In the first nine months of 2014, overall net income after taxes (profits) in the property/casualty (P/C) insurance industry was $37.65 billion. This was down by $5.07 billion (11.9 percent) from $42.72 billion in the first nine months of 2013. Keep in mind, however, that 2013 was an unusually strong year. For perspective, note that profits for the first three quarters of 2012 were $27.8 billion and for the comparable period in 2011 were $8.0 billion.
At the end of the first three quarters of 2014 vs. 2013, overall industry capacity (as measured by policyholders’ surplus—what in other industries would be called net worth) rose by $50.04 billion (8.0 percent) to $673.93 billion. But because the industry generated fewer dollars of profit from a larger capital base, the industry’s overall rate of return on capital (profitability) fell in the first nine months of 2014 to 7.6 percent from 9.4 percent in the same period of 2013.
Net written premiums continued steady growth, rising 3.9 percent in the first nine months of 2014 over the same period in 2013. But claims-related expenses rose faster, so the industry’s combined ratio rose 1.9 points to 97.7 during the first three quarters of 2014 compared to 95.8 in the comparable 2013 period. P/C companies need to maintain combined ratios below 95 in order to earn their cost of capital in a still-challenging interest rate environment. While low interest rates are likely to continue presenting a challenge throughout 2015, a stronger economy remains the industry’s best opportunity for growth; the nation’s real GDP growth surged by 4.6 percent (at an annual rate) in the second quarter of 2014 and by 5.0 percent in 2014:Q3.
The industry results were released by ISO, a Verisk Analytics company, and the Property Casualty Insurers Association of America (PCI).
The industry’s performance in the first three quarters of 2014 was positive but bore the effects of an extreme winter and several outbreaks of severe spring weather. A discussion of the key drivers of the period’s performance follows:
Losses: Higher, But Not Catastrophic
Some of the deterioration in underwriting performance in the first three quarters of 2014 can be attributed to higher claims costs relative to the year-earlier period. Although the insured damage from extreme cold and winter storms in early 2014 did not break the records set in the mid-1990s, 2014 will go down in history as one of the five costliest years on record for winter damage claims. Spring storms, including a number of severe hail and modest tornado and wildfire events in the drought-impacted West added to the tally of claims, pushing total net (of reinsurance recoveries) insured loss and loss adjustment expenses through September 30 to $253.1 billion, up $17.52 billion (7.4 percent) from $235.6 billion in the first three quarters of 2013.
Breaking the underwriting performance down into catastrophe related and non-catastrophe related claims, ISO estimates that the $17.5 billion increase in overall claims consisted of a $3.1 billion increase (to $14.7 billion) in catastrophe related claims and a $14.4 billion increase in non-catastrophe related claims (to $237.2 billion). In percentage terms, catastrophe related claims for the first three quarters of 2014 rose by 24.2 percent and non-catastrophe related claims by 6.5 percent.
Reserve releases are generally associated with new estimates of expected costs for claims occurring in past accident years. Overall inflation continues to be remarkably low, likely contributing to these lower estimates, although prices for some items that comprise claims payouts have been increasing at higher rates than general measures of inflation (see the I.I.I.’s Inflation Watch spreadsheet). For the first three quarters of 2014, the industry reported releases of prior-year claims reserves totaling $8.9 billion, down from $13.6 billion of reserve releases in the first three quarters of last year. Released reserves go directly to the “bottom line.”
Combined Ratio: Rare Underwriting Profits Continue
The industry’s overall underwriting gain was $4.3 billion, producing a combined ratio of 97.7 for the first three quarters of 2014. In long-term historical perspective, underwriting losses have been the norm over the past several decades. Quarters with an underwriting profit have occurred only 22 times in the 115 calendar quarters—28 years plus three quarters—since ISO’s quarterly data began.
Premium Income: Top Line Growth Continues
Also contributing to positive underwriting performance was continued premium growth, which slowed slightly to a 3.9 percent rate in the first three quarters of 2014 from 4.2 percent growth in the first three quarters of 2013.
There are two main drivers of premium growth in the property/casualty insurance industry: exposure growth and rate activity. Exposure growth—basically an increase in the number and/or value of insurable interests (such as property and liability risks)—is driven mainly by economic and demographic growth and development. Although real (inflation-adjusted) GDP in the first quarter of 2014 actually declined at an annual rate of 2.1 percent (in part due to the effects of the harsh winter, drawing down of inventories, and other one-time factors), economic growth snapped back in the second and third quarters, with real GDP expanding at a robust 4.6 percent annual clip and at a 5.0 percent annualized rate in the third quarter. Growth in key areas of the economy such as new vehicle sales, multi-unit residential construction, and consistent employment and payroll growth are clearly benefitting the P/C insurance industry. For the remainder of 2014 and into 2015, the forecasts call for real GDP growth to hold steady at about 3 percent, plus or minus 0.4 percent. And with inflation expected to continue to run at about 2 percent or less, the consensus is for nominal growth at a 5 percent annual rate in 2015.
The other important determinant in industry premium growth is rate activity. Rates tend to be driven by trends in claims costs, conditions in the reinsurance market, marketing and distribution costs, and investments in technology, among other factors. Although it is tricky to foresee the interplay of all of these along with macroeconomic factors, it is certainly possible that overall industry growth in net written premiums could keep pace with overall economic growth in 2014.
Improving labor market conditions in 2015 will also affect top line growth in the P/C insurance industry. Job growth benefits the entire economy, of course, but the expansion of payrolls benefits workers compensation insurers in particular. The United States economy added 2.95 million nonfarm jobs in 2014; if that rate is sustained through 2015, at year-end 2015 there will be nearly 6 million more workers than at the end of 2013. Combined with inflation-level increases in the hourly earnings of employees (as has been the case for the past few years), payrolls are expected to continue growing, resulting in billions of dollars in new premiums written by workers compensation insurers in 2015. Indeed, workers compensation, hit hard during the recession by a soft market and a precipitous drop in payrolls, has within the span of just a few years transformed itself from the fastest contracting major property/casualty line to the fastest growing. Workers compensation is likely to remain the fastest growing major P/C line of insurance in 2015 if economic growth and hiring behave as projected.
Also, continued growth in the residential construction sector and strong new car sales are just a few of the reasons why moderate premium growth is likely to continue through 2015.
The M&FG Sector: A Lift, Not a Drag
Since the bursting of the housing bubble and the onset of the “Great Recession,” P/C insurers providing Mortgage and Financial Guarantee (M&FG) insurance posted steep and continuing losses. Although this sector is tiny in relation to all other P/C lines of business (2014:Q3 net written premiums were $3.4 billion, or less than 0.9 percent of total P/C industry premiums), its losses had an outsized negative effect on overall industry results. Accordingly, since 2008, it has become customary to report results both with and without M&FG activity.
But in 2013 the M&FG line of business returned to profitability and, in both 2013 and 2014, outperformed the overall industry. For the first three quarters of 2014, M&FG insurance generated net gains on underwriting of $0.8 billion, producing a combined ratio of 83.0 (vs. 97.9 for the overall industry excluding M&FG). On the standard profitability measure, the M&FG annualized rate of return on average surplus was 14.8 percent (vs. 7.4 for insurers writing other lines).
However, although the 2014:Q3 M&FG results are attractive, they are less so than the results from the first three quarters of 2013 (combined ratio: 32.1; net gains on underwriting of $3.0 billion). Consequently, the performance of this sector in 2014 vs. 2013 contributed to the drop-off in performance of the overall industry.
For the first three quarters of 2014, net investment gains (which include net investment income plus realized capital gains and losses) rose by $2.7 billion (6.7 percent) to $43.1 billion, compared to $40.3 billion in the first three quarters of 2013. The gain was attributable solely to strength in realized capital gains vs. 2013.
Net Investment Income
Net investment income has basically two elements: interest payments from bonds and dividends from stock. The industry’s net investment income for the first three quarters of 2014 was $34.29 billion, virtually identical to the $34.28 billion in the first three quarters of 2013 (up just $9.5 million, or 0.28 percent). Most of this income comes from the industry’s bond investments, which are mainly high quality corporates and municipals.
Corporate bond market yields, as captured by Moody’s AAA-rated seasoned bond index, dropped fairly steadily throughout the first nine months of 2014. From a “high” of 4.49 percent in January, yields shed roughly 4 basis points per month, on average, ending the third quarter at 4.11 percent. Even with this dispiriting performance, yields were higher than during most of the first nine months of 2013, when they were below 4 percent.
Although many signs point to the U.S. economy improving, the same forces that have driven interest rates down for the past few years—under-used capacity (both capital resources and slack in the labor market) compounded by low inflation, little real wage growth, cautious business spending and constrained government outlays—are still present. For the near-term future, the Federal Reserve Board’s Open Market Committee has indicated that although it ended its purchasing of long-dated securities it expects to keep short-term interest rates extremely low for some months into 2015.
The other significant source of net investment income (besides bond yields) is stock dividends. In the first three quarters of 2014 stock dividends were remarkably steady. Net dividends paid during the first quarter of 2014 ran at a seasonally adjusted annual rate of $902.8 billion, in the second quarter at a $902.3 billion seasonally adjusted annual rate, and in 2014:Q3 at an $898.4 billion (preliminary estimate) annual rate. These numbers were generally lower than in the comparable quarters in 2013. But stock holdings in general represent roughly only one-sixth of the industry’s invested assets.
Realized Capital Gains/Losses
Only realized capital gains and losses affect insurer net income; unrealized capital gains and losses affect policyholders’ surplus. Realized capital gains from the first three quarters of 2014 were $8.8 billion, compared to the $6.0 billion recorded through the first three quarters of 2013.
As in the past, the downtrend in interest rates that constrains investment income pushed asset values of older bonds up, providing opportunities for capital gains on those bonds.
The broad stock market did reasonably well throughout the first three quarters of 2014—the S&P 500 rose fairly steadily, ending up roughly 9 percent. Although this gain was less than the market delivered in the first three quarters of 2013, it was certainly welcome. The near-term outlook for inflation remains quite tame, with the consumer price index and other measures of inflation expected to remain near 2 percent in 2015, especially if the current low price of oil persists. This could create conditions for future realized capital gains, but weather, geopolitical events, and issues in the global economy are all wild cards that can affect the U.S. economy and the investment markets.
Policyholders’ surplus as of September 30, 2014 stood at $673.93 billion—a new record and up $50.04 billion (+8.0 percent) from the year-earlier third-quarter period. Policyholders’ surplus has generally continued to increase in recent years as industry profits rose and as assets held in the industry’s investment portfolio increased in value in the wake of the recovery from the financial crisis and “Great Recession.” It is worth noting that surplus increased despite very high catastrophe losses in 2011 and 2012. The fact that the industry was able to rapidly and fully recoup its losses to policyholders’ surplus even in the event of disasters like superstorm Sandy (which alone produced $18.8 billion in insured losses in 2012) is continued evidence of the P/C 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 in 2014 and beyond. One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.73, close to its strongest level in modern history. (A ratio of 1.0 is considered strong, and a lower ratio is even stronger.)
The property/casualty insurance industry turned in a profitable performance in the first three quarters of 2014. In addition, policyholders’ surplus reached a new all-time record high. Despite an unusually costly winter and a number of costly springtime catastrophes, rising non-cat losses, and persistently low interest rates, the industry posted another profitable quarter aided by capital gains and reserve releases. Premium growth, while still modest, is now experiencing its longest sustained period of gains in a decade. Fundamentally, the P/C 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 three quarters of 2014 follows.