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

June 26, 2002

The property/casualty insurance industry reported a statutory rate of return of 6.9 percent during the first quarter of 2002, down from 7.4 percent during the first quarter of 2001.�� The result is nevertheless a significant improvement over the worst-ever negative 2.7 percent rate of return recorded for all of 2001.�� The results were released by the ̽����ѡ Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

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2002: The ‘Perfect Storm’ Loses a Bit of its Punch—But Still No Safe Harbor

Most of the key forces that came together to form the ‘perfect storm’ of 2001 continued to rage through the first quarter of 2002, but several lost a bit of their punch.�� Last year’s perfect storm produced a tsunami of misfortune for insurers: recession, underpricing, catastrophe losses, medical cost inflation, Enron, abuse of the legal system and, of course, the September 11 terrorist attack.�� Yet recession gave way to growth, pricing firmed, and catastrophes during the first quarter were light.�� At the same time, however, medical cost inflation remained unrestrained, the Enron debacle degenerated into a full-fledged crisis in corporate governance, trial lawyers continued to run amok and the prospect of a future terrorist attack became all but certain.�� The role that each played in the context of the first quarter 2002 financial results is described below.

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Recession: Giving Way to Modest Economic Growth

In 2001 the longest economic expansion in United States history came to an abrupt end.�� While the Federal Reserve’s aggressive bid to avert recession through a sequence of 11 rate cuts was unsuccessful, the severity and length of the recession were clearly lessened, providing a springboard for the economy to bounce back from the trauma of September 11.�� The U.S. economy expanded by a healthy 5.6 percent during the first quarter of 2002, though growth for the remainder of the year is likely to be more tepid.

Impact on Insurers
Because the current recovery in the economy has not been accompanied by a recovery in corporate profits and capital investment, both the investment environment and commercial exposure growth remain weak.�� This factor contributed heavily to the industry’s 88.8 percent drop in realized capital gains during the first quarter.�� At the same time, historically low interest rates continue to take their toll on investment income, which fell 5.5 percent.�� On an annualized basis, investment income is estimated at $35.8 billion, down $1.3 billion from $37.1 billion in 2001.

Sustained weakness in the corporate sector means businesses continue to cut back drastically on investment and payrolls, pushing the unemployment rate to 5.6 percent during the first quarter compared to 4.8 percent for 2001.�� The unemployment rate as of May 2002 stood at 5.8 percent.�� Exposure growth in commercial property lines and workers compensation has suffered as a result. On the upside, the weak dollar has made U.S. exports more affordable, a development that will likely help the ocean and inland marine insurance markets.

Personal lines insurers continue to benefit from the current low-interest rate environment because new home construction and sales of new cars continue at a near-record pace.

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Chronic Underpricing: Now Merely Underpriced

The cost of managing risk for U.S. corporations plummeted by 42 percent between 1992 and 2000, but rose by an estimated 15 percent last year with a further increase of 30 percent expected this year.�� The long overdue return to risk-sensitive pricing accounts for most of the 10.3 percent increase in net written premiums during the first quarter, but it is not sufficient to drive down combined ratios to the 95 percent to 97 percent level most insurers require to achieve reasonable rates of return (e.g., 12 percent).�� Moreover, stronger top line growth is needed to bolster sagging investment income and to meet burgeoning reserve obligations.

Commercial lines insurers will continue to realize premium growth three to four times that of their personal lines counterparts.�� The two-year old hard market in commercial lines is generating 30 percent increases at renewal on average for the typical risk.�� In contrast, the “hard” market in auto and homeowners insurance is only now getting underway, with increases in the 8 percent to 10 percent range (though drivers in homeowners in some states will see substantially higher increases).�� More information on the 2002/2003 outlook for the auto and homeowners insurance markets is available at /media/hottopics/hot/20022003outlook

Impact on Insurers
The industry’s statutory underwriting losses shrunk by $2.3 billion or 38 percent to $3.8 billion during the first quarter compared to the same quarter last year, in large part due to the improved pricing environment and implementation of tighter underwriting standards in recent months.�� On an annualized basis, underwriting losses totaled $15.1 billion.�� If sustained, 2002’s underwriting loss would be the lowest since 1997.

Insurers are still coming to terms with the pricing sins of the past and the cost drivers of the future, as the industry’s stubbornly-high underwriting losses continue to reveal.�� Restoring rate adequacy (which includes a reasonable profit provision) and underwriting discipline is a process that will take years.�� For this reason, significant underwriting losses can be expected for many insurers through 2002.�� As a result, there is every reason to believe that the current hard market will remain intact through 2003.

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Catastrophes: So Far, So Good

The first quarter catastrophe losses were a trifling $615 million in comparison to the record losses of 2001.�� Although wildfires were raging throughout the West late in the second quarter and have captured the national media’s interest, insured losses from wildfires tend to be comparatively small, accounting for less than 3 percent of catastrophe losses between 1981 and 2000 according to ISO, in contrast to 32 percent for tropical cyclones and 34 percent for tornadoes.

Hurricane season has just begun and with no hurricanes making landfall since 1999, the United States is statistically “overdue” for a strike.�� 2002 is also the tenth anniversary of Hurricane Andrew, still the largest natural disaster in world history in terms of insured losses.�� In conjunction with this event, the ̽����ѡ Information Institute has prepared a detailed study and a companion PowerPoint presentation that survey the economic and insurance consequences of a major hurricane strike in Florida today, what lessons have been learned in the past decade, and the impact of mitigation efforts undertaken in the state.�� These may be downloaded at: /media/hottopics/hot/hurricane.

Most importantly, there were no acts of domestic terrorism, large or small, through the first half of 2002—despite direct warnings from the government that fresh attacks were virtually imminent.

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Medical Cost Inflation

The cost of providing medical care is a key cost driver in many lines of insurance, including auto, workers compensation, medical malpractice and numerous commercial liability lines.�� The cost of reinsurance and various excess and surplus lines markets is likewise affected.

After peaking at 9.0 percent in 1990, medical cost inflation fell until reaching just 2.8 percent in 1997.�� By 2001, the cost of providing health care rose 4.6 percent, according to the U.S. Bureau of Labor Statistics.�� The cost of employer-sponsored health care plans is rising by 15-20 percent.�� Clearly the cost of delivering health care through insurance schemes has diverged considerably from the official federal estimates, which merely compare the change in price of a fixed “basket” of goods and services through time.�� In reality, consumers of health care—whether through an employer-sponsored health care plan or through the workers compensation system—are becoming more sophisticated and more demanding.�� According to the National Council on Compensation ̽����ѡ, medical claim cost severity accelerated to 11 percent last year, more than twice the 4.9 percent rate of increase recorded in 1999.

Federal statistics also do not capture the full impact of the legal system on the cost of providing health care.�� In several states, the medical malpractice market has essentially collapsed, in large part due to excessive litigiousness.�� The average jury award in medical malpractice cases more than tripled from $1.1 million in 1994 to $3.5 million in 2000, according to Jury Verdict Research.�� Likewise, the average jury award in a vehicular liability case rose from $187,000 to $269,000 over the same period.

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The Crisis in Corporate Governance

The $60 billion bankruptcy of Enron last December was the opening act in what has since become one of the greatest and most serious tragedies in the financial history of the United States.�� What began as an ethically-challenged relationship between a corrupt energy trader and its shredder-happy auditor has mushroomed into a crisis that has engulfed the entire market for U.S. equities.�� Insurers are exposed to the fallout from the crisis in corporate governance in several ways.�� Property/casualty companies have a mixture of investment risk and insurance risk arising from directors and officers programs sold on the besieged companies as well as exposure from surety, entity and fiduciary liability covers.��

Impact on Insurers
Millions of investors have lost trillions of dollars in the current equity market swoon and through bond defaults.�� As large institutional investors, insurers have shared in these losses.�� Directors and officers coverage is the principle insurance exposure associated with the crisis in corporate governance, though the extent of the exposure is unclear given that allegations of criminal wrongdoing and misrepresentation on the part of insureds could void coverage in some cases.

In 2001, trial lawyers declared open season on corporations with complex organizational structures.�� Last year, the number of shareholder federal class action lawsuits surged to a record 487—a 125 percent increase over 2001.�� Through the first six months of 2002, a large number of high-profile lapses in corporate governance have come to light, sparking additional litigation and putting additional pressure on D&O and errors and omissions markets.

Revelations concerning Enron, dozens of other companies and their auditors has also spawned a crisis of confidence among investors regarding the quality of financial reporting.�� The crisis is contributing to the current poor performance of equity markets despite the recovering economy.�� According to a recent Wall Street Journal survey, one-third of investors no longer trust the quarterly numbers released by big Blue Chip companies.

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Abuse of the Legal System

Though a perennial issue with insurers, abuse of the nation’s legal system produced very tangible impacts on insurer operations in 2001.�� The average jury award reached $1.2 million in 2000 (the latest year for which data are available), up 179 percent from $419,000 in 1994.

Impact on Insurers
The extraordinary surge in new asbestos cases is perhaps the most spectacular and best-known example of tort system abuse.�� Despite having paid or reserved nearly $32 billion in asbestos claims, new analyses revealed that insurers’ ultimate liability could reach a staggering $65 billion.��

The collapse of medical malpractice markets around the United States provide another vivid example of how abuse of the tort system is forcing insurers to change their operating practices.�� With few prospects for a turnaround—out-of-control jury awards forced several of the country’s leading writers of medical malpractice coverage to withdraw from the market entirely.

Abuse of the legal system can also be seen in the growth of novel types of claims, such as those alleging bodily injury and property damage from “toxic mold.”�� Such claims very often wind up in litigation.�� In the Texas homeowners insurance market, for example, mold claim costs per policyholder rose by an inexplicable 1,805 percent between early 2000 and late 2001.�� Insurers have had to adopt much more stringent underwriting standards, including moratoria on new policies, in the wake of the surge in mold suits and several multimillion dollar judgments.

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Terrorism

The ̽����ѡ Information Institute currently estimates insured losses stemming from the September 11 terrorist attack at $40.2 billion (across all types of insurance).�� ISO estimates that U.S. property/casualty insurers face an estimated $25 billion in net underwriting losses from the attack.�� Because only about $10 billion of that amount appears to have been reported in the 2001 results, it is likely that September 11 charges will affect the balance sheet of insurers for years to come. [Note: A detailed PowerPoint presentation on the September 11 attack is available at�� /media/hottopics/insurance/sept11 ].

Impact on Insurers
The effects of the September 11 terror attack will extend well into the future.�� The event forced a top-to-bottom reevaluation of the underwriting and pricing risk associated with insuring against the peril of terrorism—a coverage that had been thrown in for free before the attack.�� Even lines not normally thought to be catastrophe prone, such as workers compensation, are being reevaluated.

The United States Senate recently passed a bill that would establish the federal government as the reinsurer of last resort in the event of future attacks.�� However, it is very different from the bill that emerged from the House of Representatives last November and must survive a conference committee debate before any bill can be sent to the President, possibly this fall.

Time is critical, however, as most commercial policies continue to be renewed with terror exclusions.�� The longer the interval until the next attack, the more exposed U.S. businesses are to uninsured losses arising from a future terrorist attack.�� According to a recent Prudential Securities survey, 50 percent of commercial insurance buyers have no terror coverage while 26 percent have limited coverage.�� The survey also found that six percent of risks had stand-alone terror coverage and just 18 percent had full coverage against terrorist acts.�� The fact that trillions of dollars of exposure have been pushed back to business owners seems to finally be attracting the attention of commercial creditors, who are beginning to require mortgage holders to purchase terror coverage under the threat of declaring the mortgage to be in default.

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Capacity: Edging Upward

The $5.4 billion increase in surplus from $289.6 billion as of December 31, 2001, to $295.1 billion in the first quarter represents a small increase of $1.9 billion.�� As noted in the ISO/NAII release, most of the increase was due to $5.1 billion in net income generated during the quarter.�� Very little of it due to new capital being raised in the industry (much of which is flowing to offshore entities).�� Surplus is down 13 percent since peaking at $339.3 billion in June 1999 and remains at less than what it was at year-end 1997.

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Stock Prices: Holding Steady

Through June 21, property/casualty insurance stocks were almost unchanged for the year, up 0.12 percent.�� Although the year-to-date return on p/c stocks is tiny, it compares very favorably with the 13.8 decline in the S&P 500 over the same period.��

A detailed industry income statement for the first quarter of 2002 follows:

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