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July 25, 2005

Robert P. Hartwig, Ph.D., CPCU
Senior Vice President & Chief Economist
̽����ѡ Information Institute
212.346.5520
bobh@iii.org

The property/casualty insurance industry reported a statutory rate of return on average surplus of 15.1 percent in the first quarter of 2005 (after adjusting for a special dividend paid by the investment subsidiary of one insurer), up from 10.5 percent during calendar year 2004 (1).�� The results were released by the ̽����ѡ Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI).

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2005: So Far, So Good (All Things Considered)

Given all the fireworks on the legal front during the first quarter of 2005, it may come as some surprise that the financial results for the first three months of the year were quite spectacular in their own right.�� The adjusted first quarter return on average surplus of 15.1 percent was extraordinary and above the 14.5 percent return on equity expected for the Fortune 500 group of companies this year.�� Should insurers maintain similar levels of profitability through the remainder of 2005, the industry would record its best year since 1987, which was the profit peak of the last hard market.�� It should be noted that the industry’s ability to maintain a 15-plus percent return through the remainder of the year is anything but certain.�� Despite what appears to have been an excellent second quarter, insurers are just entering the disaster-prone third quarter (which many weather experts have predicted is likely to be particularly disastrous), while the fourth quarter is traditionally the period during which companies take reserve charges.���� Nevertheless, a good profit showing in 2005 would be consistent with past hard markets, the only period during which the property/casualty insurance industry typically�� records rates of return that exceed the Fortune 500 group.�� While most of the profits in 2005 are associated with the adoption and adherence to sound underwriting principles, insurers appear to have stumbled into an investment windfall that significantly boosted profits, a topic which is taken up in detail later in this report.�� Also discussed in the sections that follow is a continued deceleration in premium growth, underwriting trends that remain generally favorable and a new record high for policyholder surplus (capacity).�� Special discussions of “tiering” and the impact of China’s revaluation of the yuan on the property/casualty insurance industry are included as well.

The first quarter’s better-than-expected financial performance represents the continuation of an historic, multi-year demonstration of underwriting and pricing discipline that earned the respect of investors worldwide. On the other hand, the industry continued to attract international notoriety after allegations of improper accounting centered on the use of finite (re)insurance products as well as the ownership and control of offshore reinsurance facilities mushroomed during the first quarter.�� These accusations come on the heels of allegations of bid rigging leveled by New York Attorney General Eliot Spitzer and others beginning in October 2004. The accusations have led to high-profile resignations, firings, indictments and expensive settlements—not to mention a lot of bad press.�� That being said, only 29 percent of Americans are aware of the investigations into the insurance industry according to a June 2005 survey commissioned by the ̽����ѡ Information Institute, compared to an awareness rate of 80 percent for the Enron/Worldcom scandals and 48 percent for the investigations into the mutual fund industry.

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Premium: Slowdown is Ominous, But Not Quite as Bad as It Seems

As expected, premium growth continued its sequential decline, from 4.7 percent during calendar year 2004 to 2.4 percent during the first quarter of 2005 (and 4.6 percent during the same quarter in 2004).�� This means that premium growth on an inflation-adjusted basis is negative for the first time since 1999 (negative 0.6 percent during the first quarter, to be exact).�� That being said, the deceleration in net written premium growth does not signal a wholesale loss of pricing discipline.�� Indeed, some of the deceleration in premium growth is associated with favorable underlying loss cost trends, most of which are frequency driven, in lines such as private passenger auto, homeowners (apart from the Southeast) and to some extent in workers compensation, especially in states with recent reform initiatives.�� This is in stark contrast to the late 1990s, when prices were falling rapidly despite rapidly rising claim costs and significant adverse reserve development, sowing the seeds for the hard market that began in 2000.�� There is increasing concern (and evidence), however, that the magnitude of price decreases in certain commercial lines, including directors and officers coverage and workers compensation is not fully supported by underlying improvements in claim frequency and severity.�� Overall, the average rate decrease for commercial buyers of insurance was 8 to 10 percent during the first quarter.�� Drivers and homeowners (outside the southeast) typically saw prices that were flat or declined slightly.

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Underwriting: Where Money is Made and Fortunes are Lost

Property/casualty insurers typically lose money on underwriting.�� In fact, 2004 was the first time the industry managed an underwriting profit in 26 years—a slim $5 billion dollars resulting from a combined ratio of 98.1.�� In contrast, the industry accumulated $459 billion in underwriting losses between 1979 and 2003 with an average combined ratio of 108.5.�� The good news from the first quarter is that the industry is on track to turn in another underwriting profit in 2005.�� Indeed, the first quarter combined ratio of 91.9, the best for any quarter since ISO/PCI have tracked figures on a quarterly basis, coupled with what appears to have been a good second quarter, virtually assure another underwriting profit in 2005—just the second since 1978.�� The first quarter combined ratio of 91.9 implies an underwriting profit of $28.6 billion on an annualized basis.�� Though such an underwriting profit would represent a record, its realization is anything but certain, again because of the possibility of significant catastrophe losses and reserve charges during the second half of 2005.�� An additional risk is that sluggish premium growth will begin to negatively impact underwriting results sooner than expected, in late 2005 rather than 2006.

Insurers can only hope to get a little more help from Mother Nature in 2005.�� Record catastrophe losses of $27.5 billion in 2004 seem to suggest that the combined toll from hurricanes, tornados, earthquakes, hail and other “acts of God” should be lower in 2005.�� First quarter catastrophe losses ($2.5 billion in 2005) are not particularly reliable indicators of full-year losses (first half losses totaled only $3.1 billion).�� This is because the plurality of insured disaster losses are associated with tropical cyclones, which reach their statistical peak in terms of frequency and severity during the third quarter.�� Unfortunately tropical activity is expected to be well above average in 2005 with 15 named storms, including 8 hurricanes.�� Ominously through mid-July—two full months before the peak of hurricane season—a record seven storms had already formed.

Underwriting Renaissance?
With all the focus on the potential impact of mega-disasters on the financial performance of the p/c insurance industry, analysts, the media (and occasionally insurers themselves) have failed to pay sufficient attention to the day in, day out underwriting decisions that define the financial health of insurance companies over the long run.�� Fortunately, this is no longer the case, with insurers emerging from the underwriting Dark Ages of the late 1990s chastened and determined to rediscover their raison d’être.

Today insurers find themselves engaged in a technological arms race sparked by the realization that underwriting is where fortunes are made or lost.�� Credit-based insurance scores, perhaps the most important rating criteria to emerge in personal lines underwriting in more than a decade, have been instrumental in helping insurers better match the risk assumed to the price charged.

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Is Tiering the Wave of the Future

More recently, a number of major personal lines insurers have announced the introduction of “tiering.”�� General speaking, tiering refers to the creation of pricing structures (ratings systems) with many hundreds or thousands or even millions of price points, compared to just a few dozen not long ago.�� The large number of price points is made possible by an increased number of rating variables (such as insurance scores) that are available quickly and inexpensively and improvements in computing power.�� Interactions between these variables can also be studied. Together, the combination of more and better information can be analyzed statistically allowing insurers to distinguish increasingly fine gradations of risk.�� The result for individual policyholders is a premium charge that is more closely aligned with the risk assumed by the insurer.�� In aggregate, the effect is a rating system that is more fair and equitable for all policyholders because cross subsidies from individuals who impose the least costs (i.e., file the fewest claims) to those who impose the most are reduced. Tiered pricing also reduces the frequency with which insurers will need to file rate changes.�� This is because improvements in underwriting technology produce a better initial match between price and risk and because thousands of price points are able to accommodate policyholders under a wider variety of circumstances (e.g., the policyholder receives a moving violation, is involved in an accident, moves or adds a teenage driver to the policy).
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Despite favorable underwriting trends in terms of accident frequency (and in some cases severity) in several key lines 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.

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 more than a quarter century will be a short-lived phenomenon.

Investment Performance: Stumbling on an Investment Strategy that Works

��Investment income rose by 20.2 percent after adjusting for special dividends (44.4 percent before adjusting) during the first quarter of 2005 relative to the first quarter of 2004.�� This compares to unremarkable growth of 2.4 percent for all of 2004. Growth in investment income (which consists primarily of interest income generated from the industry’s substantial bond portfolio) had been tepid (or even declined) despite stronger cash flow because of declining interest rates over the past several years. Indeed, the average yield on 10-year Treasury securities during the first quarter was 4.30 percent, not significantly different from calendar years 2003 and 2004, at 4.01 percent and 4.27 percent, respectively, which were the lowest in 40 years.�� Given recent tightening by the Fed and strong economic growth, insurers, like most institutional investors, believed that long-term rates would have headed higher many months ago.�� They didn’t.�� Instead the yield curve simply flattened as short-term yields rose in response to the Fed’s actions while long-term rates stayed flat or declined—a phenomenon Fed Chairman Alan Greenspan famously labeled a “conundrum” in testimony in February.

Nine rate hikes by the Federal Reserve since June 2004 have pushed the federal funds rate up by 2 ¼ points to 3.25 percent from 1.00 percent, forcing money market rates and rates on short-term securities upward.�� Ordinarily, such an increase would have only a marginal impact on insurer investment earnings, but insurers have been accumulating significant assets with very short maturities in a bid to minimize interest rate risk and because the flat yield curves afforded virtually no premium for investing long.�� A special ̽����ѡ Information Institute analysis of the industry’s current investment position estimates that 10 percent of the industry’s invested assets in 2004 were held as cash or short-term securities compared to just 4.1 percent in 1999 (2).���� Portfolio decisions on the long-end of the maturity spectrum mirrored those on the short end.�� The proportion of the industry’s bond portfolio with maturities ranging from 10 to 20 years fell from 21 percent in 1999 to an estimated 15 percent in 2004.

Fed rate hikes during the second quarter are expected to continue through the end of 2005.�� The next Federal Open Market Committee meeting is August 9.�� It is quite likely that the federal funds rate will rise to 4.00 percent by December.

Realized capital gains fell by $1.9 billion during the first quarter of 2005 relative to the first quarter of 2004, in large part because of declining stock prices.�� While the S&P 500 was down 2.6 percent during the first quarter, it was down just 1.7 percent through June 30 and was up by 1.8 through July 22.���� Given the certainty of higher interest rates (at least for short-term yields) through the remainder of 2005 and likelihood that no stock market crash will occur in the final five months of the year, 2005 is shaping up to be the strongest investment year for the industry since the stock market crash of 2000.

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What Does the Chinese Revaluation of the Yuan Mean for Insurers?

On July 21 the Chinese surprised global financial markets by announcing that its currency, the yuan, would be allowed to strengthen against the US dollar by 2.1 percent.�� Furthermore, the Chinese government said that the yuan would no longer be pegged solely to the US dollar, but to a basket of currencies (details of the composition of that basket have yet to be made public).�� While the initial revaluation is small, further moves are expected in the future.�� Economists generally believe the yuan to be overvalued relative to the dollar by 15 to 30 percent.

The yuan’s revaluation has implications for many sectors of the US economy.�� For example, a cheaper dollar means that US goods imported into China cost less while Chinese goods exported to the US cost more.�� Theoretically, therefore, the revaluation should improve the US’s massive trade deficit with China.

For property/casualty insurers and institutional investors generally, the impact is most directly felt through interest rates.�� Because China will now peg its currency against a basket of currencies rather than the US dollar alone, its demand for US Treasury securities will shrink.�� As the demand for US government debt falls (China has been among the biggest buyers in this market in recent years), bond prices will fall and rates will rise.

Relatively few US p/c insurers have major Chinese operations, so the revaluation does not directly affect the operations of most companies.�� However, for those that do operate in China, profits generated in yuan and repatriated into dollars are bolstered by the move.�� On the other hand, investments in China (including the purchase of stakes in Chinese insurers) will now be more expensive because of the dollar’s lower value.�� On the flip side acquisitions of US companies by Chinese companies will become cheaper as the yuan rides higher and higher against the dollar.�� Few, if any, such bids in the financial services sector are likely anytime in the near future, however, because China’s bank and insurance industries need to be transformed through years of significant modernization, reform and privatization before stepping onto the global stage.�� Beyond that, any bid by a Chinese financial institution for a US-based financial institution is likely to encounter significant political flak not unlike that experienced by the Chinese oil company Cnooc in its recent ill-fated bid for Unocal.

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Policyholder Surplus Sets New Record: Issue Becomes Capital Management

Policyholder surplus increased by 2.1 percent, or $8.3 billion, to a record $401.8 billion during the first quarter of 2005, compared to $393.5 billion at the end of 2004.

The dilemma most p/c insurers now face is how to produce reasonable rates of return going forward in the face of rising surplus.�� The “solution” of the 1990s—slashing prices and broadening terms and conditions to gain market share is certainly not a smart option.�� Such short-sighted strategies produce strong top-line growth initially but guarantee disastrous results longer-term as underwriting losses mount.�� Increasingly, insurers appear to be looking to return excess capital to its owners—shareholders in the case of stock companies (through share repurchases or higher dividends) and policyholders in the case of mutual companies (via higher policyholder dividends).�� Another option, of course, is to make acquisitions, though many insurers remain chastened by their experience in this area in the 1990s.�� Expansion into new lines or new territories is also possible, but like any business venture the results from any such expansion are uncertain.

Unfortunately, the role of policyholder surplus (PHS) is generally not well understood by people unfamiliar with the insurance 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 Florida coast.

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 ̽����ѡ 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 the first quarter of 2005 was the best in many years.�� Results through the first six months of the year (at least) are likely to be very good as well.

Combined ratios are likely to rise later in 2005 and certainly in 2006 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 2005 is sluggish and decelerating, with real growth in net written premiums already having turned negative.�� The fact that the industry’s adjusted average return on surplus during the first quarter of 2005 was 15.1 percent, despite a combined ratio of just 91.9 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.
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A detailed industry income statement for the first quarter of 2005 follows:

(1) The unadjusted return on average surplus was 17.4 percent.�� The one-time special dividend added approximately $2.3 billion to net income during the quarter.

(2) The full report “The Investment Environment for Property/Casualty: Insurers Impact of Volatility and Low Yields on P/C Insurer Investment Decisions” is available at:

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