lending and capital investment, thereby adding to the economic stimulus of traditional interest rate policy.

Interest rates are falling not only because the Fed is trying to decrease the cost of credit in an economy where credit markets have frozen, but also because fear has driven a flight to quality in Treasury securities. Interest rates charged to even the most creditworthy of corporate, consumer and municipal government risks soared during the third quarter. On the flip side of this severe dislocation of credit market risk was the stampede into Treasury securities. Because U.S. Treasury securities are assumed to have zero default risk, they are widely viewed as the safest in the world. The immense demand for Treasury debt means that their price at auction was pushed up and that their yield was pushed down. Indeed, the Treasury actually issued $30 billion of one-month bills in early December 2008 with a yield of 0.000 percent. In other words, fear-stricken investors were willing to accept no return on their investment. The yield on three-month bills was actually briefly negative during the month, implying that investors were actually willing to pay the Treasury to hold their money for them.

Lower interest rates are an important consideration for insurers. As large as the realized capital losses are, capital gains (losses) are generally a smaller proportion of investment earnings than investment income, which decreased only modestly through the first nine months of 2008. In fact, because capital gains and underwriting profits are both in negative territory in 2008, investment income will account for all of the industry’s net income (profit) this year. Through nine-months 2008, investment income totaled $38.0 billion, down 4 percent from $39.6 billion during the first nine months of 2008. The decline is largely attributable to lower interest rates in 2008 as well as lower cash flows.

Impacts of the Economic Crisis on P/C Insurer Policyholder 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 in the end there will be a significant impact on insurance industry capacity. As noted by ISO/PCI, industry policyholder surplus (the industry’s primary measure of capacity—akin to net worth in other industries) continues to trend downward. Policyholders’ surplus decreased in the first nine months by $39.4 billion, or 7.6 percent, to $478.5 billion from $517.9 billion at year-end 2007. The decline is the fourth consecutive quarterly drop in policyholders’ surplus, which peaked a year earlier at $521.8 billion during the third quarter of 2007. The net $43.3 billion decline in surplus represents a reduction of 8.3 percent in the industry’s capital base. In contrast, surplus increased by 6.2 percent in 2007, 14.3 percent in 2006, 8.2 percent in 2005, 13.4 percent in 2004 and 21.6 percent in 2003, following declines in 2000, 2001 and 2002. The return to negative capital accumulation is attributable to several factors, the largest and most obvious being declining prices for financial assets. During the first nine months, insurers recorded unrealized capital losses totaling $31.1 billion in addition to $9.7 billion in realized capital losses and $19.9 billion in underwriting losses. The reduction in capital has led many (though not all) insurers to scale back, suspend or discontinue the return of capital to shareholders through share buybacks. Share buybacks reached a record $23.2 billion in 2007.

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 property/casualty insurance companies were managed for many decades before the era of high interest 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 successfully at doing so in most. Investment earnings were considered helpful but were certainly not viewed as a reliable source of significant earnings.

Underwriting Performance: Not as Bad as It Seems

The combined ratio through the first nine months was 105.6, up 11.8 from the same period a year earlier. Despite the jump, the results are not as poor as they might initially appear to be. In fact, two of the three key factors that drove underwriting performance during the first nine months were either unusual ($24.9 billion in catastrophe losses) or not reflective of the business mix of most insurers (mortgage insurance and financial guarantee operations). Virtually all insurers, however, continued to experience deterioration in underwriting performance due to flat or falling prices for many types of insurance. Each of these factors is discussed in detail below.

Catastrophe Losses: Nine-Month Total Exceeds All of 2007—By Far

As noted by ISO, insured catastrophe losses reached $24.9 billion during the first nine months, their highest level since 2005, the year of Hurricane Katrina. The nine-month total for 2008 is higher than the full-year totals for both 2006 and 2007, at $9.2 billion and $6.7 billion, respectively. The nine-month total alone secures 2008’s place as the fourth most expensive year ever for catastrophe losses (behind 2005, 2004 and 2001). ISO states that higher catastrophe losses through the first nine months of 2008 added five points to the industry combined ratio above the level of catastrophe losses experienced over the same period in 2007.

Catastrophe losses during the first half of 2008 were fueled primarily by record-breaking tornado activity and severe hail and wind losses (apart from tornadoes). The third quarter, however, is historically the most expensive for insurers due to the fact that the peak of hurricane season occurs in September. The most significant catastrophe in 2008 was Hurricane Ike, which roared ashore in Galveston, Texas, on September 13 as a strong Category 2 storm. Official PCS insured loss figures put total insured damages at $10.655 billion, making Ike the fourth most expensive hurricane in U.S. history. Ahead of Ike (stated in 2007 dollars) are Hurricane Katrina ($43.6 billion), Hurricane Andrew ($22.9 billion) and Hurricane Wilma ($10.9 billion). A significant share of the loss in Texas will be borne by the Texas Windstorm Insurance Association, which insures the majority of properties in the state’s coastal counties.

Hurricane Ike was not the only severe hurricane of the year. Hurricane Gustav caused $2.1 billion in insured losses, according to PCS, when it struck the Louisiana coast on September 1.

Underwriting: Separating Mortgage and Financial Guarantee Impacts

The first nine-months' underwriting performance was influenced significantly by underwriting losses reported by many mortgage and financial guarantee insurers. This category of insurer generated a negative 130.6 percent rate of return during the first nine months of 2008. While it is not unusual for results in any given quarter to be driven by the experience in a small number of lines or by a specific event (such as home and commercial property coverage after a major catastrophe), it is rare for lines that account for just a sliver of industry premiums to produce large-scale impacts on industry performance. The mortgage and financial guarantee lines—with $6.4 billion in net written premiums during the first nine months—accounted for just 1.9 percent of the $336.0 billion industrywide total. Nevertheless, according to ISO, the loss and loss adjustment expenses of this segment ballooned to $17.9 billion through September 30—an increase of 352.1 percent—propelling its combined ratio to an unprecedented 279.4 through the first nine months compared to 93.1 during the same period in 2007. That was enough to add 3.7 points to the industrywide combined ratio, which finished the first nine months at 105.6—its highest level since 2001.

Cyclical Considerations

Another important factor influencing the nine-month underwriting performance was the continuation of the soft market, now well into its fourth year. As previously discussed, stripping out the mortgage and financial guarantee insurer results yields a combined ratio of 101.9, up from 93.8 in first half 2007 and 95.6 for all of 2007. The deterioration is generally in line with expectations and reflects the effects of a sustained, highly competitive pricing environment for most types of insurance, particularly commercial lines, as well as adverse claim frequency and/or severity trends in some key lines—not to mention higher catastrophe losses. According to the Council of Insurance Agents and Brokers, commercial renewals for larger brokered accounts were down 13.5 percent during the first quarter, 12.9 percent during the second and 11.0 in the third. Of course, actual changes experienced by individual insurers can vary substantially and few commercial insurers are actually reporting premium declines of this magnitude. In contrast, pricing in personal auto insurance, which accounts for one-third of industry premiums, appeared to become somewhat firmer during the first nine months of 2008. According to the U.S. Bureau of Labor Statistics, auto insurance prices averaged 2.1 percent higher during the first nine months of 2008 compared with the same period in 2007. This contrasts with an increase of 0.4 percent for all of 2007 relative to 2006. The pace of increase appears to be quickening. Through the first 11 months of 2008, auto insurance prices averaged 2.4 percent higher than during the same period one year earlier. In fact, auto insurance prices were up 0.9 percent in January 2008 compared with January 2007, but were up 3.7 percent in November versus a year earlier. Pressure on auto insurance rates is driven primarily by rising claim cost severity (average cost per claim) and increasing claim frequency for some coverages in some states.

Premium Growth Remains Negative

Net written premiums declined by 0.4 percent during the first nine months. Excluding mortgage and financial guarantee insurers produced a net decline of 0.5 percent. The premium decline is larger when mortgage and financial guarantee insurers are excluded because of that segment’s 4.5 percent increase in premiums written through the first three quarters. The overall decline comes on the heels of a 0.7 percent decline in calendar year 2007. Last year’s decline was the first in 64 years, when premium growth fell in 1943 in the midst of World War II. It appears likely that 2007-2008 will become the first consecutive years of negative premium growth since the Great Depression, when industry premiums fell for four consecutive years (1930 through 1933, inclusive) after peaking in 1929.

Summary

Economic turbulence has had an impact on the financial and underwriting performance of the P/C insurance industry during the first nine months of 2008. The sharp decline in profitability is primarily attributable to poor investment market performance, high catastrophe losses and a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the property/casualty insurance industry. Excluding this segment and normalizing catastrophe losses reveals a much more modest decline in profitability more in keeping with the pace normally associated with cyclical downturns. One continued cause for concern in 2008 is that premium growth remains in negative territory, though there are some early signs of a reversal of this trend.

Fundamentally, the property/casualty insurance industry remains quite strong financially, with policyholders’ surplus close to all-time record highs.

A detailed industry income statement for the first nine months of 2008 follows:

First Nine-Months 2008 Financial Results*

($ Billions)

	$
Net Earned Premiums	$330.4
Incurred Losses (Including loss adjustment expenses)	258.8
Expenses	90.5
Policyholder Dividends	1.0
Net Underwriting Gain (Loss)	-19.9
Investment Income	38.0
Other Items	0.7
Pre-Tax Operating Gain	18.9
Realized Capital Gains (Losses)	-9.7
Pre-Tax Income	9.2
Taxes	5.1
Net After-Tax Income	$4.1
Surplus (End of Period)	$478.5
Combined Ratio	105.6**

*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.
**Includes mortgage and financial guarantee insurers. Excluding these insurers the combined ratio was 101.9.

For the full release, go to P/C Industry Achieves a Small Profit Through Nine-Months 2008 Despite Significant Deterioration In Underwriting and Investment Results.

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