The property/casualty industry reported a statutory rate of return of 1.0 percent in 2002, up from the worst-ever negative 2.4 percent recorded in 2001. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).
2002: A Major Disappointment
The good news is that the U.S. p/c insurance industry earned $2.9 billion in net income after taxes in 2002. That’s also the bad news. Although last year’s profit of $2.9 billion is a lot better than the $7.0 billion loss in 2001—it is, amazingly, $2.1 billion less than the $5.0 billion earned during the first nine months of the year. In other words, insurers earned more during the first three quarters of 2002 than they did during the full four quarters. Accomplishment of this remarkable feat was not the result of natural disasters or investment debacles, but of massive charges taken during the fourth quarter to strengthen reserves. These charges added billions to 2002 underwriting losses, half a dozen or more points to the combined ratio of many insurers and transformed what would have been a mediocre year into what charitably can be described as a major disappointment.
A little perspective is helpful here. Last year’s 1.0 percent return for the p/c insurance industry was half the 2.0 percent return investors received risk free in 2002 from a simple investment in one-year Treasury securities—without any worries about terrorists, tornados, toxic mold or trial lawyers.
To be sure some insurers did well last year in terms of underwriting performance and profitability—and most fared much better than in 2001. Moreover, every penny of last year’s reserve strengthening was very much needed. Yet the investors, who over the past two years poured billions into the industry in hopes of benefiting from the current hard market, have not, as a group, done as well as they had expected. Last year’s combined ratio of 107.2 is at least 15 points above where the industry needs to be (low 90s), given the current dreary investment climate, if it expects to generate rates of return similar to that of the Fortune 500. The performance gap is so enormous that any discussion of the end of the current hard market should now be regarded as recklessly premature. Clearly, were the hard market to end in 2003, it would end very badly indeed for a good number of insurers.
With the current hard market well into its second year, tort reformers in the White House and Congress and al Qaeda on the run, 2002 certainly had the potential to be a blockbuster. To say that 2002 fell well short of the mark would be an understatement, but the last year’s results and the factors that led to them did leave top management with a very clear picture of where this industry’s major challenges lay in the years ahead. These include a swift and sharp increase in profitability, a dramatic improvement in underwriting performance, operating with increasingly scarce capital resources, addressing concerns over ratings and solvency, slaying the tort beast while there’s still a chance and learning to live with that recurring nightmare otherwise known as Wall Street.
Profits and the Insurance Industry: Still an Oxymoron?
Improving profitability is job number one with the vast majority of p/c insurance CEOs—stock companies, mutual companies and state funds alike. Despite the fact that a few insurers managed to hit profit targets in 2002, the industry overall continues to languish in a profit drought that has now spanned the better part of two decades. For an amazing 16 consecutive years, in fact, p/c insurance industry profitability (as measured by return on equity) has underperformed the Fortune 500. Last year’s skinny 1.0 percent rate of return was underwhelming by any measure, a fact rendered even more disappointing given that net written premiums surged by 14.1 percent last year, the fastest growth since 1986. Insurers have likewise failed to achieve their own cost of capital for many years. The inevitable consequence of repeatedly disappointing investors is a diminished ability to attract and retain capital, shrinking capacity on a global scale, ratings agency downgrades and a loss of investor confidence as manifested by falling share prices. All three are presently coming to pass in the p/c insurance industry.
Improve Underwriting Performance
The 2002 results clearly demonstrate that sustained profitability depends on far more than hefty price increases. While insurers have successfully managed to push insurance prices sharply upward over the past three years, in the long run it is smart underwriting that separates truly successful companies from the pack. Elite underwriters experience higher ROEs over the long run, are better able to remain in the good graces of investors and generally have sufficient earnings to seize new opportunities through expansion, new product innovation and acquisitions. While the virtues of disciplined underwriting are widely recognized, the industry’s overall underwriting performance in recent years has been atrocious. The period from 1999 through 2002 witnessed four of the six largest underwriting losses in the history of the U.S. p/c insurance industry. The cumulative underwriting loss over this period was a staggering $138 billion. Last year’s $30.5 billion loss—while a marked improvement from the terrorism-impacted $52.6 billion loss in 2001—was far worse than anticipated, in large part because of the enormous charges taken to bolster prior-year reserves mentioned earlier. Endless asbestos litigation, accelerating medical inflation, and monster jury awards are long-term problems responsible for a good number of these charges, but many insurers and reinsurers increasingly find themselves struggling with liabilities from the much more recent past, affecting lines like workers’ compensation, medical malpractice and directors’ and officers’ coverage.
Nightmare on Wall Street
Investment income fell by 2.8 percent in 2002 to $36.7 billion, its lowest level since 1995 and the fourth decline in the past five years. Interest rates at 40-year lows are the principal reason for the drop-off in investment income but with the bear market now into its fourth year, it is now clearer than ever that all the heavy lifting in terms of generating adequate profits will have to be done through pricing and underwriting. Although total investment gains (investment income plus realized capital gains less realized capital losses) last year amounted to a still substantial $35.6 billion, that’s down considerably from a peak of $57.9 billion in 1998.
