Robert P. Hartwig, Ph.D., CPCU
Senior Vice President & Chief Economist
Insurance Information Institute
bobh@iii.org
December 17, 2002
The property/casualty insurance industry reported a statutory rate of return of 4.4 percent during the first nine months of 2002, compared with the terrorism-impacted negative 1.2 percent during the same period in 2001. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).
2002: The ‘Perfect Storm’ Continues to Howl
There’s plenty of good news to be found in the property/casualty insurance industry’s financial results for the first nine months of 2002, but the “perfect storm” that ravaged insurers’ balance sheets in 2001 clearly continues to rage in 2002. The results also seem to suggest that the hard market cannot end in 2003, at least if the industry expects to post reasonable rates of return by 2004.
The key forces that came together to form the perfect storm of 2001 were recession, catastrophe losses, medical cost inflation, Enron, abuse of the legal system and, of course, the September 11 terrorist attack. In 2002, the same forces were still largely intact with some becoming notably more intense. The economy—while no longer in recession—remained weak, catastrophe activity was “average” at best, medical inflation continued to spiral upward, the Enron scandal mushroomed into a full-blown crisis in corporate governance and abuse of the legal system reached epic proportions. And although no terrorist attacks occurred on US soil in 2002, the specter of terrorism loomed large as interests abroad came under attack (e.g., Bali, Kenya) and as the US moved closer to war with Iraq in early 2003—a war that the majority of Americans believe increases the likelihood of terrorist attacks in the United States.
In sum, insurer financial performance continues to improve but at a painfully slow pace that is disappointing to management and investors alike. The much-improved profit situation, discussed below, epitomizes the plight of insurers.
Profit Potential
The news that net income (i.e., profits) after taxes surged to $9.3 billion during the first nine months of the year is of paramount importance for two reasons. First, the figure represents an improvement of nearly $12 billion over the $2.6 billion loss in net income experienced during the same period last year. Second is the fact that $9.3 billion—as large as that figure might appear to be—produces a woefully inadequate rate of return on capital. The 4 to 5 percent return expected in 2002—while a marked improvement over 2001’s worst-ever performance—is still dreary, even when compared to today’s recession-reduced ROE expectations for American industries generally of about 10 percent. Moreover, for at least 12 consecutive years, profitability (as measured by return on equity) in the property/casualty insurance industry has managed to trail the industry’s cost of capital—often by a wide margin. [The cost of capital is that rate of return required by investors, given the risks assumed and the alternative investments available].
Pricing and Underwriting are Doing the Heavy Lifting
Premium growth of 13.6 percent is the best in 16 years, easily outstripping the 0.5 percent increase in loss and loss adjustment expenses and providing the basis for dramatic improvement in the combined ratio, which plummeted from 114.4 through the first nine months of 2001 to 104.9 during the same period in 2002. Last year’s results were, of course, greatly affected by the September 11 terrorist attack and a multitude of much smaller natural disasters that added a total of 9.5 points to the combined ratio. As noted in the ISO release, however, non-catastrophe loss and loss adjustment expenses rose 7.1 percent during the first nine months of 2002—more than four times the expected overall rate of inflation of 1.6 percent. Such a high rate of loss trend is worrisome because it suggests a stubborn underlying trend in losses that is likely to be resistant to—or beyond the scope of—insurer cost containment initiatives. Factors largely beyond insurers’ control include health care cost inflation, which hit 15 percent in 2002, and record-shattering jury awards.
The premium growth figure of 13.6 percent for the first nine months of 2002 is identical to insurance analyst expectations for full-year 2002, as discussed in the Insurance Information Institute’s annual Earlybird survey released earlier this month. Analysts forecast an easing to 12.3 percent in 2003—the first deceleration since 1998. The survey also found that underwriting results are expected to continue to improve in 2003, with the combined ratio falling to 103.3 from and estimated 106.3 in 2002. The full text of the Earlybird survey is available on the Insurance Information Institute’s web site at /media/industry/financials/forecast2003.
Capital Punishment
The industry’s capital base (surplus) continued to shrink during the third quarter of 2002. By September 30 total policyholder surplus stood at $273.3 billion, a decline of $16.3 billion since year-end 2002—and a sharp decrease from its June 1999 peak of $336.3 billion. The net decline in surplus of $63 billion (18.7 percent) over the past 3-plus years implies a loss in underwriting capacity equal to nearly $100 billion in net written premiums. In other words, the industry could prudently accept $100 billion more in premiums were this capacity still in place. Whether such business could be underwritten profitably, however, is a separate issue.
The decline in surplus, while diminishing the industry’s overall capacity to underwrite, will have the effect of raising the industry’s return on equity on the capacity that remains. Raising that return to reach the industry’s cost of capital (hurdle rate) of 11 to 12 percent is imperative if the industry hopes to maintain the confidence of investors and appease ratings agencies.
Investments: Conservative Portfolio Management Saves the Day
Insurers are notoriously conservative investors. Of the industry’s $782 billion in invested assets in 2001, 66 percent was invested in bonds while just 17 percent was invested in stocks. This is fortunate since the S&P 500 index declined 29 percent through the first nine months of 2002 (though the index was down “just” 20 percent through mid-December). Nevertheless, the market decline helped produce an unrealized capital loss of $29 billion through the first nine months of the year, according to ISO. The market decline also impaired the industry’s ability to realize capital gains, which fell sharply to $3.1 billion through the first nine months of 2002, down $3.6 billion or 53.9 percent from the year-earlier period
At the same time, interest rates continued to drift lower, with yields in many cases now at 40-year lows. Consequently, investment income continues to shrink. Investment income was down 5.4 percent through the first nine months of 2002 to $26.4 billion. Investment income for all of 2003 is likely to be off by a similar percentage or about $2.5 billion dollars.
Insurer Stock Price Performance
Through December 13, property/casualty insurance stocks were down 6.0 percent. While off for the year, the performance nevertheless compares favorably to S&P 500, which was down 21.4 percent over the same period. It is clear that investors are expecting the hard market to deliver healthy profits in the year(s) ahead.
A detailed industry income statement for the first nine months of 2002 follows:
