The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 6.7 percent through the first nine months of 2010, much improved from 4.6 percent from the same period in recession-battered 2009. This year’s nine-month result also compares favorably with the full-year rates of return of 5.8 percent in 2009 and 0.6 percent in 2008. On a quarterly basis, the third quarter was the best so far this year with return on average surplus reaching 7.5 percent compared to 6.7 percent and 5.7 percent in the first quarter and second quarters, respectively. Premium growth data for the third quarter appear to confirm that the era of mass exposure destruction in the property/casualty insurance industry is finally over, with demand for insurance now beginning to stabilize and recover in the aftermath of the “Great Recession.” It is now all but certain that the P/C insurance industry will record positive growth in 2010—the first since 2006. While underwriting losses deteriorated marginally, the industry is still operating on a “breakeven” basis with a combined ratio of 99.7, after excluding mortgage and financial guaranty insurers. As has been the case since mid-2009, virtually all of the improvement in the industry’s financial performance came from a massive reversal in asset values, which allowed the industry to realize $4.4 in capital gains during the first nine months compared to a $9.6 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) Hits a New Record
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 $33.4 billion or 6.4 percent to a record $544.8 billion, up from $511.4 billion at the end of 2009, although after adjusting for a unique transaction the figure stands at $522.3 billion—up 2.3 percent 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 $54.1 billion or 11.0 percent. Even after adjusting for the aforementioned unique transaction, the increase is a still-impressive $31.6 billion or 6.4 percent.
With $544.8 billion in surplus through September 30, capacity has surpassed the previous record high set at the end of the first quarter of 2010 and is now $23.0 billion or 4.4 percent above the pre-crisis record of $521.8 billion achieved exactly three years earlier in 2007. The bottom line is that the industry is and will remain 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—currently stands at 0.77, its strongest level in modern history. Given positive stock market gains in the fourth quarter, the industry is all but certain to record another record in policyholders’ surplus as of year-end 2010.
Profit Recovery Is Impressive but Incomplete
Net income after taxes (profit) totaled $26.7 billion during the first nine months of 2010 compared to $16.4 billion during the same quarter a year earlier. 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 is on track to surpass by a significant margin its profit level as well as its profitability relative to 2009.
As mentioned earlier, the impact of higher profits in the first nine months of 2010 was to push the industry’s annualized return on average surplus in the period to 6.7 percent (compared to4.6 percent in the first nine months of 2009). This bodes well for full-year 2010 performance. 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 35.7 percent annualized return on average surplus through the first nine months, continue to exert a disproportionate impact on industry profitability. 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 7.7 percent through the first nine months, up from 6.0 percent in the first nine months 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 7.7 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 mid-2010. This means that there is about a 2.7 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. Indeed the combined profits from 2008, 2009 and 2010 will likely only match or slightly exceed what the industry earned in a single year immediately before the global financial crisis. 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.
Slow Growth Is Better Than No Growth: Top Line Begins to Stabilize After Years of Decline
Net written premiums were up 0.8 percent through the first nine months of 2010—the combination of a 1.3 percent decline during the first quarter, a 1.3 percent increase in the second and a more substantial 2.3 percent increase in the third. While near-zero growth is usually not cause for celebration, the third quarter’s 2.3 percent represents the first back-to-back quarterly growth since the first quarter of 2007. Indeed, the second quarter’s 1.3 percent gain snapped a 12-quarter losing streak during which premiums written had declined every quarter dating back to the second quarter of 2007. There now appears to be mounting evidence that the property/casualty insurance industry is benefitting from early-stage growth in the American economy, which is translating into insurable exposure growth.
Growth of just under 1 percent through the first nine months of 2010 (+1.0 percent excluding mortgage and financial guaranty insurers), represents a marked improvement over the 4.5 percent 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 and third quarters of 2010 quarter suggest that that the freefall in premiums that began three years ago is now over. Continued growth during the fourth quarter of 2010 seems very likely and would lock in positive premium growth for full-year 2010, placing the industry on a favorable growth trajectory for 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—a scenario that seemed very likely as the year began but increasingly unlikely today—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. Nine-month 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 2008 and 2009 are less of a factor today. Indeed, the era of “mass exposure destruction” is over as the economic recovery continues to pick up momentum. 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 2.6 percent annual rate during the first three quarters of 2010, growth in property/casualty insurance exposure usually lags behind economic growth by a year or more. This is because the early stages of economic recoveries are always led by productivity gains rather than additions to fixed investment (e.g., plants, equipment) or hiring (which would add to payrolls). Fortunately, the economy is now on a sustained growth trajectory. Despite extreme economic pessimism through much of 2010, the odds of a so-called “double-dip” recession have greatly receded in recent months and real GDP growth is expected to accelerate to 3.2 percent by late 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 5.2 percent in the third quarter of 2010, renewals over the past year have remained anchored in a range between negative 5 percent and 6.5 percent, according to Council of Insurance Agent and Broker (CIAB) data. Other commercial lines price indexes confirm that pricing continues to trend downward, though at a slower pace than the CIAB survey—close to minus 1 percent. On the personal lines side, auto insurance premiums were up approximately 5 percent on annualized basis in the nine months, according to consumer price index data. Home insurance prices were up about 2.5 to 3 percent.
Lingering economic weakness cut into the demand for most types of insurance during the first half of 2010, with some increases in demand becoming more noticeable in the year’s second half. Lines such as workers compensation have benefited from the fact that the economy added approximately 1.2 million private sector workers in 2010, adding tens of billions of dollars in payroll, which is the exposure base for this large and compulsory line of coverage.
Over the past two and one-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 590,000 units in 2010 and 690,000 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 12.8 million in 2011.
- Employment/Underemployment: Unemployment remains stubbornly high—averaging 9.7 percent during the first nine months (and reaching 9.8 percent in November). 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 in 2010 finally began to add jobs for the first time in more than two years. During 2010 private sector employers added an estimated 1.2 million 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 nine months. In other words, nearly one in six workers was either unemployed or underemployed in the first nine months of 2010, compared to about one in 12 in the months before the recession began in 2007. All told, workers compensation insurers should continue to see a modest and possibly accelerating recovery in payroll exposure in 2011.
- Industrial Production and Capacity Utilization: Industrial production increased by 5.2 percent during the third quarter of 2010, on the heels of a pair of 7.1 percent gains in the first and second quarters. Industrial production had plunged by as much as 17.6 percent in the midst of the financial crisis during the first quarter of last year. Capacity utilization—at 75.2 percent in November—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: Strong Gains Continue
Total investment gains (which include investment income plus realized capital gains and losses) were up sharply in the first nine months of 2010, surging 50.1 percent or $13.2 billion to $39.5 billion from $26.3 billion during the same period in 2009.
Breaking down the individual components of the nine month investment gain is revealing. Net investment income (primarily interest earned on the industry’s bond portfolio plus stock dividends) actually fell by 2.5 percent during the first nine months to $35.0 billion, down $0.9 billion or 2.5 percent from the first nine months of 2009. Bullish stock market conditions during the final three quarters of 2009 and in the first and third quarter of 2010 helped propel realized capital gains, which totaled $4.4 billion during the first nine months compared to a realized capital loss of $9.6 billion during the first nine months of last year. Falling interest rates through the third 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. Stock market volatility remains a concern for insurers. The S&P 500 index was up 4.9 percent through March 31, but finished the first half of the year down 7.6 percent. However, by the end of the third quarter the S&P 500 was up 2.3 percent. The fourth quarter has seen stocks rise still further, with the S&P 500 up 11.6percent through December 20—virtually assuring a strong performance for realized investment gains in 2010 relative to 2009.
Interest rates on the safest of assets plunged in late 2008 and remained low through 2009 and into 2010, though longer-term yields began to creep up during the fourth quarter of the year. 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 in 2010 were also held down by subdued inflationary expectations and concerns through much of the year about the durability of the current economic recovery. Indeed, fears of a double-dip recession were foremost on investors’ minds well into the third quarter. The combination of persistently 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 September 2010, the average yield on 10-year U.S. Treasury securities stood at just 2.65 percent (55 basis points lower than in June) while the yield on 30-year bonds was 3.77 percent (compared to 4.13 percent three months earlier). For interest rates to be so low suggests little concern on the part of investors about inflation. Indeed, investors and the Federal Reserve recently have been more concerned about the possibility of deflation. Consequently, the Fed has embarked upon a “quantitative easing”program in an effort to keep longer term interest rates down, reduce borrowing costs and thereby stimulate the economy.
What Does Reduced Investment Income Mean for P/C Insurers?
The combination of low interest rates 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.
One 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 nine months of this year, the industry’s 101.2 combined ratio resulted in a 6.7 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 cost, lower expenses or some combination of the three.
Underwriting Performance and Catastrophe Losses: Discipline, Good Fortune or Both?
Profits during the first nine months of 2010 were hurt by an underwriting loss of $6.2 billion after policyholder dividends on a combined ratio of 101.2. The period’s underwriting performance was marginally worse than the 100.7 recorded during the first nine months of 2009, which was associated with an underwriting loss of $3.2 billion.
Weakness in commercial lines pricing currently stands as the greatest challenge to industry underwriting performance. Catastrophe losses—at $10.7 billion—were virtually unchanged from the year earlier period, up a mere $0.4 billion, according to ISO’s PCS unit. Given the very active 2010 hurricane season, insurers were extremely fortunate that no major storms made landfall in the United States. It should be noted that losses from the Deepwater Horizon explosion and oil 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 nine-month 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 192.2 during the first nine months of 2010, up from 175.0 during the same period in 2009. According to ISO, exclusion of the mortgage and financial guaranty segment knocks 1.5 points off the combined ratio, leaving it at 99.7 through the first nine months of 2010, up slightly from 99.3 in the year earlier period. Because the mortgage and financial guaranty segment so profoundly distorted the first-half industry results, the combined ratio of 99.7 (rather than 101.2) 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 $3.1 billion from $26.7 billion to $29.8 billion through the first nine months of 2010 and the associated average return on surplus from 6.7 percent to 7.7 percent.
The property/casualty insurance industry’s performance continued to improve during the first nine months of 2010. Increased profitability and rising capacity through the first three quarters 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 lingering but receding 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 transitions into 2011. Indeed, there is now a good chance the P/C insurance industry will show positive premium 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 nine months of 2010 follows.
Nine-Month 2010 Financial Results
|Incurred Losses (Including loss
|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 99.7.