Contrary to reports in the popular media, the decline is not the result of reckless management of investments. In fact, the industry’s investment profile remains very conservative, with two-thirds of invested assets held as bonds (mostly treasuries, munis and high-grade corporates) and only 20 percent in stocks. This asset allocation mix has muted the impact of the ongoing swoon in equity prices on overall investment performance, but the decline in investment income associated with the recent precipitous decline in interest rates is impossible for conservative institutional investors such as insurers to avoid.
Surplus and Capacity
The corollary to the poor underwriting and investment performance discussed above is a contraction in available capital. The sharp drop in the pool of capital available to underwrite insurance is a principal factor fueling price increases and availability shortages in insurance markets today. Capital held by U.S.-domiciled p/c insurers has plunged by more than 15 percent or $52 billion since mid-1999. Foreign capital, which is critical to the U.S. insurance market, is also shrinking. Globally, capacity fell by an estimated 25 percent or $230 billion from between 2000 and 2002. Because of consistently poor returns to investors, attracting fresh capital could become more of a challenge in the year ahead.
Ratings, Solvency and Reinsurer Concerns
One sure sign of stress among p/c insurers and reinsurers are the hundreds of ratings downgrades and watches issued by all the major ratings organizations over the past two years. Not surprisingly, the flood of downgrades has been accompanied by a surging insolvency rate among p/c insurers, which hit 1.33 percent last year, up from just 0.23 percent in 1999 and nearly double the 10-year average insolvency rate of 0.72 percent.
Downgrades have taken their toll, effectively putting a few companies out of business and leading some industry observers to predict the end of the ‘Triple-A’ rating, now held by just a handful of major insurers. Insurers that slip into the B-range are generally shunned by brokers and commercial customers and may be forced to sell-off profitable books of business to raise capital or cease operations altogether.
Reinsurers have also taken it on the chin. Among the world’s top 10 reinsurers, four were rated in the B-range by Moody’s as of April 1—one of which is presently in runoff. A year earlier, all ten could boast ratings in the A-range. Among the largest 150 reinsurers, there were more than 50 downgrades in 2002 compared with only three upgrades, according to Standard & Poor’s. Moreover, with a combined ratio of 121.3 last year, reinsurers’ underwriting performance generally continues to lag behind the p/c industry.
To be sure, the global p/c insurance and reinsurance industries are not on the brink of collapse, but ratings worries are a mounting concern within the industry, among brokers and customers. Ratings affect an insurer’s ability to attract and retain business and companies with superior ratings can command premium prices for their products. Reinsurance uncollectibles and slow pays are likely to be an issue of increasing concern for some primary insurers in the year ahead.
If CEOs in the insurance industry (and every industry, for that matter) agree on one thing it is this: the U.S. civil justice system is out of control. According to Tillinghast Towers-Perrin, tort costs consumed two percent of GDP or $205 billion in 2001. An enormous percentage of these costs are passed along to insurers. In fact, Tillinghast estimates that insured tort costs totaled $128.1 billion in 2000, up from about $100 billion in 1990 and $34 billion in 1980. While casualty insurers are in the business of providing liability coverages, the actual insurability of some types of liability risks remains in doubt. Insurability becomes difficult when trends in the frequency and severity of casualty risks depart from historical norms and become subject to enormous and unpredictable variation. While medical malpractice is the best recent example of this phenomenon, the out-of-control jury awards that led to physician walkouts in many states and demands for caps on non-economic damage awards are by no means confined to the healthcare sector. In fact, the average jury award across a wide variety of exposures has doubled, tripled or, as in the case of products liability, quintupled.
Beyond concerns over profits, underwriting, investments, capital, ratings and torts is a vast, nightmarish inventory of scary insurance problems. Many are manageable but some are downright frightening. “Toxic” mold, which certainly sounds scary, has cost the insurance industry at least $5 billion over the past few years. Catastrophes cost the industry nearly $6 billion last year—a good year by recent standards—but the next Hurricane Andrew or Northridge earthquake is never too far away. The crisis in corporate governance has cost the industry much more than $6 billion because of exposure through multiple lines of insurance (D&O, surety, etc.) as well as exposure through the investment portfolio. Asbestos will cost still more—perhaps another $30 billion over the next 30 years. Terrorism—the 9/11 attacks cost the industry $40 billion—is a number potentially without bound. And so the list goes on and on.
It is difficult to put a positive spin on the p/c insurance industry’s 2002 financial results. If there is one bright spot, it is that underwriting results are moving in the right direction. Stripping away last year’s extraordinary reserve charges reveals very respectable combined ratios for a number of major insurers. Also, improved cash flow is slowing the decline in investment income, which was shrinking at a 5 to 6 percent annual clip earlier in 2002. There is even solace to be found in last year’s large reserve charges, which are indicative of the industry’s resolve to address the issue of reserve deficiencies. In the final analysis, however, the yawning gap between the industry’s ROE and its cost of capital must be closed. Without some significant movement in that direction, capital will continue to flow out of the industry and investor confidence in the industry will be increasingly challenged.
Robert Hartwig is senior vice president & chief economist for
Insurance Information Institute.