<b><u>Components of Property/Casualty Insurer Profitability</u></b>
The financial performance of property/casualty insurance companies is determined primarily by two factors: underwriting performance and investment performance. Underwriting performance refers to how much an insurer pays out in claims relative to what it earns in premiums. Investment performance refers to how much an insurer earns on its portfolio of invested assets. The drivers of underwriting profit (loss) and investment profit (loss) are detailed in the next section.
Insurers, of course, also have overhead expenses, pay dividends to shareholders or policyholders, and owe taxes to federal and state governments. The sum of what an insurer earns on underwriting and investments less expenses, dividends and taxes is equal to its after-tax profit, also known as net income after taxes.
<b><u>Underwriting Profit (Loss)</u></b>
The principal source of revenue for insurers is from insurance premiums, while the largest component of cost for insurers is claim payments. In most years, insurers actually pay more in claims and associated expenses than they earn in premiums, resulting in an underwriting loss. In fact, the property/casualty insurance industry has experienced just one underwriting profit since 1978 (in 2004). Claim costs are affected not only by events that occur during a particular calendar year (such as a hurricane), but also because funds set aside to pay claims that occurred in the past—known as reserves—turn out to be inadequate (because of higher-than-expected medical or legal costs, for example), therefore requiring additional contributions.
Insurers invest the premium dollars they earn until the money is needed to pay claims. Insurers also set aside and invest reserves for claims that have already occurred and which may need to be paid out over a period of years or even decades.
Property/casualty insurers maintain a very conservative investment portfolio, designed to minimize investment risk and to maintain a high degree of liquidity. Approximately two-thirds of the portfolio is held in the form of bonds (primarily high-grade corporate and government bonds), while less than 20 percent is in vested in common stocks. Most of the remainder is held as cash and short-term securities.
The primary source of investment earnings for insurers is interest from bonds. Other sources of investment earnings are dividends paid on stocks and capital gains. Capital losses can also occur, which reduce overall investment performance. The sum of what insurers earn in interest from their bond portfolio, plus stock dividends and capital gains (less capital losses) is known as the industry’s investment gain.
<b><u>Measuring Profitability: Dollars vs. Return on Equity (or Return on Surplus)</u></b>
Aggregate dollar amounts of profit (or loss) are not particularly meaningful statistics for comparative purposes. A standard measure of financial performance across all industries is known as return on equity (ROE). ROE is the ratio of profit to a company’s average net worth (sometimes referred to as “owners’ equity” in publicly traded companies). Net worth in the world of insurance is often referred to as policyholder surplus and is simply the difference between a company’s assets and its liabilities. Net worth is money (capital) that belongs to the company’s owners. In an insurance company, the owners could be shareholders (in a publicly traded company) or policyholders (in a mutual insurance company). Owners of capital expect a rate of return on their investment that is commensurate with the risk they assume. Insurers that fail to maintain profitability can also suffer downgrades from ratings agencies and could be seized by regulators.
The following example illustrates the advantage of measuring profitability using ROE rather than simple dollar amounts. Assume there are two companies, both of which earned $1 million in profits last year. The companies are identical in every respect except that Company A had an average net worth of $10 million during the year while Company B had $20 million. The ROE for Company A is 10 percent ($1 million profit divided by $10 million net worth), but for Company B it is just 5 percent ($1 million profit divided by $20 million net worth). The two companies earned exactly the same amount in profit, but Company A was twice as profitable because it earned the same amount in profits with half as much capital (net worth). Company A provided a superior return on investor capital (as measured by ROE) than Company B even though both companies earned the same profit in when measured in dollar terms.
<b><u>Insurer Profits: Each Line and Each State Must Stand on its Own</u></b>
The insurance industry is regulated at the state level. By law, insurance rates in each state must reflect the actual and expected loss experience in that state and that state only. Consequently, each line of insurance—such as auto and homeowners coverage—needs to stand on its own in terms of profitability. Profits in auto insurance or workers compensation coverage, for example, cannot be used to subsidize losses in homeowners insurance that arise from hurricanes or other natural disasters. Likewise, insurance markets in each state must be profitable in their own right and cannot be subsidized by profits in other states. Hurricane-related losses to homes in a state like Florida, for example, cannot be subsidized by profits generated by homeowners insurers in Minnesota. Conversely, Florida homeowners cannot and should not be called upon to subsidize severe winter storm losses in Minnesota.
Underwriting performance and investment return are the two principal drivers of insurance industry profitability. Profits are also affected by overhead expenses, dividend payouts and taxes. Profitability in the insurance industry cannot be evaluated by comparing simple dollar amounts. Return on equity, which reflects profits generated relative to the capital investors put at risk, is the best way track performance across companies and over time. Because insurance is regulated at the state level, only the loss experience of that state can be factored into the rates charged in that state. Profits from other coverage types or from other states cannot be used to subsidize unprofitable lines of insurance or unprofitable states.