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June 28, 2006

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 10.1 percent for the 12-month period ending March 31, 2006, down 11.2 percent from the 12-month period ending March 31, 2005. The results were released by the ̽����ѡ Services Office, Inc. (ISO) and the Property Casualty Insurers Association of America (PCI). For the first quarter of 2006 alone, however, the estimated return on average surplus was 15.9 percent. Profitability in this range, if maintained, would catapult insurers to their best financial performance in nearly 20 years and put industry margins on par with the Fortune 500 group of companies, which are expected to turn in an average return on equity of about 15 percent in 2006. For calendar year 2005—a year of record catastrophe losses—the property/casualty insurance industry recorded a return on average surplus of 10.5 percent, well below the Fortune 500 group’s return of 14.9 percent. The results, of course, are unlikely to be representative of the full year results because of the expectation for another active and destructive hurricane season.

2006: A Strong Start, But You Can’t Fool Mother Nature

The financial performance of the property/casualty insurance industry during the first quarter of 2006 was extraordinary and provided tangible proof of the resilience of the industry in the face of 2005’s unprecedented adversity. Rocked by record catastrophe losses of $61.2 billion arising from more than 3.3 million claims in 2005, the industry bounced back with a combined ratio of just 91.2 during the opening quarter of 2006, the best result since ISO began recording quarterly figures in 1986. This means that for every dollar of premium income that insurers earned during the first quarter of 2006, about $0.91 exited in the form of claims payments, claims reserves and expenses. The remaining 9 cents is an underwriting profit—an exceedingly rare occurrence in the property/casualty insurance industry. In fact, the industry recorded just two full-year underwriting profits over the past 28 years (1978 and 2004). This suggests that something usually happens during the year that puts a combined ratio out of reach. In 2005, for example, the industry was on track for a record underwriting profit after turning in an impressive combined ratio of 92.2 for the first quarter, but wound-up finishing the year with a combined ratio of 100.9 and a multi-billion dollar underwriting loss. Mother Nature was to blame, of course, and her fury—at least in terms of hurricanes—doesn’t reach its peak until the third quarter.

Insurers face several significant challenges in 2006 beyond the possibility of above-average catastrophe losses, including:

• A virtual across-the-board softening in the personal and commercial lines pricing environment, with the exception of hurricane exposed property exposures and property catastrophe reinsurance.
• A slowing economy that will reduce exposure growth in the home, auto, commercial property and workers compensation lines—which collectively account for more than 70 percent of all premiums written.
• A very slow growth environment that pushes some insurers into price-based battles for market-share or increased pressure on CEOs to make potentially ill-fated acquisitions.
• A rapid accumulation of excess capital leading to depressed ROEs and potentially poor capital allocation and pricing decisions.
• Margin compression in catastrophe-prone areas as regulators refuse to allow insurers to fully recoup higher reinsurance costs.
• A possible end to Fed rate hikes that have been lifting investment returns, and sideways movements in stock markets.
• Rising inflation that threatens to increase claim severity in key lines such as workers compensation and auto insurance and, longer run, could aggravate reserve adequacy in longer-tail casualty lines and cause more burn through into reinsurance layers.

In short, it is highly unlikely that property/casualty insurers will be able to maintain a combined ratio in the low 90s throughout 2006 because catastrophe losses in most years tend to fall most heavily in the second half of the year. Additionally, insurers face mounting competitive pressure which is taking the form of falling prices across a broad spectrum of commercial and personal lines coverages, a slowing economy and regulatory rate suppression.

In the final analysis, insurers will need to find ways to generate adequate rates of return not only to compensate investors for the risk they assume and preserve their claims-paying capital, but also to maintain their financial strength and credit ratings and to avoid regulatory sanctions. A financially weak insurance industry is of no use to anyone, including policyholders, millions of whom depend on the industry to pay hundreds of billions of dollars in claims each year.

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Slowdown Ahead

Several factors are currently conspiring to bring property/casualty insurance industry growth—which came in at just 1.9 percent during the first quarter—to a virtual standstill. First and foremost is continued price erosion in most lines and geographic areas not subject to hurricane risk. On the personal lines side, the ̽����ѡ Information Institute predicts that the average expenditure on auto insurance in 2006 will increase by just $4—little more than a single gallon of gasoline—to $867 from $863 in 2005 (1).���� The increase is the smallest in six years. Many drivers with good records will actually see decreases, some for the second year in a row. At the same time, homeowners in areas not significantly affected by hurricanes should expect the average cost of homeowners insurance to increase by $28, or 4 percent—roughly the rate of inflation.

Commercial lines rate changes, with the exception of wind-exposed commercial property insurance, are almost universally negative—down to 2.7 percent, on average, during the first quarter of 2006. Prior to Hurricane Katrina, commercial programs were renewing down by nearly 10 percent, on average.

Exposure growth is fast become a determining factor in the insurance industry’s growth potential. Rising mortgage interest rates are eating into new home construction, a prime source of exposure growth for personal lines insurers. New home starts are expected to decline by 18 percent between 2005 and 2009, according to Blue Chip Economic Indicators. Similarly, rising interest rates will dent new car sales, as will rising gas prices. Higher prices at the pump also mean that more drivers will dump their expensive gas-guzzling SUVs in favor of fuel-sipping cars, including hybrids, which are generally less expensive to insure.

Moratoria on new policies in catastrophe-prone states and the non-renewal of many policies in these areas—many of which (like Florida) are among the fastest growing in the United States—will also have a deleterious effect on growth (though potentially a salutary impact on losses).

Slowing growth will make some insurance industry investors anxious for growth. To that end, some insurers could be tempted to slash prices in a bid to rapidly increase market share—a strategy that almost universally leads to a deterioration in results. Alternatively, some insurers could be lured into undertaking a merger and acquisition strategy. While M&As are potentially rewarding, relatively few actually return value to shareholders, often due to problems in execution.

Capital Accumulation Conundrum

Policyholder surplus, the most comprehensive but often misunderstood method for measuring insurance industry claims paying capacity, increased by $13 billion or 3 percent to $440.1 as of March 31, according to ISO and PCI, from its year-end 2005 level of $427.1 billion. The increase in the first quarter of 2006 comes after a gain of more than nine percent or $36 billion in 2005. Increasing industry claims paying capacity is critical in the current era of mega-catastrophes. At the same time, it is important to recognize that the owners of capital (shareholders in a stock insurer or policyholders in a mutual) must earn a fair rate of return for the risk they assume. Equally important is the fact that only a fraction of the industry’s $440.1 billion in surplus is available to pay claims from any given disaster. Much, if not most, of the capital will belong to companies that do not operate in the affected areas or is needed elsewhere to support insurance lines or states unaffected by the event. Surplus belonging to a Midwest auto insurer, for example, is not available to pay hurricane losses in the Southeast. Nor is the capital that backs the operation of homeowners insurers in the hurricane belt available to pay losses arising from a terrorist attack, should one occur.

Property/casualty insurance industry surplus has risen by 47 percent since its 2002 slump. The initial phases of that growth helped to restore capital consumed by the September 11 terrorist attacks and the stock market crash of 2000 through 2002, while offsetting huge charge-offs for adverse reserve developments. More recently, however, accumulation of surplus poses something of a conundrum for insurers. On the one hand, the increase in capital is helpful in that it better insulates insurers against the financial shock of large scale catastrophes. Regulators and ratings agencies view such solid claims paying capacity favorably. On the other hand, carrying capital on the books is expensive because the owners of that capital must be compensated. If the insurer cannot find uses for the capital capable of earning the insurer’s cost of capital (the rate of return necessary to retain or attract capital) then the capital should theoretically be returned to its owners. Returning capital to owners in a stock company implies paying stock dividends and/or buying back shares. In a mutual company, capital can be returned to policyholders/owners in the form of a policyholder dividend.

While some insurers have implemented share-buyback programs, it is likely that the accumulation of surplus, if it continues, will have a dampening affect on profitability in the quarters ahead.

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Rate Suppression:�� An Obstacle to Capital Attraction

By July 2006 Florida’s Citizens Property ̽����ѡ Corporation, the market of last resort, will become the state’s largest insurer of homes and condominiums. This need not have happened.�� Recent growth in Citizen’s policy count and the residential residual markets in other states are derived from several sources, including limits and moratoria on new policies written by some private insurers, along with non-renewals. Moreover, construction of nearly 1,500 new homes is being permitted in coastal communities across the country, fueling building booms in some of its most vulnerable areas. The fact of the matter is that Florida and other states have failed the test when it comes to creating a business environment that is attractive to insurers who are being asked to assume extraordinary amounts of risk in the country’s most disaster-prone areas. The ̽����ѡ Information Institute has estimated that in 2005 Florida needed nearly $500 million in net new insurance capital just to keep pace with demographic growth. Instead, capital has exited the state in the wake of the devastating 2004 and 2005 storm seasons. Florida’s proximate problem, of course, is its susceptibility to hurricanes. But that is a function of its geography. The state’s insurance problems are almost entirely of its own making. The most serious of these reflect the state’s staunch opposition to allowing insurers to charge market-based prices for the risk they assume. Similar problems exist in most states exposed to hurricane risk.

Insurers operating in the hurricane belt face reinsurance costs that are up 100 percent or more in 2006. Insurers need to recoup these costs and charge an appropriate premium for the capital they themselves put at risk. Regulators have in many cases and for many years turned a blind eye to this need, choosing instead to keep rates artificially low. Price controls are always unattractive to owners of capital. The system of artificial price controls on homeowners insurance policies in Florida and other states is largely responsible for the current availability problems and recent rapid growth in markets of last resort. Though prices may be higher, a system of risk-based market-determined prices would go a long way toward solving hurricane-related homeowners insurance headaches for coastal states.

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Summary

The financial and underwriting performance of the property/casualty insurance industry during 2006 is expected to be strong, assuming “normal” catastrophe activity. Insurers, however, face a variety of challenges unrelated to catastrophe losses, including increasing price pressures that could erode underwriting performance and profitability in the quarters ahead.

One cause for concern is the fact that top line growth in the first quarter of 2006 was less than two percent and is, in fact, negative on an inflation-adjusted basis. Record catastrophe losses in 2004 and 2005 and the outlook for more of the same in the years ahead are leading to significant price impacts on residential, commercial property and property catastrophe reinsurance prices. The aftermath of this year’s hurricanes will push net written premium growth upward, but the effects will be focused on the Southeast and Gulf coast areas.

A detailed industry income statement for the first quarter of 2006 follows:

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(1) The full report can be accessed at /media/industry/additional/2006autooutlook/ .