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By Robert P. Hartwig, Ph.D.
Senior Vice President & Chief Economist
Insurance Information Institute
bobh@iii.org

The property/casualty insurance industry reported a statutory rate of return on average surplus of 10.5 percent in 2004, up from 9.5 percent for calendar year 2003, just 1.1 percent in 2002 and the worst-ever negative 2.3 percent recorded in 2001. The results were released by the Insurance Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI). ��

2004: Glorious and Notorious

��In the normally staid world of property/casualty insurance there has never been a year quite like 2004. On the one hand the year’s uncharacteristically respectable financial performance represents the culmination of an historic, multi-year demonstration of underwriting and pricing discipline that earned the respect of investors worldwide. On the other hand, the industry gained international notoriety after allegations of bid rigging, improper accounting and other unsavory deeds were leveled by New York Attorney General Eliot Spitzer and others beginning in October. The accusations have led to high-profile resignations, firings, indictments and layoffs—not to mention a lot of bad press.

There were plenty of other highs and lows in 2004. Record catastrophe losses of $25.5 billion dented the year’s underwriting performance and profits—and with 80-plus percent of those losses attributable to the four hurricanes that pummeled the southeast coast during a mere 6-week span in the third quarter, revealed a multi-event exposure problem that no insurer or modeling company had previously considered seriously. Yet the storms, which spawned a record 2.2 million claims and an unprecedented claims handling challenge for insurers, set the stage for the industry’s proudest achievement of 2004—the settlement of nearly 90 percent of all claims by year’s end.

Insurers also continued to weather attacks on certain underwriting practices, such as the use of insurance scoring. Yet this tool helped insurers in 2004 to more accurately match risk to price and therefore protect more homes (and cars) at greater value than at any time in US history. In fact, insurers are delighted that their use of increasingly sophisticated underwriting tools like insurance scoring helped propel homeownership rates in the United States to an all-time record high 69 percent in 2004. There is also a great deal of pride over the fact that homeownership rates in 2004 climbed to an all-time record high in the nation’s largest urban areas as well as among minority populations.

Also noteworthy is the observation that the most recent recovery was accomplished amid some of the most challenging investment conditions since the Great Depression—as interest rates plunged to 40-year lows and stock markets tanked in three of the past five years. But even this dismal fact has an upside. The abysmal-to-lackluster performance in financial markets so far this millennium has forced CEOs at insurers large and small to focus intently on underwriting and eliminated the distraction—if not the possibility—of outsized investment gains papering over poor underwriting and pricing decisions. Strong underwriting is the most critical distinguishing feature of successful insurance companies in the long-run. The question for 2005 and beyond is whether there has been a shift to the “underwriting culture” within the property/casualty insurance industry or whether the discipline that restored the industry to underwriting profitability for the first time in 26 years will be a short-lived phenomenon.������

The ‘Underwriting Culture’ in Property/Casualty Insurance

The odds were against it, the investment analysts didn’t see it coming and Mother Nature did everything in her power to stop it, but the first underwriting profit since 1978 happened anyway.

The odds were against it because getting the combined ratio below 100 in 2004 would require the most remarkable underwriting recovery in modern history, but that’s exactly what happened—with insurers slicing 17.6 points off the combined ratio in just three years. In 2001, amid the ashes and record losses of the September 11 terrorist attack, enormous mold-driven underwriting losses in homeowners insurance, rampant fraud and abuse in private passenger auto insurance and a tort system run amok, the industrywide combined ratio had ballooned to a staggering 115.7, leaving the industry awash in red ink and a record underwriting loss of $52 billion. During the cycles of the 1970s and 1980s, the peak-to-trough fluctuations in the combined ratio were just 10.7 points and 11.7 points, respectively.

Investment analysts were justifiably skeptical about 2004’s prospects—after all, some of them were in elementary school the last time the industry ran an underwriting profit. An Insurance Information Institute survey of leading industry analysts in early 2004 produced a consensus combined ratio estimate of 100.0, nearly two points above the actual 98.1 combined ratio for the year.

Mother Nature delivered what would be the coup de grace in most years--$25.5 billion in insured catastrophe losses. However, some of the losses were ultimately borne by foreign reinsurers (and hence recorded in the financial statistics of the country in which that reinsurer is domiciled). Also, recoveries from the Florida Hurricane Catastrophe Fund, into which insurers have been paying reinsurance premiums since its inception in 1993, further reduced losses on a “net” basis. Finally, the experience of Florida’s state-run high-risk insurer, Citizens Property Insurance Corporation, is not included in the general industry results.

Was 2004 a fluke—never to return for another quarter century? Or, instead, are we at the cusp of a new era in which underwriting profits are relatively commonplace, as was the case prior to the 1980s?

The fact of the matter is that the commonly-held notion that a combined ratio equal to or exceeding 100 is acceptable is antiquated—a vestige of a management philosophy that dates to the late 1970s, the 1980s and 1990s, when interest rates were much higher and stock returns, on average, more generous. The table below shows the relationship between rate of return, combined ratio and bond yields for the decades beginning with the 1970s through the first five years of the 2000s. The fact that a relatively lousy average combined ratio of 109.2 was nonetheless associated with an average ROE of 11.5 percent during the 1980s while a better average combined ratio of 106.3 so far this decade is associated with an ROE of just 5.3 percent suggests an urgency in the need to shift permanently to a culture of underwriting as insurers set their course for the second half of the 2000s.

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Halftime in the P/C Insurance Industry

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Through the first half of the current decade, p/c insurers managed only a 5.3 percent average rate of return, well below that of the three prior decades and only a fraction of the 12.3 percent return generated by the Fortune 500 group over the same period. Interestingly, however, the average combined ratio of 106.3 through the first half of the 2000s, despite the myriad disasters that befell the industry over the past five years, is better than that of the 1980s or 1990s despite the below-average ROE. This apparent paradox is almost entirely explained by the superior investment environment of the 1980s and 1990s. The average yield on US Treasury securities with 10 years left to maturity, for example, was 10.6% during the 1980s but less than half that—just 4.8%—from 2000 through 2004. Bonds have long since represented the majority of the industry’s invested assets and presently account for 67 percent of the entire investment portfolio, providing an enormous investment advantage available to chief investment officers of yore but not today.

The financial performance of the p/c insurance industry over the past 35 years has been so volatile that it begs two very fundamental questions, taken up in the next section:

• �������� What is an appropriate rate of return in the P/C insurance industry?
• ������ Can insurers consistently meet that target rate of return?

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What is an Appropriate Rate of Return in the P/C Insurance Industry?

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What sort of return can be considered adequate in the p/c insurance industry and do insurers have any hope of realizing that rate of return over the long run?

Generally speaking, an industry’s cost of capital is the rate of return determined to be “adequate” in the sense that it is the minimum rate of return a company must earn in order to retain and attract capital. It is a function of returns available on alternative investments and the relative volatility of the company’s (industry’s) performance. For publicly traded US p/c insurers in 2004, the cost of capital stood at approximately 10 percent. This does not mean that the cost of capital for all segments of the p/c insurance industry was 10 percent. Some segments (e.g., property insurers in Florida, auto insurers in Massachusetts, medical malpractice insurers or sellers of directors and officers coverage) could reasonably be expected to command higher (possibly much higher) costs of capital because results are more volatile, exposing potential investors to significantly greater risk, and can therefore justify a high return.(1)(2)

As the table in the previous section shows, the average ROE for the p/c insurance industry through the first half of the current decade was just 5.3 percent, barely half the current 10 percent cost of capital. Logically, the absolute floor for return on investment is associated with yields on “risk-free” assets (US Treasury securities), which averaged 4.8 percent for securities with 10 years to maturity from 2000 through 2004. In other words, investors in the p/c insurance industry over the past five years who were subjected to risks ranging from typhoons, toxic mold, terrorism and trial lawyers, earned little more, on average, than they could have earned assuming no risk at all through a simple investment in a 10-year Treasury note. This suggests that capital should have exited the p/c insurance industry during the first half of this decade. In fact, between mid-1999 and the end of 2002, that’s exactly what happened, as policyholder surplus fell by 16 percent or $54 billion. As ISO/PCI note, however, policyholder surplus has since recovered (along with financial performance in 2003 and 2004), reaching a record $393.5 billion at the end of 2004.

It is notable that last year’s 10.5 percent return on average surplus represents the first year since 1987 that the p/c insurance industry has exceeded its cost of capital, though the industry came close in 1997.

Can This Decade Be Saved?

The average combined ratio of 106.3 through the first half of this decade would have generated an ROE of 10 percent or more through most of the two prior decades, but only low single-digit returns in the current period. Today, achieving the industry cost of capital of 10 percent requires a combined ratio of 98 or better. What, then, are the prospects of salvaging the second half of the decade for the sake of posterity?

Assuming current investment conditions prevail for the remainder of the decade, the industry would need to produce an average combined ratio of about 94 through 2009 just to end the decade with an average ROE of 10 percent—an impossible task.

A better question to ask is whether the industry can remain sufficiently disciplined in terms of pricing and underwriting to generate average rates of return of at least 10 percent in the remaining five years of this decade (2005 – 2009). An Insurance Information Institute survey of industry analysts released in February 2005 indicates a consensus combined ratio estimate of 99 for 2005—so far so good. However, analysts are already grumbling about the industry’s prospects in 2006 as the pricing environment—particularly in commercial lines—continues to weaken. Consequently, there is a general expectation of an incremental deterioration in operating results in the years ahead.����

Premiums and Pricing: How Low Will They Go?

Premium growth during 2004 tumbled by more than half to 4.7 percent, compared to 9.8 percent in 2003. The deceleration is due almost entirely to significant moderation in commercial and personal lines rates. As noted by ISO/PCI, the Council of Insurance Agents and Brokers reported a 7 percent decline in the price of the average commercial account during the fourth quarter of 2004. The report also reported that 86 percent of commercial property accounts renewed negative during the fourth quarter, as did more than half of all casualty risks. Private passenger auto rates are also moderating. While increases in the 6 to 8 percent range were common in 2003, many drivers in late 2004 experienced little or no change in their premiums while others began to see the cost of auto insurance fall. The Insurance Information Institute has projected an average increase in auto insurance expenditures of just 1.5 percent in 2005, while the average expenditure on homeowners insurance is expected to increase by 2.5 percent.(3)

Pricing, of course, has been a critical factor in the industry’s improved performance. Insurers successfully managed to push insurance prices sharply upward from 2000 through 2003, forging a stronger link between price and risk. But in 2004, pricing power began to erode. Because the investment environment remains volatile, sustained profitability depends increasingly on maintaining underwriting discipline. While underwriting discipline remains largely intact, at least for now, current pricing trends portend somewhat ominously for 2005.

The fact of the matter is that pricing seems to be weakening more rapidly than anyone anticipated. As noted earlier, net written premium growth came in at just 4.7 percent during 2004, well under half the 9.8 percent increase in 2003. In an I.I.I. survey taken in December 2003 the consensus estimate among analysts was for net written premium growth of 8.1 percent in 2004. Even the lowest estimate among the respondents—at 5.2 percent—appears to have been too optimistic and was 0.5 points above the actual result of 4.7 percent.

The I.I.I.’s Groundhog Survey of industry analysts, released in February 2005, calls for net written premium growth to slow to 2.7 percent this year. This implies that net written premium growth on an inflation-adjusted basis will be approximately zero in 2005, the lowest real rate of growth since 1999.(4)

In contrast to previous years, when premium growth was chiefly the result of higher rates, the sharp weakening in the pricing environment over the past year means that current gains are more directly related to increased exposure growth and higher demand associated with the current economic recovery. Until 2004, exposure growth was concentrated on the personal lines side, as low interest rates propelled new home construction to record levels while at the same time boosting auto sales. During 2004, however, business investment and hiring finally began to pick up, pushing up demand for commercial insurance. In 2005, the pace of hiring appears to be slowing while sales of SUVs and trucks are buckling under record high gas prices. Nevertheless, new home construction remains strong despite rising mortgage interest rates. Rising interest rates will eventually take its toll on both auto and home sales, however, and slow the pace of exposure growth for personal lines insurers.

As noted by ISO/PCI, a negative spread between written premium growth and economic (GDP) growth has re-emerged. During 2004, premium growth fell 2 percentage points below the 6.6 increase in GDP whereas premium growth outpaced growth in GDP by 4.5 percent points in 2003.����

Investment Performance: A Mixed Review

Investment income rose by an unremarkable 2.4 percent to $39.6 billion in 2004, up from $38.6 billion in 2003. Growth in investment income (which consists primarily of interest income generated from the industry’s substantial bond portfolio) has been tepid despite stronger cash flow because of declining interest rates over the past several years and which remained low throughout 2004. Indeed, the average yield on 10-year Treasury securities in 2003 and 2004, at 4.01 percent and 4.27 percent, respectively, were the lowest in 40 years.

Realized capital gains also rose last year, but by a much more impressive 40.9 percent to $9.3 billion from $6.6 billion in 2003 as insurers benefited from a post-election stock market rally that pushed the S&P 500 index up 9 percent for the year, compared to 26.4 percent in 2003. As noted by ISO/PCI, however, the sum of realized and unrealized capital gains in 2004 fell sharply (39.2 percent), reflecting more bullish stock market conditions in 2003. Looking ahead to 2005, the 2.6 percent decline in the S&P 500 in the first quarter implies a likely shrinkage in capital gains. However, a recovery later in the year is possible, especially if oil prices recede from there record highs recorded during the first quarter.������

Fed Continues to Tighten as Concerns Over Inflation Mount

Although the Federal Reserve increased rates five times in 2004, intermediate and longer-term interest rates barely budged. There is some evidence that may be changing, with the yield on the benchmark 10-year Treasury note moving through 4.5 percent in March following two additional Fed increases during the first quarter of 2005. Short-term yields are up sharply, however. The average yield on 3-month Treasury bonds stood at 2.8 percent in March 2005, compared with the full-year 2004 average of 1.4 percent.

Because many insurers appear to have shortened the duration of their bond portfolios in order to reduce the interest rate risk inherent in the Fed’s policy shift toward higher rates, the increase in short-term yields will likely boost investment income earnings in 2005. According to an analysis by Credit Suisse First Boston the average effective duration (i.e., including holdings of cash and short-term securities) of the fixed income holdings of leading publicly traded insurers and reinsurers fell from 4.6 years as of December 31, 2001 to 4.1 years by year-end 2004.
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Policyholder Surplus Sets New Record: Terrorism Will Still Come Up Far Short

Policyholder surplus increased by 13.4 percent, or $46.5 billion, to a record $393.5 billion in 2004, compared to $347.0 billion at the end of 2003.

Unfortunately, the role of policyholder surplus (PHS) is generally not well understood by people unfamiliar with ������ý industry, including many policymakers and legislators. PHS is insurance nomenclature for what is referred to as “net worth” or “owners’ equity” in other industries. It is a measure of underwriting capacity because PHS is a measure of the financial resources (capital) that stand behind every policy underwritten by an insurer. A weakened surplus position can lead to downgrades and, if the drop is steep enough, regulatory actions or insolvency.

It is also the case that policyholder surplus is not fungible. In other words, surplus gains that accrue to one segment of the industry or a particular company as the result of improved underwriting and/or investment performance, are generally not available to back-up other types of risk. For example, the very large increase in policyholder surplus among some major auto and homeowners insurers in 2004 had absolutely no impact on the ability of the p/c insurance industry to provide coverage against terrorist attacks. Likewise, surplus accumulated by a workers compensation insurer in Missouri cannot be used to underwrite homes on the San Andreas Fault in California.

Nevertheless, some regulators and industry critics inappropriately cite rising industry- wide capacity and profitability as a rationale for rate rollbacks, thwart proposed rate increases in high-risk zones like coastal Florida or derail ongoing tort reform efforts. Of course foes of reauthorization of the Terrorism Risk Insurance Act (currently set to expire at the end of 2005), or even individuals and government agencies trying to make an honest assessment of industry resources, may misinterpret the significant increase in policyholder surplus since the end of 2002 and wrongly assume that the gain means that insurers are financially able and willing to underwrite full-limit terrorism coverage.

It means no such thing. The industry’s policyholder surplus is, in effect, already committed to the risks being underwritten today. Moreover, because potential losses from a terrorist attack or sequence of attacks are potentially unlimited, no amount of policyholder surplus is sufficient to cover the full range of attack scenarios. Additionally, capital markets appear to have little or no interest in securitizing terrorism risk. Even the federal government, with theoretically unlimited resources, caps its own liability under TRIA at $100 billion. Insurers, with far more limited resources than Washington, and no ability to meaningfully reinsure terrorism risk, will, in many cases, be forced to walk away from the policyholders in the event TRIA is not reauthorized.
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Summary

The financial and underwriting performance of the property/casualty insurance industry during 2004 was the best in years, despite the magnitude of catastrophe losses.

On a catastrophe-adjusted basis, 2004 is likely to represent the zenith in the current cycle in terms of underwriting and profit performance. Combined ratios are likely to rise in 2005 and beyond as the effects of an intensification in price competition through much of the commercial sector and increasingly in private passenger auto begin to trickle down to the bottom line. But price competition in the industry is not yet “destructive” and terms and conditions remain relatively firm.

Ominously, top line growth in 2004 was well below expectations, with real growth in net written premiums likely to turn negative by late 2005. The fact that the industry’s average return on surplus in 2004 was 10.5 percent, despite a combined ratio of just 98.1 is a stark reminder that a renewed commitment to underwriting and pricing discipline are needed if the industry hopes to maintain Fortune 500 rates in 2005.

A detailed industry income statement for 2004 follows:

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(1) The 10 percent figure is an equity-based cost of capital. In other words, there is no accounting for debt. Computing a weighted-average cost of capital would have the effect of lowering the cost of capital because the cost of debt is generally lower than that of equity capital. Hence an individual insurer’s cost of capital is dependent on its capital structure (mix of equity and debt capital). An equity-based cost of capital ignores the presence of mutual insurers. While it is difficult to calculate the cost of capital for a mutual enterprise, the fact that mutual insurers are owned by their policyholders (as opposed to shareholders) suggests that the cost of capital for mutual insurers (all else being equal), is somewhat lower than for stock companies.

(2) The cost of capital is not static. During the mid-1990s estimates for the p/c insurance industry ranged from 11 to 14 percent, with more recent declines attributable primarily to lower interest rates. It is likely that the industry’s cost of capital in 2005 will increase by at least 50 to 100 basis points (0.5 to 1.0 percentage points) as interest rates rise and sector volatility increases in response to ongoing investigations and uncertainty over the nature and compliance costs associated with future regulation.

(3) Full reports available at: /media/industry/additional/2005autooutlook/ and /media/industry/additional/2005homeoutlook/

(4) The full 2005 Groundhog Report is available at: /media/industry/financials/groundhog2005/.