Insurers breathed a collective sigh of relief in the first quarter of 2012 as catastrophe losses fell by nearly one-half, driving a sharp improvement in underwriting performance, which resulted in a substantial, very welcome and much needed improvement in profitability. According to ISO’s PCS unit, catastrophe losses plunged by 48 percent ($3.2 billion) to $3.4 billion in the first three months of this year from $6.6 billion in the same quarter of 2011—the result of a mild winter and diminished tornado activity. The effect: the industry combined ratio fell to 99.0 in the quarter from 103.3 a year earlier (and 108.2 for full-year 2011) on underwriting losses that shriveled to virtually zero from $4.5 billion in the first quarter of 2011. The industry’s bottom line benefited commensurately as overall net income after taxes (profits) surged in the first quarter by 29.6 percent to $10.1 billion from $7.8 billion in the year earlier period, pushing the industry’s return on average surplus up to 7.2 percent during the first quarter of 2012, from 5.6 percent in the first quarter of 2011 (and just 3.5 percent for full-year 2011). Profitability improved despite still tepid premium growth of 3.1 percent. The improvement in underwriting performance and favorable investment market conditions during the quarter enabled the industry to fully recoup the loss of capacity sustained during a catastrophe wracked 2011. Indeed, policyholders’ surplus rose to a new all-time record high of $570.7 billion.
The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
Policyholders’ Surplus (Capital/Capacity): Catastrophe Impacts Fade
Policyholders’ surplus hit a record $570.7 as of March 31, 2012, up $20.4 billion or 3.7 percent from $550.3 billion at year-end 2011. The new record supersedes the previous record high of $566.5 set exactly one year earlier (as of March 31, 2011). Following that record, policyholders’ surplus actually shrank by 4.6 percent as catastrophes took their toll. The fact that the industry was able to not only fully recoup that loss but also achieve a new record—within the span of just six months—is further evidence of the property/casualty insurance industry’s remarkable resilience in the face of extreme adversity.
The bottom line is that the industry is, and will remain, extremely well capitalized and financially prepared to pay very large scale losses again in 2012 and beyond. One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.79, close to its strongest level in modern history. Indeed, barring a mega-catastrophe or significant investment market turmoil, it is quite likely that capacity in the property/casualty insurance industry will continue to expand, reaching one or more new record highs in the three remaining quarters of 2012.
THE BOTTOM LINE RECOVERY: IS IT SUSTAINABLE?
Profit Recovery: Shifting Out of Reverse
Ever since plunging by 96 percent during the height of the global financial crisis, net income after taxes (profit) had been rebounding fairly steadily and robustly as asset prices recovered, underlying claim frequency and severity trends remained relatively subdued and the release of prior year reserves bolstered the bottom line. That is, until Mother Nature got her way in 2011.
So far in 2012, however, Mother Nature has been much less cruel. As noted earlier, the P/C insurance industry reported an annualized statutory rate of return on average surplus of 7.2 percent during the first quarter (8.2 percent after excluding mortgage and financial guaranty insurers), up from 5.6 percent in the first quarter of 2012 (6.1 percent after excluding mortgage and financial guaranty insurers). Overall net income after taxes (profits) in the first quarter reached $10.1 billion, up 29.6 percent from $7.8 billion a year earlier. The favorable net income comparisons are likely to continue in the second quarter. Catastrophe losses in the second quarter of 2012 are certain to be well below the $17.4 billion recorded in the second quarter of last year, providing an additional boost to earnings. While it is difficult to anticipate catastrophe loss activity and the investment environment through year’s end, it is possible that the P/C insurance industry in 2012 could surpass the post-crisis profit peak of $35.2 billion reached in 2010.
While the reduction in catastrophe losses was the dominant factor favorably impacting earnings in the first three months of 2012, the quarter’s profits were also bolstered by $3.9 billion in prior-year reserve development. While down from $4.6 billion in the first quarter of 2012, the addition to earnings is still considerable. Indeed, billions in profits over the past several years were actually the result of downward revisions in the estimated ultimate cost of claims occurring in years past. During 2011, prior-year reserve releases actually increased to $11.0 billion from $9.7 in 2010, a gain of 13.4 percent. Despite continued favorable reserve development in the first quarter of 2012, the contribution to the bottom line from prior-year reserve releases is expected to diminish as the pool of redundant reserves diminishes over time, pushing the combined ratio up. This dynamic will contribute to higher underwriting losses in the future and eventually exert pressure on rates.
Of course, a firming in the pricing environment would help the bottom line on a sustained basis. While pricing in personal lines (which account for approximately half of all premiums written) has been trending positive for several years, and appears likely to continue that trend through 2012, commercial lines pricing also finally appears to be much firmer than a year ago. According to the Council of Insurance Agents and Brokers (CIAB), the average commercial rate change in the first quarter of 2012 was +4.4 percent compared with a decline of 2.9 percent in the first quarter of last year. The quarter’s 4.4 percent gain represents the third consecutive quarter of increase following 30 consecutive quarters of decline dating back to the start of 2004. Despite recent gains, the overall commercial lines price level today is equivalent to where it was in late 2000. In other words, the cost of insurance sold to businesses today is basically the same as it was more than a decade ago.
Top Line Growth Accelerates But Remains Quite Modest
Net written premiums were up 3.1 percent though the first three months of 2012. While the current tepid rate environment does not portend imminent hard market conditions, the improvement is evidence that personal and commercial insurance renewals are consistently trending positive—and that the property/casualty insurance industry is benefiting even from the frustratingly slow growth in the American economy, which is translating into an increasingly steady stream of additional insurable exposures. On a quarterly basis, premium growth has been positive since the second quarter of 2010 and all indications are that the industry will remain on a modest growth trajectory for the remainder of 2012.
Deconstructing the first quarter growth of 3.1 percent reveals several interesting trends. Personal lines net premiums written were up 2.5 percent (down from +3.9 percent growth in the first quarter of 2011). This deceleration was anticipated. According to data compiled from the Bureau of Labor Statistics, the consumer price index component for auto insurance was up 2.9 percent through the first three months of this year, compared with a gain of 4.2 percent in the same period in 2011. Auto accounts for approximately 70 percent of personal lines premiums written. Commercial lines insurers saw growth of 4.7 percent during the quarter (up from 3.4 percent a year earlier). Insurers with a more diversified book of business experienced growth of 2.8 percent during the first quarter, down slightly from 3.0 percent in the first quarter of 2011.
Any growth is welcome after three years of decline (2007–2009) and anemic growth (+0.9 percent) in 2010. The figures for 2011 (+3.3 percent)—and thus far in 2012—demonstrate that while growth is likely sustainable through 2012 and possibly several years beyond, the trajectory of growth remains quite modest. Premiums in 2010 and much of 2011 were held back in part by continued soft market conditions, primarily in commercial lines, which continued to grip the industry through the first half of last year. The economy was also a factor (details below) and remains a significant factor in 2012, though the massive exposure losses that plagued the industry in 2008 and 2009 are much less of a concern today. Indeed, the era of “mass exposure destruction” is over as the economy continues to recover—albeit weakly and unevenly. Although the nation’s real (i.e., inflation adjusted) gross domestic product (GDP) actually began to expand during the second half of 2009 and further expanded, by 3.0 percent, in 2010, the economy grew at a feeble rate of just 1.7 percent in 2011. That weakness continued through the first quarter of 2012, with GDP growth of just 1.9 percent. In general, P/C 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).
P/C insurers in 2012 should continue to see the benefits of exposure growth that began in earnest last year. For example, the value of manufacturing shipments, has nearly returned to its pre-crisis peak. Indexes of manufacturing and non-manufacturing activity through May 2012 indicate that expansion was continuing, despite economic turmoil in Europe. Such activity fuels premium growth across many commercial coverages including commercial property, liability, commercial auto and workers compensation. Perhaps most importantly, the private sector created 2.105 million jobs last year, up from 1.423 million in 2010. Through the first three months of 2012, private sector employers added an additional 678,000 workers (and a total of 847,000 through May). Overall payrolls, the exposure base for workers compensation insurance, now exceeds its pre-crisis peak. During 2011, the unemployment rate ranged from a high of 9.2 percent in June to a low of 8.5 percent at year’s end. By March 2012, the unemployment had dropped still further to 8.2 percent.
Despite extreme economic pessimism through much of the past two years, including the past several months of 2012, the economy appears to have successfully avoided a much feared and often discussed “double-dip” recession. Although real GDP growth came in at a disappointing 1.9 during the first quarter, economic growth is projected to reach 2.1 percent for full-year 2012 and 2.4 percent in 2013, according to Blue Chip Economic Indicators.
Investment Performance: Investment Gains Continue
Total investment gains (which include net investment income plus realized capital gains net of realized capital losses) were down by $1.2 billion (8.9 percent) in the first quarter of 2012, to $12.3 billion from $13.6 billion in first-quarter 2011.
It is instructive to compare the components of the quarter’s total investment gains with the first quarter of 2011. Net investment income (primarily interest earned on the industry’s bond portfolio plus stock dividends) fell by $0.9 billion or 7.5 percent to $11.7 billion during the first quarter. Realized capital gains, which totaled $0.7 billion during the quarter, fell by $0.3 billion. About two-thirds of the property/casualty insurance industry’s investment portfolio is invested in bonds.
Bond market yields (and prices) in the first quarter of 2012 were steady, if unspectacular. Moody’s AAA-rated seasoned bond index yields ranged between 3.77 percent and 3.93 percent in January and February, then rose above 4.0 percent in mid-March. The index yield briefly hit 4.18 percent, then retreated, ending March at 4.04 percent. In contrast, the broad stock market did quite well throughout the quarter: the S&P 500 rose 4.36 percent in January, 4.06 percent in February, and 3.13 percent in March. By the end of May, however, all of those gains had been lost, though a subsequent rally pushed the S&P 500 to a gain of 6.2 percent through June 25.
The conventional wisdom is that interest rates will remain low for several more years. The Federal Reserve continues to hold its key federal funds rate between zero and 0.25 percent and has signaled multiple times that it expects to keep it there until perhaps late 2014, if not beyond. Moreover, the Fed has also endeavored to push longer-term interest rates down through a series of “quantitative easing” (or QE) programs. With the Fed’s QE II program coming to a close, there is speculation that the Fed will embark on a QE III program later this year should the economy show additional signs of weakness.
The outlook for inflation remains quite tame, with the consumer price index expected to rise by 2.2 percent in 2012 and 2.1 percent in 2013. Low inflation gives the Fed the latitude to pursue an aggressive monetary policy. Relatively high unemployment, remaining underutilized industrial capacity, and generally weak consumer demand all continue to point to inflation (and, therefore, interest rates) remaining low for the foreseeable future.
The property/casualty insurance industry turned in a relatively strong performance during in the first quarter of 2012 in terms of underwriting performance and overall return on average surplus (profitability). In addition, policyholders’ surplus reached an all-time record high as insurers fully recouped capacity lost in the wake of the heavy catastrophe activity of 2011. Although profitability surged amid much lower catastrophe losses this year, investment gains were down and premium growth remains very modest. The outlook for the remainder of 2012 is reasonably good, though significant risks abound, including the potential for high catastrophe losses during this year’s hurricane season, the prospect of high underwriting losses associated with non-cat losses and more uncertainty in the investment markets.
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 first quarter 2012 follows.
FIRST QUARTER 2012 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 97.6.