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

June 25, 2001

The property/casualty insurance industry reported a statutory rate of return of 7.4 percent for the first quarter of 2001, up from 7.1 percent for the same quarter last year and substantially above the 6.3 percent return for the year 2000.�� The results were released by the ���ϲ����� Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

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Turning the Corner—Slowly

Financial results for the first quarter of 2001 continue to indicate that the financial performance of the property/casualty insurance industry is gradually improving at a modest pace in spite of a general economic slowdown and poor financial market performance.�� Strong growth in net written premiums—up 10.4 percent—and indications of improving underwriting performance are at the core of the industry’s multi-year recovery.�� The $15 billion decrease in surplus during the quarter to $303.7 billion and $35.6 billion decrease since peaking at $339.3 billion in June 1999 means that the industry has purged itself of a significant amount of excess capacity—28 percent to 36 percent—of the $100 billion to $125 billion in excess capital it holds.�� At the same time, net underwriting losses, which soared 41.1 percent in 2000 as years worth of chronically underpriced business assaulted the industry’s balance sheet, rose by a very modest 2.4 percent during the first quarter of this year.

Through the remainder of 2001, hard market forces will continue to clash with the residual effects of a soft market that began in the late 1980s.�� As the industry gradually recovers from its soft market hangover, insurers will continue�� (or at least begin) to experience improved earnings, assuming normal levels of catastrophe losses.�� The recovery is well underway in most major commercial lines of insurance, including reinsurance, while momentum is just now building in the personal lines.
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On Wall Street, investors took profits on many insurance stocks during the first half of 2001.�� Nevertheless, property/casualty insurer stocks continue to outperform most major market indices.�� Property/casualty insurers are down just 3.1 percent as a group so far this year (through June 22) compared to declines of 7.2 percent and 17.6 percent in the S&P 500 and Nasdaq, respectively.

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Premium Growth

The 10.4 percent increase in net written premium, as noted by the ISO/NAII release, is the best since the second quarter of 1987—the tail end of the industry’s last hard market.�� It is also far in excess of the 7.4 percent forecasted by Wall Street analysts in the ���ϲ����� Information Institute’s annual Groundhog Survey released earlier this year.

The acceleration in premium growth during the first quarter is almost entirely due to greater pricing discipline on the part of insurers and surprising strength in certain key segments of the economy—auto sales, new home and commercial construction as well as resilience in U.S. labor markets.�� 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 are increasing 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.

Pricing—Commercial Lines: Not Business as Usual
Pricing remains the single most important factor in the industry’s current turnaround.�� Spring 2001 renewals in most commercial lines (including reinsurance) appear to be in the 10 to 12 percent range, compared with 8 to 10 percent in Fall 2000, according to several major rate surveys.�� Workers compensation—the line in need of the most relief—is leading the way, as evidenced by last year’s $3.3 billion or 14.9 percent increase in net written premiums, which ended six consecutive years of decline.�� Numerous commercial liability lines are also realizing significant gains, as out-of-control jury awards create spot shortages of coverage in many jurisdictions, leading to substantial increases in price.�� The average jury award in several major categories of liability insurance now exceeds $1 million, nearly double what it was in 1993.�� Most affected by these trends are medical malpractice, long-term care facility liability coverages (e.g., nursing homes), errors and omissions coverages for accountancy firms, and construction defects covers.�� Renewals in these areas between 30 and 100 percent or more are not unusual.�� Some carriers are willing to offer coverage only through their excess and surplus lines subsidiaries, a move that has rankled state regulators.

Pricing—Personal Auto: Shifting Out of Neutral
Personal lines insurers are only now responding in earnest for the need to raise rates significantly.�� Auto rates nationally rose just 1.5 percent last year.�� This year, however, the average increase should be in the 3 to 6 percent range.�� While an improvement over the previous year, increases of this magnitude barely keep pace with underlying cost drivers such as rising medical and vehicle repair costs.�� The personal auto line is now the single largest drag on earnings for property/casualty insurers.�� The same financial pressure that forced commercial lines insurers last year to embark on a multi-year phase-in of price hikes, larger retentions and more restrictive terms of coverage, will push the cost of auto insurance up at an accelerated pace for at least the next two years.�� The effort is likely to be ugly in some jurisdictions.�� The recent decision by several major insurers to withdraw or reduce their exposure to the dysfunctional New Jersey personal auto market, for example, could leave the owners of as many 20 percent of the state’s 4.8 million vehicles in search of coverage.�� While some cherry-picking will occur, the remaining New Jersey insurers simply do not have the capacity to absorb a million new policyholders.�� The announced withdrawals combined with the fact that several major auto insurers that write in virtually all other states but refuse to do so in New Jersey implies that capacity is 30 percent to 40 percent below what could be expected in a healthy market.

Pricing—Homeowners: Winds of Change
Homeowners insurance is also under tremendous pressure in a large number of states.�� Many insurers have traditionally viewed homeowners insurance as a loss leader, offering the coverage at a discount and bundling it with auto and other coverages to achieve overall profitability at the individual customer level.�� The industry combined ratio for this line over the period from 1990 through 2000 was 115.1, far above the line’s economic breakeven combined ratio of 103, and a clear indication that bundling is a strategy that is marginally successful at best for some insurers, and wholly unsuccessful for most.��

The days of the loss leader homeowners policy are probably coming to an end for several reasons.�� First, the widespread recognition after Hurricane Andrew in 1992 that policies sold in catastrophe-prone areas were grossly underpriced led to a significant rationalization of prices in these areas.�� Most policies sold in such areas now “carry their own weight.”�� Second, insurers can no longer rely on “bundling” as a strategy to achieve overall profitability.�� Bundling is less successful than in the past because aggressive direct writers of auto insurance have successfully attracted millions of customers, leaving the “bundling” insurer with millions of orphaned and unprofitable dwelling policies. Finally, the homeowners line is under assault from the trial bar.�� A recent $32 million verdict in Texas related to mold damage underscores the fact that courts and juries appear willing to broaden coverage under homeowners policies.�� Claims for routine maintenance and bodily injury are becoming more frequent even though homeowners policies are primarily designed (and priced) to provide protection against perils that cause physical loss or damage to the dwelling and its contents.��

The typical homeowners policy today is renewing with an increase of 5 to 9 percent, up from just 2 percent in early 1999, but still well behind what is necessary to achieve profitability as a stand-alone line in a reasonable interval of time.�� It will take some time for price momentum to build in this line and regulatory and political opposition is likely to be fierce in some states.�� Nevertheless, the homeowners line, like the commercial and personal auto lines, will necessarily succumb to the mounting financial pressure.

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Economic Activity and Exposure Growth

Economic growth in the United States slowed considerably last year.�� In fact, real (inflation-adjusted) growth in the nation’s gross domestic product (GDP) fell from 8.3 percent during the fourth quarter of 1999 to just 1.0 percent during the fourth quarter of 2000.�� Real GDP growth rose slightly to 1.3 percent during the first quarter of this year.�� Although the United States appears to have narrowly averted a recession (which is defined as two consecutive quarters of negative real growth in GDP), real economic growth is expected to remain sluggish for the remainder of this year at 1.8 percent before accelerating to 3.1 percent in 2002.�� As mentioned in the ISO/NAII release, the first quarter of 2001 was the first time since the fourth quarter of 1993 that growth in the p/c insurance sector had outpaced the economy as a whole.�� With nominal (i.e., no adjustment for inflation) economic growth estimated at about 5 percent for this year, the p/c insurance sector should expand at a pace at least twice that of the general economy.

There are several reasons why the U.S. economy did not slide into recession earlier this year.�� First, the Federal Reserve has moved aggressively, slashing the federal funds rate five times since January, from 6.5 to 4.0 percent (an additional rate cut was expected in late June).�� Second, the loss of economic momentum was in part the result of a massive (and necessary) deflation in overvalued financial assets (such as tech stocks) as opposed to�� a deflation in real assets such as real estate, tightening monetary policy or an accumulation of excess inventories of manufactured goods.�� As such, the most severe economic pain was reserved for the tech sector, which had benefited a great deal from the speculative excesses of the Internet boom.�� The spillover impact has been substantial but manageable and has had a particularly mild impact on the p/c insurance industry, in large part because the Fed’s aggressive rate action has helped credit sensitive sectors of paramount importance to property/ casualty insurers.�� New home construction and automobile sales remain near record levels, benefiting personal lines insurers while commercial insurers (including surety) benefit from a backlog of commercial and public works projects and relatively robust labor markets.�� Inland marine insurers are among those who stand to benefit from the coming building boom in the energy sector.�� Even labor markets remain relatively healthy.
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Of course, lower short-term interest rates make growth in investment income more difficult, as evidenced by the 2.6 percent decline in this important component of earnings during the quarter.

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The View from Wall Street:�� Steady as She Goes

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. P/C stocks gained 43.4 percent last year compared to a slide of 9.1 percent on the S&P 500 and 39.3 percent on the Nasdaq. Prior to their comeback last year, the prices of many insurer stocks were at their lowest levels in years.

While some investors have taken profits in the wake of the industry’s phenomenal performance on Wall Street last year, insurer stock valuations have managed to hold their own and continue to outperform the S&P 500 and Nasdaq.�� Over the past 52 weeks, the performance gap is extraordinary.

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Surplus & Capacity

As noted in the ISO/NAII release, surplus fell $15 billion to $303.7 billion during the first quarter. The drop in industry surplus represents a decline of just 4.7 percent since December 31, 2000.�� Since peaking at $339.3 billion in June 1999, however, industry surplus has fallen by $35.6 billion or 10.5 percent.�� The drop in surplus does not represent a threat to insurer solvency.�� In fact, the drop represents only about one-third of the industry’s “excess” capital at $100 billion to $125 billion, according to Wall Street analysts (assuming a premium-to-surplus ratio of 1.2 to 1).�� If insurers are eventually 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:

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