June 23, 2010
The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 6.7 percent during the first quarter of 2010, up from negative 1.2 percent during the crisis-stricken first quarter of 2009. This year’s first quarter also compares favorably to the full-year rates of return of 5.8 percent in 2009 and 0.6 percent in 2008. The results mark the fourth consecutive quarter of improved financial performance since the end of the financial crisis in March 2009. Key factors driving improved results during the quarter include vastly improved investment market conditions compared to the same period a year earlier, a 21 percent decline in catastrophe losses and significant releases of prior year reserves. It is notable that the improved recovery occurred despite the fact that net written premiums declined by 1.3 percent amid sluggish economic conditions that continued to dampen insurance demand as well as continued soft market conditions in key commercial lines. It should be noted that because the Deepwater Horizon disaster in the Gulf of Mexico occurred in late April it had no impact on the first quarter results. The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Policyholder Surplus (Capital/Capacity)
Perhaps the most extraordinary sign 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 $29.2 billion to $540.7 billion or 5.7 percent during the quarter, up from $511.5 billion at the end of 2009, although after adjusting for a unique transaction the figure stands at $518.2 billion. Even after the adjustment—which involved a contribution of $22.5 billion in capital to one insurer by its parent to absorb a major non-insurance acquisition—the increase remains notable and important. Property/casualty insurance industry capacity had plunged by $84.7 billion or 16.2 percent from the pre-crisis peak of $521.8 billion at the end of the second quarter of 2007 to the crisis trough of $437.1 billion at the end of the first quarter of 2009. The bottom line is that P/C insurance industry capacity is within 1 percent of its all time record high just one year after reaching its crisis low even after excluding the impact of the unique transaction noted previously. Given increased market volatility in the second quarter of 2010, including a substantial drop in major stock market indices, the pace of growth in policyholders’ surplus will likely be more subdued in the second quarter. The bottom line, however, is that the industry is extremely well capitalized. One commonly used measure of capital adequacy—the ratio of net premiums written to surplus—is at its strongest level in modern history. This means that private P/C insurers (and reinsurers) are financially prepared for the 2010 hurricane season, which is predicted to be nearly twice as active as average.
Why the Industry’s Resilience Should Influence Pending Regulation
The resilience of the property/casualty insurance industry even during times of extreme distress and volatility in the global economy and financial markets truly sets P/C insurers and reinsurers apart from the rest of the financial services industry. At its zenith the crisis consumed approximately 16percent of the industry’s policyholders’ surplus—more than any other “capital” event in history including Hurricane Katrina (13.8 percent) or the September 11 terrorist attacks (10.9 percent). Unlike most banks, insurers and reinsurers continued to operate normally without any disruption to their operation.
From a public policy perspective, the rapid and effectively complete recovery in capacity could not come at a more propitious moment. As Congress continues to consider financial industry reform, which could include the imposition of taxes on large financial firms (including insurers) in order to create a fund to resolve those that fail in the future, P/C insurers have been arguing vociferously that they were not the cause of the crisis and that the industry does not pose a systemic risk to the financial system. No P/C insurer failed because of the financial crisis (compared to more than 250 bank failures to date), no claim went unpaid and no policy was cancelled. Insurers continued to compete vigorously and introduce new products throughout the crisis whereas most banks radically scaled back their operations and product offerings.
The fact that P/C insurers recovered more quickly and completely than virtually any other segment of the financial industry is concrete proof that subjecting insurers to bank-style regulation would constitute a significant policy error, would needlessly raise insurance costs for hundreds of millions of insurance consumers and would unfairly require insurers to subsidize the reckless lending practices and speculative activities of failed banks. Indeed, the subsidy that banks would receive from insurers would contribute to an already significant moral hazard problem, encouraging those institutions to take even greater risks, secure in the knowledge that insurers (among others) would be obliged to bail them out.
A BOTTOM LINE RECOVERY—BUT IT’S STILL LONELY AT THE TOP
Profit Recovery Is Impressive but Incomplete
Net income after taxes (profit) in 2009 totaled $8.9 billion during the first quarter of 2010 compared to a net loss of $1.3 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. As mentioned earlier, the impact of higher profits was to push the industry’s annualized return on average surplus in the quarter to 6.7 percent, compared to negative 1.2 percent in the first quarter of 2009. The first quarter figures are a welcome beginning to the year after several years of tough first quarters. 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. This year’s stock market rally during the first quarter and improved credit market conditions, along with lower catastrophe losses, favorable claim cost trends and reserve releases all worked to the benefit of property/casualty insurers during the first three months of 2010 and will boost the full-year results.
It is worth noting that mortgage and financial guaranty insurers, which account for just 2 percent of industry premiums but ran a negative 65.0 percent annualized return on average surplus during the first quarter, are again having a disproportionate impact on industry profitability. Net income for these insurers was a negative $1.8 billion during the quarter. 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 8.3 percent during the first quarter, up from 2.1 percent in the first quarter of 2009, according to ISO/PCI.
Still, the current profit recovery must be kept in perspective. While net income is once again growing, an 8.3 percent rate of return is inadequate for many insurers. The U.S. property/casualty insurance industry’s equity cost of capital stood at approximately 10.5 percent in early 2010. This means that there is about a 2 percent 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.
Top Line Shrinks Even as the Bottom Line Grows: Insurance Exposure and Demand Continue to Suffer from the Lingering Effects of the “Great Recession”
Despite continued improvement in the industry’s bottom line, net written premiums fell by 1.3 percent during the first quarter of 2010 (1.0 percent excluding mortgage and financially guaranty insurers), a marked improvement over the 3.6 drop during the same period last year and the 3.7 percent drop recorded for full-year 2009. The deceleration in premium loss suggests that the industry could see positive premium growth by late 2010 and perhaps full-year growth in 2011. The industry has not recorded positive premium growth on annual basis since 2006.
This first quarter’s 1.3 percent decline in net written premium growth is inauspicious in that it marks the beginning of the fourth 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 quarter 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 major factor (details below). Although the nation’s real (i.e., inflation adjusted) gross domestic product (GDP) actually expanded by 3.0 percent during the first quarter, 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 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. The odds of a so-called “double-dip” recession have greatly receded in recent months and real GDP growth of between 3.0 and 3.5 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 5.1 percent in the first quarter of 2009, renewals over the past year have remained anchored in a range between negative 5 and 6 percent. According to Council of Insurance Agent and Broker data, the average commercial account renewed down 5.3 percent during the first quarter of 2010. Auto insurance premiums, however, were up approximately 5 percent in the quarter. 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 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 a peak of 2.07 million units in 2005. 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 690,000 units in 2010 and 940,000 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. (Note: the Insurance Information Institute estimated that the program netted auto insurers about $300 million in net new auto premiums). The current forecast is for new car/truck sales to rise to 11.7 million vehicles this year and 13.3 million in 2011.
- Employment/Underemployment: Unemployment remains stubbornly high—at 9.7 percent during the first quarter. 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 three months of 2010 employers added 261,000 jobs. In April and May, more than 330,000 additional jobs were added (excluding temporary Census workers). High unemployment 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 quarter. In other words, nearly one in six workers was either unemployed or underemployed in the first quarter of 2010, compared to about one in 12 in months before the recession began in 2007. All told, workers compensation insurers should begin 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 7.5 percent during the first quarter of 2010, after plunging 19.1 percent during the first quarter of last year. Just 72.9 percent of industrial capacity was utilized during the first quarter, according to the Federal Reserve, but recent trends are nevertheless favorable. Capacity utilization is now well above its recession low of 68.3 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
The financial crisis continued to loosen its grip on P/C insurer profitability during the first quarter of 2010. Net investment income was basically flat during the quarter, down 1.0 percent or $0.1 billion to $11.6 billion during the quarter from $11.7 billion during the first quarter of 2009. Bullish stock market conditions, however, helped 2010 get off to a much more promising start in terms of realized capital gains, which totaled $1.0 billion during the quarter compared to a realized capital loss of $8.0 billion during the same quarter last year. The S&P 500 index was up 4.9 percent though March 31, 2010, whereas markets hit their crisis low during last year’s first quarter (on March 9).
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. While there has been concern that the Obama administration’s $800 billion-plus economic stimulus program, combined with the Federal Reserve’s ballooning balance sheet, would put inflationary pressure on the economy, there remains no inflation on the horizon. The combination of high unemployment, low factory utilization and the bursting of 2008’s’s energy and commodity price bubble means that there is plenty of slack in the system to absorb 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-June 2010, the average yield on 10-year U.S. Treasury securities stood at 3.31 percent while the yield on 30-year bonds was 4.21 percent. Neither suggests a great deal of concern on the part of investors about inflation. Moreover, the Federal Reserve is highly cognizant of the risk and is already looking at the timing dimensions for partial withdrawal of its monetary stimulus.
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 recession 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. The industry’s 2009 combined ratio of 101.0 resulted in a 5.8 percent return on average surplus. In 2005, the identical (full-year) 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 quarter of 2010 were hurt by a modest underwriting loss of $1.8 billion after policyholder dividends on a combined ratio of 101.1. The quarter’s underwriting performance was marginally better than the 102.2 recorded during the first quarter of 2009, which was associated with an underwriting loss of $2.6 billion.
Weakness in commercial lines pricing now stands as the greatest challenge to industry underwriting performance. One break that insurers caught in the first quarter came from notably lower catastrophe losses, which fell by 21 percent to $2.6 billion from $3.3 billion in the year earlier period, according to ISO’s PCS unit. Given predictions for a very active 2010 hurricane season, there is concern that catastrophe losses this year could greatly exceed the $10.6 billion recorded for all of 2009.
Mortgage and Financial Guaranty Insurers Continue to Distort Results
It is important to bear in mind that the first quarter 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 232.1 in the first quarter of 2010. As bad as that result is, it is much improved from the 291.4 percent result recorded in the full year 2009. According to ISO, exclusion of the mortgage and financial guaranty segment knocks 2.1 points off the combined ratio, leaving it at 99.0 in first quarter. Because the mortgage and financial guaranty segment so profoundly distorted the 2009 results, the combined ratio of 99.0 (rather than 101.1) 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 guaranty insurers increases the industry’s net income by $1.8 billion from $8.9 billion to $10.7 billion in the first quarter of 2010 and the associated average return on surplus from 6.7 percent to 8.3 percent.
The property/casualty insurance industry’s performance continued to improve during the first quarter of 2010. Increased profitability and rising capacity during the quarter (the latter adjusted for a unique transaction) are primarily attributable to improved investment market performance. 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.
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 quarter of 2010 follows.
FIRST QUARTER 2010 FINANCIAL RESULTS*
|Net Earned Premiums
|Incurred Losses (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 99.0.