Robert P. Hartwig, Ph.D., CPCU
Senior Vice President & Chief Economist
Insurance Information Institute
bobh@iii.org
December 22, 2003
The property/casualty insurance industry reported a statutory rate of return of 9.3 percent in the first nine months of 2003, up from a disappointing 1.0 percent in 2002 and the worst-ever negative 2.4 percent recorded in 2001. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).
2003: As Good as It Gets?
A rare alignment of market forces has brought the property/casualty insurance industry to the threshold of its best profit performance in five years. Results through the first nine months confirm that the industry remains in the midst of a broad-based recovery, with significant improvement noted in every key financial statistic. Premium growth, while decelerating from previous periods, rose at a healthy 10.1 percent clip while the combined ratio fell to 100.3 from 105.0 over the same period last year. Investment income was up 3.2 percent, despite historically low interest rates. Realized investment gains swung from a $1.3 billion loss in the first nine months of 2002 to a $5.9 billion gain this year on the strength of a bull market that was up 13.2 percent through September 30. Policyholder surplus, the industry’s measure of capacity, increased by $34.5 billion or 12.1 percent on the strength of higher net income and rising stock values. Another sure indicator that the industry is doing better is its burgeoning tax bill. Income tax payments by insurers through the first nine months of 2003 totaled $6.9 billion, exceeding total payments for the prior 36 months, when record losses destroyed the industry’s profits and taxable income.
Yet as good as the 2003 results are, it now appears that the current cycle will usher in a new and unwelcome profit dynamic, one that signals a distinct departure from the past. Specifically, previous hard markets invariably led to a period of flush industry returns well-above the Fortune 500 benchmark ROE. During the hard market of the mid-1980s, p/c insurer returns were, on average, 3.2 points higher than the Fortune 500 while in the 1970s they were 4.7 points higher. With the industry’s return on equity still mired in the single digits, matching—not to mention exceeding—an estimated Fortune 500 ROE of 13 to 15 percent this year, is now clearly out of reach. The outlook for 2004 includes improved profitability, but unless catastrophe results in 2004 are abnormally low and/or investment returns unexpectedly robust, the p/c insurance industry will not be able to produce the outsized returns necessary to leapfrog the Fortune 500 group, especially as the improving economy propels the fortunes (and ROEs) of most other industries while the current hard market continues to lose steam. In another departure from the past, the current “sweet spot” in the insurance cycle should be prompting ratings agencies to upgrade insurers, yet downgrades still outnumber upgrades by a wide margin.
It should not be inferred from the preceding discussion that all insurers are falling short of the mark. In fact, many are doing quite well. It is the industry’s performance as a whole during the hard market that is somewhat disappointing and provides an unfavorable historical comparison.
In the remainder of this commentary, we provide a detailed discussion of what the nine -month results mean for the industry in the context of major challenges insurers face today—many of which don’t appear on financial statements.
2004: From Perfect Storm to Goldilocks?
Rising prices and tougher underwriting are at the core of the insurance industry’s current recovery. But the industry’s voyage toward recovery has proved to be exceptionally slow, difficult and dangerous, despite price and underwriting discipline. A confluence of events conspired to form a “perfect storm” that battered the industry for five years and pushed insolvency rates and guarantee fund payouts to record highs by 2002. Elements of that perfect storm included: unrestrained jury awards, surging asbestos claims, soaring medical inflation, high catastrophe losses, the crisis in corporate governance, loss of critical capacity, a weak investment environment, the sluggish economy and, of course, the extreme risk of terrorist attacks. Needless to say, not all of these problems have been completely vanquished. Insurers and their allies failed to get tort reform or asbestos legislation through Congress in 2003; medical inflation remains rampant; catastrophe losses in 2003 were the third highest in history; and the threat of a terrorist attack is omnipresent. Moreover, few are betting that 2003’s 20-plus percent stock market gains will be repeated in the year ahead.
Yet despite the lingering storm clouds, a rare Goldilocks market—a brief period of time when everything is just right—might well pay a visit to the property/casualty insurance industry in 2004. Pricing will neither be too high nor too low and business and consumer demand for insurance will generally be met with relatively few areas of acute shortage. Interest rates will rise but not too quickly, lest bond prices fall too much. For the icing on the cake, the expanding economy ensures that exposure growth will accelerate—meaning that insurers will at least have some opportunity to compete for new business rather than resort to destructive price wars with each other for the same old business. All in all, market conditions could be just right in 2004.
Among major external risks, tort costs remain among the factors that most significantly affect insurer financial performance. The failure of tort and asbestos reform legislation was easily the industry’s biggest disappointment in 2003. According to a recent study by Tillinghast-Towers Perrin, tort costs jumped $27.4 billion or 13.3 percent to $233 billion in 2002 (representing 2.23 percent of GDP or $809 per capita). Insurers’ share of those costs totaled $165.8 billion (excluding medical malpractice). Controlling these costs will enhance insurer performance and the stability of casualty coverages. For this reason, tort and asbestos reform will be high on the industry’s agenda once again in 2004.
Premium Picture: A $400 Billion Business for Sure, But Kiss Double-Digit Growth Goodbye
Net written premiums during the first nine months of 2003 totaled $308.6 billion, up a healthy 10.1 percent from the same period last year—keeping the industry on track to exceed $400 billion in net premiums written for the first time in its history. While net premium growth during the quarter was undeniably strong, the deceleration from calendar year 2002’s 14.3 growth rate is significant and appears to be occurring more rapidly than many industry observers anticipated. Indeed, growth in the third quarter fell to just 8.4 percent from 12.7 percent and 9.3 percent in the first and second quarters of 2003, respectively. When fourth quarter data become available in early 2004 they are likely to reveal a growth rate barely half that recorded in 2002.
That premium growth is slowing more rapidly than anticipated is reflected in the Insurance Information Institute’s recent Early Bird survey of leading industry analysts (visit /media/industry/financials/forecast2004/ for the full report). The average of the analysts’ estimates for 2003 net written premium growth is 10.8 percent. Given the 10.1 percent actual figure for the first nine months and the sequential quarterly decline noted previously, the full-year 2003 change in net written premiums will likely be a full percentage point below analyst expectations (closer to 9.8 percent than 10.8 percent).
Among the biggest downside risks for 2004 is a loss of pricing discipline, or, at minimum, a sharp loss of pricing momentum. This concern likely explains the wide disparity among analyst forecasts in the Early Bird survey for net written premium growth in 2004, which range from 5.2 percent on the low end to as much as 10.5 percent on the high side.
The fact that premium growth is leveling off sooner than expected is not necessarily all bad news for insurers. In some cases it simply reflects the fact that underwriting performance targets have been realized more quickly than anticipated. According to a recent Council of Insurance Agents and Brokers rate survey, 32 percent of commercial property accounts renewed negative during the third quarter of 2003—yet this was much more a reflection of vastly improved underwriting results than any substantive loss of pricing discipline. Similar concerns were voiced when the auto insurance component of the Consumer Price Index (CPI) showed an increase of just 5.0 percent in November, down sharply from 7.3 in October and the year’s 9.3 percent peak in May. Here, too, the deceleration reflects good underwriting results as many auto insurers have seen their combined ratios fall into the low – to mid-90s during the year.
Underwriting: Rediscovering a (Nearly) Lost Art
The most important piece of information—by far—to emerge from the nine-month results is the remarkable turnaround in the industry’s underwriting performance—from a combined ratio of nearly 116 in 2001 to just over 100 through the first three quarters of 2003. In terms of dollars, underwriting losses are on track to fall from a record $52 billion in 2001 to just $12 billion or so this year—a decline of 77 percent in just two years.
According to the I.I.I. Early Bird survey mentioned previously, the combined ratio for 2004 is projected to be 100.7, down from an estimated 101.7 in 2003 and well below the terrorism-impacted 115.7 result in 2001.
The majority of the improvement in recent years—apart from the non-recurrence of a terrorist attack in the U.S.—is due to a disciplined approach to risk selection and better matching of price to the risk assumed. While insurers have benefited from an improved investment environment in 2003, investment considerations are clearly no longer driving underwriting decisions, nor should they.
To underscore the importance of this final point, consider that a combined ratio of 100 today generates a rate of return of about 9.5 percent while in 1978, the last time the industry broke even from an underwriting standpoint, the same result would have produced an ROE of about 16 percent. In fact, the combined ratio from 1977 through 1979 averaged 98.4, just a bit better than the 100.3 figure for the first nine months of this year, yet insurers enjoyed an average return on equity during that period of 17.5 percent. The difference, of course, was that the cash that poured in during the hard market of the mid-to-late 1970s could be invested at sky high interest rates that dwarf today’s puny yields.
The implications are sobering: as good as 2003’s results are through the first nine months, they’re still not good enough. More improvement is needed in 2004 and probably 2005 as well. A combined ratio of 100 still produces big “losses” from the point of view of disappointed investors who could have earned more elsewhere, perhaps with less risk. Investors are looking at ROEs in the neighborhood of 13 to 14 percent for the Fortune 500 this year compared to less than 10 percent in the p/c insurance world. Moreover, if every penny of premium income is paid out for losses and expenses, not a nickel is left for anything else—like profits or funds needed to expand the business or offset adverse reserve development. Insurers today need to push their combined ratios down to the low 90s (and keep them there) before they can expect to generate Fortune 500 type rates of return. Some segments of the industry have already managed this mystical feat of underwriting and actuarial wizardry, but many have not.
Investment Income: Up, Up but Not Too Far Away
Anyone who was hoping that a rising tide of investment income in 2003 would rush in fast enough and deposit a sea of cash deep enough to wash away any lingering red ink (i.e., reserve deficiency) from the soft market of the 1990s or any recent underwriting or pricing blunders is likely to find themselves up a creek with just one paddle. Net investment income through the first nine months of 2003 rose by just 3.2 percent, representing a gain of only $1.1 billion on an annualized basis—barely enough to pay for a middling-size disaster. Likewise, expectations for rising investment income in 2004 could be overdone because lower-than-expected inflation (the CPI actually fell by 0.2 percent in November) and still-weak job growth (2.5 million fewer people had jobs in late 2003 than in early 2000) may well give the Federal Reserve more breathing room to keep rates low through much if not all of 2004. The Fed will also be reticent to raise rates anywhere near next year’s presidential election.
Note that rising investment income was once taken as a given in the property/casualty insurance industry. These earnings, which consist primarily of interest earned from insurers’ bond holdings, rose in 21 of the 23 years from 1975 though 1997. In four of the past five years (1998 – 2002), however, as well in the first quarter of 2003, investment income has declined.
The good news is that investment income will likely increase modestly for the foreseeable future:
- Cash flow is improving. Even with declining interest rates and decelerating premium growth through much of the year, the rising volume of investable funds is beginning to turn the tide in favor of greater (though still not great) gains. Investment income also includes dividends paid on common stock, which are beginning to slide in the current bull market. The dividend yield on the Dow Jones Industrial Average as of December 12 was 2.1 percent, down from 2.7 percent early in 2003. Nevertheless, improved corporate earnings will put pressure on firms to raise their dividends (or start paying them for the first time) while the reduction in the tax on corporate dividends, which makes dividend paying stocks more attractive, could help keep yields high and will allow insurers to keep more of their earnings on an after-tax basis.
- President Bush’s tax cut earlier this year has forced the federal budget into deficit for the foreseeable future, despite the nascent economic recovery, leading to the largest deficits in the nation’s history and record borrowing by the federal government. The federal budget deficit was a record $374 billion for fiscal year 2003 (which ended September 30, 2003). For 2004 and 2005, the deficits are estimated at $480 billion and $341 billion, respectively. Many economists view even these gargantuan figures as optimistic, with project deficits exceeding $500 billion for the next few years. State governments, such as California, looking to close yawning budget gaps, are also borrowing heavily. Large deficits, all else being equal, increase the demand for borrowed funds, thereby forcing the price of those funds (interest rates) higher.
- The economic recovery in the second half of 2003 showed remarkable vigor with real GDP shooting up by 8.2 percent during the third quarter, compared to just 2.6 percent in the first half of the year. Expectations are for economic growth to settle out at a more sustainable 4.2 percent in 2004 (Blue Chip Economic Indicators, November 2003). The recovering economy and the expectation of higher interest rates in 2004 are creating a rush to issue bonds. These factors have already pushed longer-term interest rates up. As noted in the ISO release, the yield on 10-year Treasury notes rose from a 45-year low of 3.33 percent in June to 4.3 percent in November.
- Eventually the Federal Reserve will raise interest rates. Although the Fed cut its overnight lending rate for banks (the federal funds rate) to just one percent in June 2003, the economic recovery, loose fiscal and monetary policy, and the mammoth federal budget deficits will build inflationary expectations, forcing the Fed to raise rates. This could happen in 2004, though election year political forces will rally against such a hike, even if warranted.
- The stock market recovery that began in March, will likely drain away assets from the bond markets as investors seek higher yields in equities, pushing bond prices down and yields up.
- Financing the twin U.S. budget and trade deficits requires the infusion of hundreds of billions of dollars in foreign capital. With interest rates so low and investment opportunities abroad picking up, U.S. interest rates will need to rise in order to make investments in U.S. assets relatively more attractive.
What About Wall Street?
Major U.S. stock markets were down in 2000, 2001 and 2002 and continued to fall until the middle of March 2003. A subsequent powerful rally on Wall Street erased the 3.6 percent first quarter loss on the S&P 500 and propelled the market to year-to-date gains of 10.8 percent by the end of the second quarter and 13.2 percent through the third quarter. Through December 12, the market was up an additional 8.9 points for a year-to-date gain of 22.1 percent. While the 2003 rally is a welcome respite from the markets’ dreadful performance in the previous three years, enabling insurers to realize $5.9 billion in capital gains during the first nine months, it is still unclear if the current bull market has the staying power to last through 2004. Many analysts believe that the major stock markets indices have gotten ahead of themselves (especially the NASDAQ, which is up more than 40 percent for the year) and are exhibiting the same sort of “irrational exuberance” they displayed in the late 1990s and are due for a pullback.
Insurance Company Stock Performance
Investors appear to be hedging their bets when it comes to insurer performance. Investors, who poured billions into insurer equity offering since 2001, have in some cases been disappointed, though some have been richly rewarded. The biggest U.S. IPO in any industry in 2003, China Life, rose 26 percent on its first day of trading, December 17. Generally speaking, however, strength in other sectors of the economy, questions about the staying power of the current hard market, ratings downgrades and worries over a variety of other issues have led p/c stocks to a performance that is on par with broader market indices. Through December 12, p/c stocks were up 21.0 percent on a market-cap weighted basis, compared to 22.1 percent for the S&P 500. Over the same period, multi-line insurers were up 9.1 while life/health insurers were up 26.7 percent. Broker stocks were up just 6.7 percent over the same period.
Surplus and Capacity
Surplus expanded by 12.1 percent or $34.5 billion during the first nine months to $319.9 billion from $285.4 billion at year-end 2002. The upshot is that 2003 will mark the first year since 1999 to record an expansion in the industry’s capacity. While increases in surplus are almost universally heralded as good news, there is a downside risk. Specifically, if capacity expands in what is an otherwise moribund economy, then capacity will expand faster than exposure growth. New exposures (like terrorism) can absorb some of the increased capacity, but most will seek a home with traditional property and casualty-type risks. In other words, there may be too much money chasing too little exposure.
Summary
The first nine months of 2003 represents the first sustained period of truly good financial performance the property/casualty insurance has experienced since the current hard market began more than three years ago. The fact that the industry’s statutory return on average surplus was just 9.3 percent, despite a combined ratio of just 100.3, is a stark reminder that additional improvements in underwriting are needed if the industry hopes to generate Fortune 500 rates of return in the 12 to 15 percent range anytime soon. As the industry heads into 2004, many insurers will be focused on the issue of financial strength and will take steps toward reversing the multi-year slide in ratings. These measures will better prepare them to deal with the challenges and uncertainties that lay ahead in 2005 and beyond.
A detailed industry income statement for the quarter follows:
