2008 - Year End Results

The property/casualty (P/C) 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 return recorded in 2007. It was the industry’s worst financial performance since 2001. The sharp decline in profitability was primarily due to a broad, rapid, steep and unrelenting deterioration in financial market conditions on a global scale. Secondary factors include the profit and premium-sapping impact of a four-year long soft market, the burden of $26 billion in catastrophe losses—the fourth highest total on record—and the growth bludgeoning effects of an economy careening towards the deepest recession since the Great Depression. The toll: a 96.2 percent plunge in profits and a 12 percent drop in capacity (policyholders’ surplus). Yet, in the final analysis, the P/C insurance industry once again demonstrated its resilience, as it has for centuries. In stark contrast to banks and investment banks, the fundamental business of insurance continues uninterrupted. Indeed, more than 40 banks have failed since the crisis began, yet not a single insurance claim has gone unpaid because of the crisis. The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI). 

The Financial Crisis: P/C Insurers Benefit from Superior Risk Management Strategies

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 P/C 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 property and businesses. The bottom line is that unlike banking, P/C insurance markets are functioning normally.

The basic explanation for the resilience and strength that P/C insurers have demonstrated during the current and countless past financial crises are attributable to a deeply entrenched and conservative operating philosophy that leads directly to superior risk management strategies. Insurers necessarily run their business under the assumption that every day is a potential doomsday—because it is. That may seem extreme, but it is what separates P/C insurers from the rest of the financial services industry at times like these. Consider the impact of just three hallmarks of P/C insurer risk management: low leverage, risk-based underwriting and pricing and keeping “skin in the game” in every transaction.

• Low Leverage: Unlike many of the banks and other financial companies that have struggled, P/C 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. Consequently, the P/C insurance industry is not suffering from a credit or liquidity crisis. Many large banks and investment banks were operating at very high leverage ratios, often borrowing $15 to $25 for every $1 in capital they held. When the crisis struck, pools of available credit dried up and the cost of borrowing soared, destroying or severely compromising these firms’ operating models.

• Risk-Based Underwriting and Pricing: Insurers use their historical experience and sophisticated modeling techniques to match risk to price. This is the very essence of what insurers do. Insurers also limit the aggregate amount of risk they assume based on the amount of capital they have on hand (sometimes making them unpopular in places like Florida). Banks around the world routinely seem to forget history, lurching from financial catastrophe to financial catastrophe every so many years. ( the savings and loan crisis of the late 1980s/early 1990s being only one of the more recent U.S. examples). In the run-up to the current crisis, many banks sacrificed risk-based underwriting and pricing (most spectacularly in the mortgage markets) in order to generate volume and fees. While insurers are sometimes accused of becoming undisciplined in their underwriting and pricing, they have never even remotely approached the lax underwriting standards that became endemic throughout much of the banking world in recent years.

• Keeping “Skin in the Game”: Property/casualty insurers, to put it bluntly, put their money where their mouth is. Every single claim costs insurers money (skin in the game), hence the strong incentive to underwrite and price to risk. Banks, on the other hand, routinely packaged up thousands of loans, selling them (through the process of securitization) to unwitting investors and letting them suffer the consequences of deteriorating underwriting standards. In contrast, insurers (along with their reinsurers), keep the risk on their own books and suffer the consequences of any laxity in underwriting in the form of reduced profits.

Property/casualty insurers are by no means immune to the effects of the global financial crisis. The investment losses (primarily related to bets on credit derivatives gone awry) incurred by a noninsurance financial products subsidiary of one of the nation’s largest insurers have resulted in it receiving some $170 billion in federal assistance. Its insurance operations, however, remain solvent and continue to operate normally. In addition, several predominantly life insurance companies have indicated their desire to receive federal funds and have sought regulatory relaxation of certain capital requirements. In early April 2009, media reports circulated that the Treasury Department had finally decided to authorize the release of TARP funds to certain qualifying life insurers. Most P/C 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.

