The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 6.3 percent during the first half of 2010, much improved from the 2.6 percent during the recession-stricken first half of 2009. This year’s first half result also compares favorably to the full-year rates of return of 5.8 percent in 2009 and 0.6 percent in 2008. On a quarterly basis, however, return on average surplus during the second quarter of 2010 slipped to 5.7 percent from 6.7 percent in the first quarter as growth in net income trailed growth in surplus. The drop ended a streak of four consecutive quarterly improvements in profitability since the end of the financial crisis in March 2009. The improvement during the first half had little to do with premium growth, claim cost trends or catastrophe losses, all of which were flat during the first six months of the year. Instead, virtually all of the improvement in financial performance came from a massive reversal in asset values, which allowed the industry to realize $2.2 billion in capital gains during the first half compared to an $11.1 billion realized capital loss a year earlier. The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Policyholder Surplus (Capital/Capacity)
Perhaps the most extraordinary indicator of the industry’s resilience over the past year was its rebound in claims paying capacity (as measured by policyholders’ surplus). Policyholders’ surplus increased by $19.1 billion or 3.7 percent to $530.5 billion, up from $511.4 billion at the end of 2009, although after adjusting for a unique transaction the figure stands at $508.0 billion—basically unchanged for the year (the adjustment involved a contribution of $22.5 billion in capital to one insurer by its parent to absorb a major non-insurance acquisition). Compared to a year earlier, however, surplus is up $67.6 billion or 14.6 percent. Even after adjusting for the aforementioned unique transaction, the increase is a still-impressive $45.1 billion or 9.7 percent. It should, however, be noted that the $530.5 billion in surplus as of June 30 is actually $10.2 billion or 1.9 percent less than the record level of surplus of $540.7 billion on the books as of the end of the quarter on March 31. Unrealized capital losses, which totaled $11.5 billion during the second quarter, are largely to blame for the decline in capacity.
Despite the minor dip in surplus during the second quarter, capacity remains at near all-time record highs. The bottom line is that the industry is extremely well capitalized and financially prepared to pay very large scale losses, if necessary. One commonly used measure of capital adequacy—the ratio of net premiums written to surplus—is at its strongest level in modern history. Given continued market volatility in the July through September period, and largely sideways movements in major stock market indices, the pace of growth in policyholders’ surplus will likely be subdued during the third quarter.
A BOTTOM LINE RECOVERY
Profit Recovery Is Impressive but Incomplete
Net income after taxes (profit) totaled $16.5 billion during the first half of 2010 compared to net income of $6.0 billion during the first half of 2009. By way of comparison, the industry earned $28.3 billion for all of 2009, up from just $3.0 billion in 2008. Thus it appears that the P/C insurance industry in 2010 could be on track to slightly exceed its profit level and perhaps its profitability relative to 2009.
As mentioned earlier, the impact of higher profits in the first half of 2010 was to push the industry’s annualized return on average surplus to 6.3 percent, compared to2.6 percent in the first half of 2009. The first-half figures are a welcome beginning to the year after several years of tough first halves. The results also bode well for the full year. During calendar year 2009 and 2008, the industry’s full year returns were 5.8 percent and 0.6 percent, respectively.
It is worth noting that mortgage and financial guaranty insurers, which account for just 2 percent of industry premiums but ran a negative 43.2 percent annualized return on average surplus during the first half, are again having a disproportionate impact on industry profitability. Net income for these insurers was a negative $2.6 billion during the half. Excluding these classes of business (which are written by only a small minority of insurers) provides a truer picture of performance, with the resulting return on average surplus rising to 7.5 percent during the first half, up from 4.6 percent in the first half of 2009, according to ISO/PCI.
Still, the current profit recovery must be kept in perspective. While net income is once again growing, even a 7.5 percent rate of return is inadequate for many insurers. The U.S. property/casualty insurance industry’s equity cost of capital stood at approximately 10.4 percent in early 2010. This means that there is about a 3 percentage point 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”. In dollar terms, insurers are earning far less than they did immediately before the crisis. The industry’s net income exceeded $60 billion in both 2006 and 2007, compared to a combined total of $31.3 billion in 2008 and 2009. The accumulated profits in the years immediately prior to the financial crisis helped cushion the impact on P/C insurers. It is abundantly clear today that widespread criticism of insurer profits in those years was misguided. Indeed, the industry’s ROE remains well below the 10.5 percent earned by the Fortune 500 group of companies in 2010.
Zero Growth Never Sounded So Good: Top Line Begins to Stabilize After Years of Decline
Net written premiums were flat during the first half of 2010—the combination of a 1.3 percent decline during the first quarter and a 1.3 percent increase in the second. While zero growth is usually not cause for celebration, the second quarter’s 1.3 percent gain snaps a 12-quarter losing streak during which premiums written had declined every quarter dating back to the second quarter of 2007. Zero growth during the first half of 2010 (+0.3 percent excluding mortgage and financial guaranty insurers), represents a marked improvement over the 4.2 drop during the same period last year and the 3.7 percent drop recorded for full-year 2009. Sequentially smaller declines in premium growth since mid-2009 combined with positive premium growth in the second quarter suggest that that the freefall in premiums that began three years ago is now over. Moreover continued growth during the second half of 2010 would lock in positive premium growth for full-year 2010 and place the industry on a trajectory for positive premium growth in 2011. The industry has not recorded positive premium growth on an annual basis since 2006.
The nascent stabilization in premium growth comes none too soon. If the industry were to record negative growth for all of 2010 it would mark the fourth consecutive year of decline in premiums written. The last time net premiums written contracted for four consecutive years was during the Great Depression (1930 through 1933) after peaking in 1929, though the declines then were much larger. First half 2010 premiums were held back in part by continued soft market conditions, primarily in commercial lines, which continued to grip the industry for a seventh consecutive year. The economy was also a factor (details below), though the massive exposure losses that plagued the industry in 2009 are less of a factor today. Although the nation’s real (i.e., inflation adjusted) gross domestic product (GDP) actually began to expand during the second half of 2009—and continued to expand at a 2.7 percent annual rate during the first half of 2010—growth in property/casualty insurance exposure usually lags economic growth by a year or more. This is because the early stages of economic recoveries are always led by productivity gains rather than by additions to fixed investment (e.g., plants, equipment) or hiring (which would add to payrolls). Fortunately, the economy is now on a sustained, albeit anemic, growth trajectory. The odds of a so-called “double-dip” recession have greatly receded in recent months and real GDP growth of between 2.5 and 3.0 percent is expected through the remainder of 2010 and into 2011, 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 5.3 percent in the first quarter of 2010, renewals over the past year have remained anchored in a range between negative 5 and 6.5 percent. According to Council of Insurance Agents and Brokers (CIAB) data, the average commercial account renewed down 6.4 percent during the first half of 2010. Other commercial lines price indexes confirm that pricing continues to trend downward, though at a slower pace than the CIAB survey.
On the personal lines side, auto insurance premiums were up approximately 5 percent on an annualized basis in the first half, according to consumer price index data. Home insurance prices were up about 2.5 to 3 percent. Nevertheless, whatever modest gains the industry earned from higher rates were restrained by lingering economic weakness, cutting into the demand for most types of insurance.
Over the past two-and-a-half years the weak economy has had a disproportionately large impact on commercial insurers due to rising unemployment (slicing payrolls and eroding the exposure base for workers compensation premiums), reduced construction and manufacturing activity, a surge in business bankruptcies and weakness in new business formation and expansions. The latter is in part due to lingering problems in credit markets and at financial institutions servicing small and medium sized businesses. These so-called “middle-market” customers are essential to any recovery in commercial insurance exposure and are core to the operating model of many commercial insurers.
There are some early signs of recovery in property/casualty insurance exposures:
- New Housing Starts: Bottomed out at 560,000 units in 2009, down 72 percent from 2.07 million units in 2007. The drop affected home insurers and insurers with books of business serving the construction, contracting and home supply industries. The forecast is for a very gradual recovery, to 600,000 units in 2010 and 760,000 in 2011.
- New Car/Light Truck Sales: Fell to 10.3 million vehicles in 2009, down 39 percent from 16.9 million vehicles in 2005. The decline occurred despite last year’s wildly successful “cash for clunkers” program, which sparked the sale of nearly 700,000 vehicles. The current forecast is for new car/truck sales to rise to 11.5 million vehicles this year and 12.7 million in 2011.
- Employment/Underemployment: Unemployment remains stubbornly high—at 9.7 percent during the first half. Indeed, some 8.4 million jobs were lost in the 24 months ending in December 2009—two years after the official beginning of the recession in December 2007. That being said, the economy finally began to add jobs for the first time in more than two years. During the first six months of 2010 private sector employers added 763,000 jobs. This means that workers compensation insurers are already seeing some benefit from the economic recovery. High unemployment, of course, saps 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) the proportion reached 16.7 percent of the potential labor force during the first half. In other words, nearly one in six workers was either unemployed or underemployed in the first half of 2010, compared to about one in 12 in months before the recession began in 2007. All told, workers compensation insurers should continue to see a modest recovery in payroll exposure in the second half of 2010 and into 2011.
- Industrial Production and Capacity Utilization: Industrial production increased by 6.7 percent during the second quarter of 2010, after plunging by as much as 17.6 percent in the midst of the financial crisis during the first quarter of last year. Capacity utilization—at 74.1 percent in June (and 74.8 percent in July)—is now well above its recession low of 68.2 percent recorded in June 2009 but remains 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 as Financial Crisis Recedes
Net investment income was basically flat during the first half at $23.6 billion, unchanged from the first half of 2009. Bullish stock market conditions during the final three quarters of 2009 and through the first quarter of 2010 helped 2010 get off to a much more promising start in terms of realized capital gains, which totaled $2.2 billion during the half compared to a realized capital loss of $11.1 billion during the first half of last year. Falling interest rates during the second quarter of 2010 helped push bond prices higher, providing insurers with additional opportunities to realize capital gains. Approximately two-thirds of the property/casualty insurance industry’s investment portfolio is invested in bonds. One dark spot was the performance of stocks during the second quarter. Although the S&P 500 index was up 4.9 percent through March 31, it finished the first half of the year down 7.6 percent. The third quarter has seen stocks recover some of those losses, with the S&P 500 roughly flat through mid-September.
Interest rates on the safest of assets plunged in late 2008 and remained low through 2009 and into 2010. The Federal Reserve cut its key federal funds rate on multiple occasions in 2008. At the beginning of that year, 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 and the first quarter of 2010 (and where they remain as of this writing).
Interest rates are also being held down by subdued inflationary expectations and concerns about the durability of the current economic recovery. Indeed, fears of a double-dip recession were foremost on investors’ minds. The combination of high unemployment and low factory utilization means that there is plenty of slack in the system to absorb future 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-September 2010, the average yield on 10-year U.S. Treasury securities stood at 2.74 percent (nearly 60 basis points lower than in mid-June) while the yield on 30-year bonds was 3.83 percent (compared to 4.21 percent three months earlier). For interest rates to be so low suggests little concern on the part of investors about inflation. Indeed, investors recently have been more concerned about the possibility of deflation.
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 as 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 weak economy and depressed investment environment. A major hurricane striking the coast of Florida in 2010 hurricane season would cost no less, and would probably cost 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 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. Through the first half of this year, the industry’s 101.7 combined ratio resulted in a 6.3 percent return on average surplus. The industry’s 2009 full-year combined ratio of 101 yielded a 5.8 percent return on average surplus. In 2005, however, the identical (full-year) 101 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 costs, lower expenses or some combination of the three.
Underwriting Performance and Catastrophe Losses: Discipline, Good Fortune or Both?
Profits during the first half of 2010 were hurt by an underwriting loss of $5.1 billion after policyholder dividends on a combined ratio of 101.7. The half’s underwriting performance was marginally worse than the 100.8 recorded during the first quarter of 2009, which was associated with an underwriting loss of $1.5 billion.
Weakness in commercial lines pricing currently stands as the greatest challenge to industry underwriting performance. Catastrophe losses—at $7.9 billion—were virtually unchanged from the year earlier period, up a mere $0.2 billion, according to ISO’s PCS unit. Given a very active 2010 hurricane season, with 11 named storms though September 15, insurers have been fortunate that none have made landfall in the United States. It should be noted that losses from the Deepwater Horizon explosion and spill in April will cost insurers an estimated $3 billion to $4 billion. The majority of these losses, however, will be borne by foreign insurers and reinsurers and therefore have little impact on the results of the reported results of the U.S. property/casualty insurance industry.
Mortgage and Financial Guaranty Insurers Continue to Distort Results
It is important to bear in mind that the first half 2010 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 197.6 during the first half of 2010, up from 171.8 during the same period in 2009. According to ISO, exclusion of the mortgage and financial guaranty segment knocks 1.6 points off the combined ratio, leaving it at 100.1 in the first half. Because the mortgage and financial guaranty segment so profoundly distorted the first-half industry results, the combined ratio of 100.1 (rather than 101.7) 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 increases the industry’s net income by $2.7 billion from $16.5 billion to $19.2 billion in the first half of 2010 and the associated average return on surplus from 6.3 percent to 7.5 percent.
The property/casualty insurance industry’s performance continued to improve during the first half of 2010. Increased profitability and rising capacity during the first half are primarily attributable to improved investment market conditions, stable underwriting results and a lack of megacatastrophes. At the same time, persistent soft market conditions and the lingering effects of the deep recession continue to impact 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 through 2010. Indeed, there is now a good chance the P/C insurance industry will show positive growth in 2010—the first such growth since 2006.
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 half of 2010 follows.
FIRST HALF 2010 FINANCIAL RESULTS*
|Net Earned Premiums
| (Including loss adjustment expenses)
|Net Underwriting Gain (Loss)
|Pre-Tax Operating Gain
|Realized Capital Gains (Losses)
|Net After-Tax Income
|Surplus (End of Period)
*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 100.1.