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

The property/casualty insurance industry reported a statutory rate of return of 6.3 percent for the year 2000, down slightly from 1999’s return of 6.6 percent.�� The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

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It was the Best of Times, It was the Worst of Times

Financial results for the year 2000 continue to indicate that the financial performance of the property/casualty insurance industry is gradually improving, albeit slowly.�� Strong growth in net written premiums and investment income (both up 5.1 percent) as well as realized capital gains (up 30.1 percent) are at the core of the industry’s much anticipated recovery.�� The $14.9 billion (4.5 percent) decrease in surplus means that the industry has purged itself of a significant amount of excess capacity—10 percent to 12 percent—of the $100 billion to $125 billion in excess capital.�� At the same time, underwriting losses soared 45.1 percent as years worth of chronically underpriced business continued to assault the industry’s balance sheet.�� In 2001, hard market forces will continue to clash with the residual effects of a soft market that began more than a decade ago.�� As the industry gradually recovers from its soft market hangover, insurers will likely begin (and in many cases continue) to experience improved earnings, assuming normal levels of catastrophe losses.

On Wall Street, investors fleeing tech stocks and hoping to get in on the ground floor of a hard market, scooped up insurer stocks with a vengeance last year, and sharply bid-up the stock price of most property/casualty insurers in spite of generally bear market conditions.�� Property/casualty insurers as a group rose 43.4 percent, last compared to declines of 9.1 percent and 39.3 percent in the S&P 500 and Nasdaq, respectively.

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Premium Growth

The 5.1 percent increase in net written premium is the result of both strong economic growth for most of last year and greater pricing discipline on the part of insurers.�� More risk appropriate pricing in catastrophe-prone areas is also a factor.�� Moreover, applications to residual market facilities (markets of last resort) in both auto insurance and workers compensation began to increase in earnest last year after years of shrinkage.�� Rates in these facilities are often much higher than in the voluntary market and so are becoming an increasingly important factor underlying accelerating premium growth in many states.

<i>Pricing</i>

Pricing remains the single most important factor in the industry’s current turnaround.�� Conning & Company and several major investment banks report that renewals for the commercial segment during the latter half of last year were up across the board for the first time in years.�� Conning reported that fall 2000 commercial rates were up more than eight percent compared to a decline of seven percent during the fall of 1998.�� Workers compensation, the largest of the commercial lines and the line in the greatest need of relief, is leading the way with increases averaging 9.5 percent, followed closely by commercial auto at nine percent.�� Combined ratios in both lines exceeded 115 in 1999 and probably more than that in 2000. The commercial multiperil and general liability lines are also benefiting from the significantly improved pricing environment.�� Pricing in the commercial property, umbrella, and excess and surplus lines is also recovering.�� Increases of six to nearly nine percent are now the norm.�� Surveys by leading investment banks and other groups corroborate the Conning figures.�� The trend appears to have continued through the first quarter of 2001.�� More than 93 percent of Fortune 1000 risk managers surveyed by Prudential Securities earlier this year indicated that the price of insurance they buy had gone up.[1]

On the personal lines side, the price war in the personal auto line shows some signs of abating.�� The Insurance Information Institute estimates that personal auto rates in 2000 rose an estimated 1.5 percent, the first increase in three years.�� Additional increases of three to six percent are likely in 2001.�� Rates fell 2.8 percent in 1998 and 3.2 percent in 2000 due, in part, to improving fundamentals but also to intense competition between insurers.�� Conning estimates that fall 2000 renewals for personal auto were up five percent while homeowners premiums rose three percent.

Price cutting in the personal auto line during the first half of last year and on policies issued in 1999 but expiring in 2000 led to huge underwriting losses at many companies and was a significant factor in the $8.9 billion (45.1 percent) increase in the industry’s net underwriting losses. The full text of the Insurance Information Institute’s most recent outlook for auto rates is available at /media/hottopics/hot/autoratesrise/ .�� Higher medical costs, rising jury awards and higher motor vehicle repair costs are also significant factors driving auto insurance costs upward.[2]

Rampant fraud and abuse and excessive attorney involvement in claims contributed to higher underwriting losses in several no-fault states, especially New York and Florida, in which PIP claims costs rose 32 percent and 15 percent respectively.���� Insurers, in cooperation with law enforcement agencies and the National Insurance Crime Bureau, are battling this problem and working toward legislative solutions.

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Outlook for 2001: The Best in Years

The year ahead is pivotal for property/casualty insurers.�� Recovery means maintaining pricing discipline, a task that could become somewhat more difficult in the face of a slowing economy.�� Nevertheless, this year’s clear signs of recovery bode well for 2001 and were confirmed in a recent I.I.I. survey of Wall Street analysts.�� Indeed the forecasts for 2001—for the first time in many years—show an industry with significantly improved growth prospects and a slight improvement in underwriting performance.

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Premiums

The consensus forecast for 2001 calls for an increase in net written premiums of 7.4 percent compared to 5.1 percent last year.�� If realized, the industry will grow at its fastest pace in nearly 15 years.�� As mentioned previously, industry premiums grew by just 1.8 percent and 1.9 percent in 1998 and 1999, respectively, the smallest increases in post-World War II history.

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Combined Ratio

The combined ratio for 2001 is projected to be 109.1, down from 110.5 last year.�� If realized, the industry will see its first decline in the combined ratio since 1997. The improvement is again attributable to a rebound in pricing in key lines, but successful management of expense ratios and moderating catastrophe

losses are also playing a role.�� According to ISO’s PCS unit, insured catastrophe losses last year fell by nearly 50 percent to $4.3 billion from

$8.3 billion in 1999.�� The combined ratio projections for 2001 assume normal levels of catastrophe activity.

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Economic Activity and Exposure Growth

Economic growth in the United States slowed considerably during the second half of 2000.�� Nevertheless, the economy expanded by 5.0 percent last year as measured by growth in real (inflation-adjusted) gross domestic product (GDP).�� Growth during the first quarter of 2001 is estimated to be just under one percent on an annualized basis—sluggish but enough to avert a recession.

The impact of the economy on the property/casualty insurance industry’s fortunes cannot be underestimated.�� Exposure growth and investment performance are both sensitive to changes in the economic environment.�� Fortunately, sales of new homes and cars—staples of the personal lines insurance business—remain robust, thanks in large part to low interest rates.�� Likewise, the unemployment rate stood at just 4.0 percent last year despite a mounting number of layoff announcements.�� This is good news for workers compensation insurers who use payrolls as their exposure base.�� Though the unemployment rate had inched up to 4.3 percent by March 2001, it remains very low by recent historical standards.

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Investment Income

The 5.1 percent increase in investment income is one of last year’s most significant developments.�� Investments had dropped in the two previous years, by 2.7 percent in 1999 and 3.8 percent in 1998.

The Federal Reserve’s shift toward an anti-inflationary bias in 1999 led to several rate hikes during the second half of 1999 and the first half of 2000.�� During the first three months of 2001, however, the Fed lowered short-term interest rates by a total of 150 basis points (1.5 percentage points) in three separate rate-cutting actions.

In 2000, insurers continued their adjustment to a world in which Treasury securities become less important in their portfolios.�� Federal surpluses for the past several years mean that the federal government has less need to borrow.�� Because these surpluses are expected to continue for years to come,�� Washington’s borrowing needs continue to shrink.�� Insurers have historically been among the largest institutional buyers of Treasury securities, which are prized by investors because they are the closest thing to a “risk-free” investment available anywhere in the world. As of year-end 1999, nearly 12

percent or $95 billion of the property/casualty insurance industry’s invested assets were Treasury securities.

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The View from Wall Street: Back from the Brink

Wall Street was unkind to the property/casualty insurance industry in 1999. On a market cap weighted-basis, industry stocks lost 25.7 percent of their value, compared to a gain of 21.0 percent for the Standard & Poor’s 500 index.�� Life insurers as a group declined 9.6 percent.

The tables began to turn last year after the tech stock bubble was pricked and the Nasdaq began its precipitous slide. Prior to their comeback last year, the prices of many insurer stocks were at their lowest levels in years.��

The table below illustrates the dramatic change in insurer share prices last year compared to 1999, though some of those gains have since been lost in the generally turbulent market conditions that prevailed during the first quarter of this year.

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Surplus & Capacity

As noted in the ISO/NAII release, surplus fell $14.9 billion to $319.4 billion. The decline represents just 4.5 percent of industry surplus and does not represent a threat to insurer solvency.�� Moreover, analysts have estimated the industry’s “excess” capital at $100 billion to $125 billion (based on a premium-to-surplus ratio of 1.2 to 1).�� If insurers are able to grow net income while at the same time reducing surplus, returns on equity will rebound quickly.�� Some insurers are also working to reduce excess capacity through stock buybacks and large dividend payouts, both of which reduce capacity by reducing surplus.

A detailed industry income statement for the full-year 2000 follows:

[1] Annual renewals; Excludes multi-year programs.

[2] In early April of this year, the Illinois Appellate Court upheld a lower court decision against a major auto insurer regarding the use of generic crash parts for repairs. The decision is likely to result in permanently higher vehicle repair costs and higher premiums for policyholders.

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