Sources of Decline in Profitability

Insurers have two sources of income: premiums and investment earnings. All else being equal, if one source declines and is not offset by an increase in the other, profits and profitability will slide. On the rare occasion that both decline significantly, then the bottom line will usually be hit hard. That is what happened during the “perfect storm” of 2008 (as well as in 2001)—net income (profits) plunged 96.2 percent from $62.5 billion in 2007 to $2.4 billion in 2008.

Investment Earnings: The Principle Cause of Decline in 2008 Profits and Capacity

The economic crisis has so far affected P/C insurer 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 $1.2 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. Both were down significantly in 2008. Given the 38.5 percent plunge in the Standard & Poor’s (S&P) 500 index last year, it is no surprise that the opportunity to realize net capital gains on stock holdings has effectively vanished. As noted by ISO and PCI, realized capital gains were nonexistent in 2008—with the industry instead turning in a record realized capital loss of $19.8 billion, compared with an $8.9 billion gain in 2007—an unprecedented 12-month swing of $28.7 billion. Last year’s realized capital losses were by far 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.

Declining stock prices were not the only reason for the plunge in realized capital gains. Beyond the current 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 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 announced late in 2008 that the U.S. economy had actually fallen into recession in December 2007 (in April 2009 the recession, at 16 months, officially became the second longest since the Great Depression, which lasted 43 months). During the third and fourth 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 recorded 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) as the year began 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. Stocks continued their decline during the first quarter of 2009, with the S&P 500 losing an additional 11.7 percent. That being said, additional decreases in stock indices will have a lesser impact on insurer investment performance, simply because the equity portfolio, after the market rout of 2008, now constitutes a much smaller share of invested assets. Indeed, it is likely that the share of assets invested in stocks shrank from about 17 percent at year-end 2007 to 12 percent or less as of year-end 2008.

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 2008, 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 plunged in 2008, 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 anti-recessionary policy prescription administered by the Fed for decades. The Fed has not been rendered impotent, however. Chairman Bernanke has engaged the Fed in a strategy known as “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. By late in the first quarter of 2009 there was clear evidence that the Fed’s new strategy was meeting with at least some success.

Interest rates fell in 2008 not only because of the Fed’s feverish efforts 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 second half of 2008. On the flip side of this severe dislocation of credit market risk was the global 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 its price at auction was pushed up and that its 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. It is obvious that Treasury securities were caught in the midst of a panic-induced price bubble in late 2008.

Lower interest rates are an important consideration for insurers. As large as the realized capital losses are, capital gains (losses) generally constitute a smaller proportion of investment earnings than investment income, which decreased by a much more modest 7 percent last year to $51.2 billion from $55.1 billion in 2007. In fact, because capital gains and underwriting profits were both in negative territory in 2008, investment income effectively accounted for all of the industry’s meager net income (profit) for the year. The decline is largely attributable to lower interest rates in 2008 as well as lower cash flows.

Stock Dividends: The Most Recent Casualty of the Financial Crisis
One often overlooked component of investment income that is also taking a nosedive is stock dividends. Many dividend paying blue chip companies reported poor earnings in 2008 and expect to do the same in 2009. Consequently, a record 367 companies announced dividend cuts during the first quarter of this year, according to Standard & Poor’s. It was the first time that dividend cuts outpaced dividend increases since the S&P began tracking dividend payouts in 1955. Altogether, the S&P said that dividend payouts during the first quarter fell by $77 billion. Because insurers are among the largest institutional investors in the United States, the loss of so much dividend income will have a meaningful impact on investment earnings on an industrywide basis (though the effects will vary from insurer to insurer). Among those recently cutting dividends: J.P. Morgan Chase (down 87 percent), Pfizer (down 50 percent) and Harley Davidson (down 70 percent).

Underwriting Performance: The Secondary Cause of Decline in 2008 Profits and Capacity

Profits and profitability were also negatively impacted by a substantial deterioration in underwriting performance, driven first and foremost by $26.0 billion in catastrophe losses during the year ($10.7 billion of which was due to Hurricane Ike, according to ISO’s PCS unit) and secondly by continued cyclical deterioration as soft market conditions ground through their fourth consecutive year. The combination of higher catastrophe losses, cyclical deterioration in underwriting performance and severe stress in the mortgage and financial guarantee segments pushed the 2008 combined ratio up to 105.1, nearly 10 points above the 95.5 combined ratio in 2007.

It is important to bear in mind that the 2008 results are somewhat skewed by the disastrous performance of many mortgage and financial guarantee insurers. This segment accounted for just $8.5 billion, or 2 percent, of industry premiums written in 2008 but ran a combined ratio of 299.3 percent—double the already poor 149.1 combined ratio recorded in 2007. According to ISO, exclusion of the mortgage and financial guarantee segment knocks 4.1 point off the combined ratio, leaving it at 101.0 for the year, compared with 94.6 in 2007. Because the mortgage and financial guarantee segment so profoundly distorted the 2008 underwriting results, the combined ratio of 101 (rather than 105.1) 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 guarantee insurers raises the industry’s rate of return to 4.2 percent, compared with 0.5 percent when this segment is included.

Catastrophe Losses: Damage in 2008 Exceeded 2006, 2007 Losses Combined

As noted by ISO, insured catastrophe losses reached $26.0 billion in 2008, their highest level since 2005, the year of Hurricane Katrina. The 2008 total is 64 percent higher than the combined $15.9 billion in loss from 2006 and 2007 (at $9.2 billion and $6.7 billion, respectively). Last year’s $26.0 billion tally 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 in 2008 accounted for about one-third of the overall deterioration in catastrophe losses and added 3.4 points to the industry combined ratio above the level of catastrophe losses experienced 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.

Premium Growth Remains Negative as Pricing, Economy Remain Weak

Net written premiums declined by 1.4 percent in 2008, the biggest drop since ISO began recording quarterly changes in premium, breaking the previous record decline of 0.6 in 2007. Excluding mortgage and financial guarantee insurers produced a net decline of 1.5 percent. The past two years mark the first sequential decline in premiums written since the Great Depression, when industry premiums fell for four consecutive years (1930 through 1933, inclusive) after peaking in 1929. Premiums were held back primarily by continued soft market conditions, which entered their fourth-consecutive year in 2008. The weak economy also produced significant headwinds, crimping new exposure growth that would have otherwise increased the demand for a wide array of P/C insurance products. Had the economy been growing at the pre-recession real growth rate of 3 to 4 percent, growth in net written premiums would likely have been slightly positive in both 2007 and 2008.

By late in 2008, the magnitude of rate decreases in most key commercial lines had begun to diminish, but remained in negative territory. Personal lines (auto and home) were seeing small increases on net. 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.

The Obama Economic Stimulus Plan: Modest Impact on P/C Insurance Premiums Written

As 2008 came to an end, the United States and most major world economies (with the sole exceptions of China and Brazil) were sinking deeper into recession. To counter the effects of economic weakness—especially rising unemployment—most of these countries (including China) in early 2009 announced economic stimulus programs designed to ease the economic suffering of their citizens. The combined spending associated with these programs totals was approximately $2.75 trillion as of March 31, 2009. In the United States, newly elected president Barack Obama successfully pushed through a $787 billion stimulus program with the stated objective of creating or preserving 3.5 million jobs. However, because only about 25 percent of the package is allocated toward “traditional” stimulus spending on infrastructure (the remainder going to tax cuts, aid to states, etc.) the impact on the demand for insurance will be muted. The Insurance Information Institute estimates that the U.S. stimulus package is unlikely to increase property/casualty insurance premiums written by more than 1 percent or about $4.3 billion by year-end 2010. Nevertheless, there will be some modest benefit that accrues to the industry and to commercial insurers in particular. Workers compensation is the line most likely to benefit from stimulus spending, again because the stated objective of the program is to create or preserve 3.5 million jobs. Other lines that will likely benefit include commercial auto, commercial property and liability, inland marine, commercial auto and surety. Existing P/C insurers will have no problem meeting any and all additional demand for insurance from the stimulus package.

Industry Experience in 2008: No Comparison to the Great Depression

As mentioned previously, net written premium growth remained negative in 2008 and continued on its negative trajectory, falling by 1.4 percent (-1.5 percent excluding mortgage and financial guarantee insurers), after a drop of 0.6 percent in 2007—the first consecutive years of negative premium growth since 1930 to 1933 during the Great Depression. During the Great Depression, however, estimates from the Insurance Information Institute indicate that premiums written fell by a staggering 35 percent over a four-year span from their 1929 peak through their 1933 trough. Policyholders’ surplus, a measure of capacity, decreased by 12 percent in 2008, the first decline since 2002. Yet during the Great Depression policyholders’ surplus fell by an estimated 37 percent. Invested assets also took a modest hit in 2008 but plunged an estimated 28 percent during the Great Depression. The bottom line is that the impact of the current financial crisis on P/C insurance, as bad as it is, is not even remotely close to the impacts experienced during the Great Depression. Indeed, premiums, surplus and assets will likely return to their precrisis levels within a few years. It took 10 to 12 years (i.e., until 1939, 1940 or 1941) for these same financials to recover in the wake of the Depression.

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 in the end there will be a significant impact on insurance industry capacity. As noted by ISO and PCI, industry policyholders’ surplus (the industry’s primary measure of capacity—akin to net worth in other industries) fell by a record $62.3 billion, or 12.0 percent, at year-end 2008 to $455.6 billion from $517.9 billion at year-end 2007. The decline is the fifth-consecutive quarterly drop in policyholders’ surplus, which peaked a year earlier at $521.8 billion during the third quarter of 2007. The net $66.2 billion decline in surplus represents a reduction of 12.2 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 2008 insurers recorded unrealized capital losses totaling $52.9 billion in addition to $19.8 billion in realized capital losses and $21.2 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.

Despite the erosion of capital, the property/casualty insurance industry ended 2008 well capitalized by historical standards. According to ISO and PCS, the ratio of premiums written to available surplus (a simple measure of financial leverage) stood at 0.95. This means that insurers had $1 in capital (surplus) on hand for every $0.95 in premium written. This compares to an average ratio of 1.52 during the past 50 years.

Although current levels of capitalization suggest industry strength remains intact, the ability of (re)insurers to raise capital following a “capital event” (e.g., major catastrophe) is something worth considering in light of the global financial crisis which has dramatically reduced access to capital. In the wake of both the September 11 terrorist attacks in 2001 and hurricanes Katrina, Rita and Wilma in 2005, insurers and reinsurers were able to raise tens of billions in new funds quickly and relatively easily. Today, there is far less available capital in the world, and the cost of what capital is available is much higher. This changes the economics of catastrophe risk financing. Already the cost of reinsurance is rising as demand increases and insurers seek to protect the capital they have on hand.

Additional evidence of strength and resilience in the property/casualty insurance industry comes from 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 liability risks of a trucking company.

Summary

Economic and insurance market turbulence had a significant impact on the financial and underwriting performance of the P/C insurance industry in 2008. The year’s sharp decline in profitability was primarily attributable to poor investment market performance, high catastrophe losses, persistent soft market conditions and a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the P/C 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 2009 is that investment markets remain unsettled and premium growth tepid, though there are some early signs of a reversal in both of these trends.

Fundamentally, the property/casualty insurance industry remains quite strong financially, with capital adequacy ratios close to all-time record highs.

A detailed industry income statement for 2008 follows: