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2006: Profitability Peak Brings the Industry Full Circle from Worst Ever Results in 2001

The financial performance of the property/casualty insurance industry in 2006 was generally excellent. Profits (net income after taxes) increased by $19.5 billion, or 44.3 percent, to $63.7 billion from $44.2 billion in 2005. While the steep drop in catastrophe losses from $61.9 billion in 2005 to $9.2 billion last year is commonly cited as the primary reason for the surge in profits, strong underwriting results were reported in virtually every key line of insurance, including those not significantly affected by catastrophic loss such as automobile insurance, workers compensation and commercial liability coverages. In general, too much of the industry’s success in 2006 has been attributed to the decline in catastrophe losses. Healthy investment returns also contributed to the bottom line. Declining charge-offs for adverse reserve development was another key factor.

The strong results in 2006 are notable for historical reasons as well. Just five years earlier, in 2001, insurers recorded their worst year ever. That year, profitability was negative for the first time ever, at minus 1.2 percent on aggregate profits of negative $7.0 billion. Last year almost certainly represents a cyclical peak in property/casualty insurance industry profitability. Since 1975, historical peaks in profitability have occurred at intervals of nine to 10 years, implying that the next peak will not occur until 2015 or 2016. At the same time, profitability will assuredly begin to ebb in 2007. The ���ϲ����� Information Institute estimates profitability will fall to 12.5 percent this year and 10 percent in 2008, assuming normal catastrophe losses. History suggests that the interval from profit peak to profit trough is four to six years, with an average trough return on equity (ROE) of 1.9 percent. The bottom line is that insurers could well be experiencing low single digit rates of return (i.e., under 5 percent) perhaps as soon as 2010 and probably no later than 2012.

The Tax Man Cometh
Profits also increase the industry’s tax obligations. Indeed, tax payments by insurers to the federal government increased to $24.2 billion in 2006—an increase of 126 percent or $13.5 billion over the $10.7 billion paid in 2005. Payments by property/casualty insurers now account for 5.1 percent of all federal corporate income tax receipts, up from 2.7 percent in 2005.(1)

Put into perspective, the industry’s tax bill in 2006 was larger than the losses paid on all but two of the most expensive natural or man-made disasters in world history, namely Hurricane Katrina (at $41 billion) and the September 11 terrorist attacks (at $32.5 billion). In fact, the 2006 federal taxes paid are so large that they exceed the $22.6 billion in insured losses from Hurricane Andrew (expressed in 2006 dollars), the second most expensive natural disaster in history.(2) Billions of additional dollars were paid to the 50 states in the form of premium taxes.

Catastrophe Losses: The Worst Has Yet to Come
Hurricane Katrina—with $40.6 billion in insured losses—was the most expensive disaster in global insurance history, but that event, as terrible as it was, only foreshadows what is yet to come. Insurers and reinsurers today actively plan for a $100 billion event (or sequence of events summing to $100 billion). There are a frighteningly large number of scenarios capable of generating a $100 billion loss, ranging from a repeat of the 1906 San Francisco earthquake, to a strong hurricane striking Miami or New York, to a major terrorist attack.

The 2007 hurricane season is illustrative of the risk. According to forecasters at Colorado State University, this year’s hurricane season is expected to be 85 percent above average. Seventeen named storms are anticipated, five of them intense, compared with long-run averages of 9.6 named storms and 2.3 intense storms. There is also a 74 percent chance of a major (category 3, 4 or 5) hurricane making landfall this year, well above the long-term average of 52 percent.

Profits: The Key to Rebuilding Claims Paying Capacity and Reinvestment in the Industry
Increased profitability and the drop in catastrophe losses mean that 2006 was a rebuilding year for the property/casualty insurance industry. Profits bolstered the industry’s policyholder surplus—a measure of claims paying capacity or capital—and will provide an additional buffer against the mega-catastrophes that lie ahead. An improved capital position will also help insurers meet the higher capital requirements imposed on them in the wake of Hurricane Katrina by ratings agencies, requirements that oblige insurers to demonstrate an ability to pay claims arising from more than one major catastrophe per year in order to maintain and improve financial strength ratings.

Notable is the fact that most of the profits generated by insurers in 2006 were reinvested in the industry. Billions of additional dollars were reinvested by carrying over unrealized capital gains into 2007. In fact, from year-end 2005 through December 31, 2006, policyholder surplus increased by $61.4 billion from $425.8 billion to $487.1 billion, a gain of 14.4 percent. The increase in surplus equates to 96 percent of the increase in after-tax net income (profits). Effectively, insurers are reinvesting the majority of their 2006 profits (and unrealized capital gains) in the property/casualty insurance industry, bolstering industry claims paying resources in advance of what is already predicted to be an active 2007 hurricane season. Insurers also returned $3.4 billion to their customers in the form of policyholder dividends.

Consumers and regulators can expect that insurers will continue to increase their claims paying capacity in 2007. In fact, property/casualty insurance industry policyholder surplus likely surpassed one half trillion dollars (i.e., $500 billion) during the first quarter of 2007.

Profitability and Pricing
Rising profitability is also intensifying competition throughout most of the property/casualty insurance industry and buyers of insurance are the unambiguous winners when it comes to reaping the benefits of lower insurance premiums. Drivers, homeowners and businesses in most parts of the United States will be left with more cash in their pockets as insurance costs fall in absolute terms, or at least relative to income growth and growth in GDP—the sole major exception being insurance for property coverages in hurricane-exposed areas. The bottom line is that falling insurance prices are lowering the cost of doing business, driving a car or owning a home for most Americans. For example, countrywide auto insurance expenditures are expected to fall 0.5 percent in 2007, the first drop since 1999.(3) At the same time the average cost of insuring a non-coastal residence is up by just 2 to 4 percent in many areas and is flat or even falling in others. Businesses, too, will see price declines of 5 percent or more in 2007 across their entire insurance program. The declines are a continuation of a downward trend in the cost of business insurance that began in earnest in 2004. Overall, the share of P/C insurance premiums relative to the overall economy shrank by 2 percent in 2006 and will likely shrink by another 4 percent in 2007 and 3 percent in 2008. Hence while critics of the industry bemoan insurer profits, the reality is that the cost of insurance for the overwhelming majority of consumers is flat or falling.

Improved profitability across the property/casualty insurance industry does not, however, mean that property insurance and reinsurance rates will fall in catastrophe-prone areas, especially those vulnerable to hurricanes. The risk in those areas remains high. Property catastrophe reinsurance prices are, however, leveling out as competition in the market heats up. One of the greatest threats to affordable property insurance coverage comes from the courts. Adverse court decisions, especially in Mississippi and Louisiana are putting upward pressure on prices and are decreasing availability.

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Premium Growth: Price Reductions, Economic Slowdown Take Their Toll

The ISO results indicate a growth rate in net written premiums of 4.3 percent 2006 compared to analysts’ expectations of 3.3 percent from the ���ϲ����� Information Institute’s annual Groundhog survey.(4) The difference is likely due primarily to stronger-than-expected growth in property related insurance premiums in hurricane exposed areas. There is, however, a consensus among analysts that premium growth will slow precipitously in 2007. Premium growth peaked during the most recent cycle at 14.6 percent in 2002 before dropping to 9.8 percent in 2003.

The average forecast from the Groundhog survey calls for an increase in net written premiums of just 1.8 percent in both 2007 and 2008. The 1.8 percent increase in premium growth forecast for the next two years would represent the second slowest rate of growth for P/C insurers since 1998, during the depths of the last soft market. The deceleration in premium growth in 2007 is a direct result of a virtual across-the-board softening in the personal and commercial lines pricing environment, hurricane-exposed property insurance coverages excepted. Other factors include a general economic slowdown that is negatively impacting exposure growth through declines in home building, new vehicle sales, business investment in new plant and equipment as well as slower wage and salary growth. Actions taken by insurers to reduce their exposure to relatively catastrophe prone (but rapidly growing) property markets like Florida are also having a negative impact on the outlook for growth.

For insurers, the current premium growth pattern is eerily reminiscent of the soft market of the late 1990s, when the industry recorded growth of 2.9 percent in 1997, 1.8 percent in 1998 and 1.9 percent in 1999. Those years presaged some of the worst years in insurance industry history with combined ratios rising from 102 in 1997 to nearly 116 in 2001. Fortunately, with a 2006 combined ratio of 92.4, the comparison—at least so far—appears to be superficial, or at least premature.

Underwriting Performance: The Crown Jewel of 2006

The property/casualty insurance industry’s underwriting results in 2006 were extraordinary. Last year’s combined ratio of 92.4 is the best since 1949 and stands tied for the fifth best result since 1920.(5) It is also down a precipitous 8.5 points from 100.9 in 2005. So extraordinary is the 2006 underwriting result that it is unlikely to be repeated for decades.

The 92.4 combined ratio implies an underwriting profit after dividends of $31.2 billion, only the second underwriting profit since 1978 (a small underwriting profit was generated in 2004).

The combined ratio is projected to rise to 96.8 in 2007 and 98.7 in 2008, according to the I.I.I.’s Groundhog survey. The estimates for both 2007 and 2008, of course, assume “normal” catastrophe losses. It should be noted, however, that underwriting profits in 2007 will likely fall substantially from 2006 levels. The considerably slimmer margin of underwriting profitability will also be eliminated entirely if catastrophe losses return to 2004/05 levels.

While the survey results indicate fundamentally sound underwriting performances in 2006 and 2007, the anticipated 4 to 7 point deterioration in the combined ratio over the next two years is another indicator of slimmer profit margins in the years ahead. A surge in catastrophe losses could easily push the industry combined ratio to 100 or beyond, too high to generate returns that are competitive with the Fortune 500 group. A combined ratio of 100 means that insurers are paying out exactly the same amount in claims and associated expenses as they have earned in premiums. As a stern reminder of the importance of generating substantial underwriting profits, the 100.9 combined ratio in 2005 produced an ROE of just 10.8 percent. The underwriting profits earned in 2006 will help insurers earn their cost of capital (the rate of return necessary to retain and attract capital) for just the second time in many years. Though up substantially in 2006, insurer profits remain highly volatile. As mentioned previously, just five years ago, in 2001, insurers suffered their worst year ever with negative profits for the year. Considering the tremendous risk assumed by investors who back major insurance and reinsurance companies, the returns in most years are woefully inadequate. It is clear that Fortune 500-level returns on equity in the neighborhood of 13 to 15 percent cannot be generated consistently without a substantial contribution from underwriting, given the murky interest rate situation going forward and continued stock market volatility.

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 to 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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Investment Returns: Satisfactory Results, Banking Gains for the Future

The industry’s net investment gain decreased by $3.8 billion or 6.4 percent to $55.7 billion in 2006 from $59.4 billion during in 2005. According to ISO, the net decrease consisted of a 5.2 percent increase in net investment income (which consists primarily of interest on bond holdings and stock dividends) and a 65.4 percent drop in realized investment gains, from $9.7 billion in 2005. The sharp deterioration in realized capital gains may seem odd given that the S&P 500 Index was up 13.6 percent in 2006. The decision to realize capital gains, of course, is one made by management, which most likely decided to “bank” the 2006 gains. By deferring the realization of capital gains, insurers have the option of bolstering future profits which may come under pressure if underwriting results deteriorate as expected in the years ahead. Looking ahead, while the S&P 500 index was up 2.4 percent through April 13, 2007, it is still far too soon ascertain the market’s impact on insurer investment gains for 2007. It is important to keep in mind, however, that property/casualty insurers hold just 17 percent of invested assets in the form of common stock, so upside from a rally in stocks is limited.

It is worth noting that the 2006 investment gain of $55.7 billion is less than the $57.9 billion earned in 1998, despite the fact that the investment portfolio of insurers is much larger today. The inability to match the investment gains of the late 1990s is directly related to higher interest rates on bonds and consistent bullish equity markets during that period of time. This underscores the need for insurers to remain disciplined both in their underwriting and pricing.

The interest rate situation going forward is somewhat murky for insurers. The direction of interest rates is critically important for property/casualty insurers because 68 percent of all invested assets are held in the form of bonds. The average yield on 10-year US Treasury notes was 4.80 percent in 2006, up from 4.29 in 2005, yet almost identical to the 4.73 yield in June 2004 (when the Fed began to raise rates). Indeed the yield curve was inverted for much of 2006. While short-term interest rates are much higher than they were at the beginning of the Fed’s campaign to raise rates (the 3-month T-bill yielded 1.29 percent in June 2004) the average yield in 2006 was 4.85 percent, 5 basis points above the yield on the 10-year note. Indeed, the 30-year Treasury bond last year yielded just 4.91 percent. This situation leaves insurance company chief investment officers with a difficult choice—lock in long-term rates now lest they fall further or stick with shorter-term instruments because of the higher yield. The decision to go long is fraught with interest rate risk. It is easy to envision situations (such as an oil-induced inflation shock or a war) that drive interest rates sharply higher in the years ahead, a development that would push the price of bonds down. On the other hand, rates could trend down further, perhaps for years. If the yield curve also returns to its normal shape, then going long today is the right strategy.

Securities investors appear to be sending a signal that they expect intermediate and long-term interest rates to decline. The traditional explanation for this is an expectation of economic weakness in the months and years ahead.

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Summary

The extraordinary financial and underwriting performance of the property/casualty insurance industry during 2006 is unlikely to be repeated for decades. The industry’s success last year is primarily attributable to a strong across-the-board underwriting performance, resulting in the best combined ratio since 1949. A return of catastrophe losses to normal or average levels from the record high losses of 2005 was an important, but secondary factor. In 2007, insurers face a variety of challenges unrelated to catastrophe losses, including increasing price pressure that could erode underwriting performance.

One major cause for concern is the fact that expected premium growth in 2007—at just 1.8 percent is less than half the 2006 growth rate of 4.3 percent and is, in fact, negative on an inflation-adjusted basis. Another is the rapid accumulation of capital on insurer balance sheets. The current slow growth environment means that insurers face very difficult capital allocation decisions over the next several years.

A detailed industry income statement for 2006 follows: