California Auto Market Journeys Upward

There’s a saying in business, “Companies don’t go broke during bad times; they go broke during good times.”

The truth of that saying was borne out recently when the California personal auto marketplace went from boom to bust in what seemed like the blink of an eye.

Today, the storm has passed. After two-and-a-half unprofitable years, it’s time. After a protracted slide, average premiums are increasing each month, and 2002 is shaping up to be a decent year. By 2003, many of the more experienced carriers should be turning decent underwriting profits.

One of the fun parts about actuarial work is the ability to extrapolate trends in your data to look ahead and see what’s around the next bend. (Mind you, this was one of the very bad parts of the pricing function back in 1998 and 1999.)

The underwriting cycle for personal auto has always been similar to a sine wave (remember the lead-in to the old sci-fi show, “Outer Limits”?). Collectively, we are in the trough of the wave, beginning the journey upward. When we get to the top, we will slide back down the other side. That much is beyond our control. But there is much that we can control, and with the memory of the last slide still fresh in their minds, many companies today are trying to figure out how to prevent or minimize the next downward curve.

A step forward
The last two or three unprofitable years have taken their toll on the marketplace, but there is a silver lining: market players appear to have picked up religion along the way. And I believe that the conversion will last, at least for the near term.

There has been a noticeable pulling back by quota share reinsurers. In the 90s, quota share reinsurers were more aggressive and provided a greater percentage of aggregate capacity, particularly in the non-standard auto arena. This shift had a significant effect on how the marketplace operates, since profitability cycles differ from quota-share treaty periods. Where reinsurers are involved on one-year contracts, they can get a divorce from their reinsureds if things don’t go well. Needless to say, the divorce rate went up considerably in the past few years.

In the past, the reinsurance market had more money than it could deploy (overcapacity), so the scrutiny given to each treaty was not always as rigorous as it might have been. Now reinsurers have laid down the law: Either generate an underwriting profit or guarantee no loss, or we won’t play. Having facilitated a large number of competitive private passenger auto programs, quota share reinsurers have once again become less involved on the front line, leaving the market primarily to net-line, risk-taking carriers.

Primary carriers now have to be prepared to take risk in order to write personal auto, where historically they had the option of laying off a portion of the risk to quota share reinsurers. This translates to a discipline that was occasionally lacking in the past.

In the late 90s, we were seeing me-too filings, minus 10-20 percent, from carriers who had no experience in the California auto market, and in my opinion, no realistic expectation of making it to the end of the party. Those days are over.

The carriers that remain have earned their spot. In general, they are more experienced players who understand market cycles and are working with smarter distributors.

Agents have also learned their lesson. They’ve learned that underwriting profitability cannot be ignored, and that price is not the only consideration when placing business. They’ve seen firsthand that if they don’t protect their carriers, they’ll lose their markets over time and jeopardize their in-force books of business.

So how did we get to this point, and why?

Too much of a good thing
In late 90s, the economy was exploding like a bottle rocket.

There were more potential earned exposure units—new cars on the road, more people buying houses—but flat premium growth. Aggregate premiums grew less than 2 percent in 1998 and 1999. By 2000 and 2001, premiums increased between 5 and 10 percent across the board, but the damage was done. The industry’s combined ratio went from a healthy 101.6 in 1997 to a horrendous 118.6 in 2001.

Personal auto was by no means the only culprit—historic rate deficiencies came home to roost in workers’ compensation, contractors, and homeowners insurance, just to name a few. But for a line that was supposed to offset longer-tail, more volatile business, it certainly dealt a serious blow to many insurers’ balance sheets.

Times were good all over the country in the mid-to-late 90s, but California reigned supreme. Not only were companies putting business on the books, they were doing so at a profit. The loss ratio for private passenger auto in 1997 was a low 49 percent, well below the national average of 62 percent. In 1998, it inched up to 53 percent, still well below the national average and still low enough to be profitable. Indeed, California was one of the most lucrative markets in the nation, with liability profits approaching 20 percent.

Attracted by this success, companies that had no expertise in personal auto and no excess capital to speak of themselves got caught up in the fray. The result was a battle for marketshare that left few participants unscathed.

From 1990-1999, rates fell 10 percent statewide. Meanwhile, claims severity worsened, owing to higher medical and vehicle repair costs. Making matters worse was the fact that many agents (often with the acquiescence of their carriers) used creative low annual mileage and prior insurance discounting to offer consumers rates that were artificially low and clearly inadequate.

By 2000, the bubble had burst. Data published last fall by the National Association of Insurance Commissioners (NAIC) showed that countrywide, carriers took a 9.7 percent underwriting loss on physical damage (as a percentage of net premiums earned, not taking into account investment gains), with liability running a loss of 13.4 percent.

By 2001, the party was over—literally, for many carriers and general agents that lost their reinsurance and had to exit the market. The number of casualties was greater than it should have been because the state was slow to approve needed rate increases.

When the industry could not raise rates to address deteriorating loss results in 1999, 2000, and most of 2001, it became abundantly clear that California’s prior approval system is in need of an overhaul. In 2000-2001, what we call the “smack-down ratio”—the proportion of approved-to-filed rate increases—was about two-thirds of what companies were able to demonstrate. If a company had a rate indication of +15 percent, it might get a 10 precent. If that sounds like an overly broad generalization, consider that this ratio of “filed to approved” was measured for dozens of filings over many months, with statistical variation so low the concept of coincidence gets strained to the breaking point.

As a result, many companies just couldn’t get the rate increases they needed to stay in business. Arrowhead was lucky to get a modest rate increase in 1999 when it saw the market going south but before the storm really hit. This early action cushioned the blow somewhat. Other facilities were not so lucky. The estimate is that there are 40-50 percent fewer programs on the street than there were three years ago.

Blue skies ahead
Within the last six months, carriers have found some relief, as the Department of Insurance has approved larger increases—including several above 30 percent, a feat that would have been unheard of just three years ago. (Let’s hope that the upcoming change in leadership at the DOI does not result in more politicization of the rate review process.)

Now with rate adequacy improving in 2002, companies will need to turn their attention to combating rising lost costs and increasing operational efficiency. It’s a challenge that the marketplace is up to.

In a sense, the marketplace just got more professional—the companies that remain are credible players that understand the marketplace. And you can be sure that they’ve learned from one another’s successes and mistakes. One thing is for sure, intentionally swallowing a $5.6 billion underwriting loss to pick up marketshare as State Farm did last year, is probably not the strategy that will succeed in the future. For once, the marketplace taught a lesson to everyone, big and small.

It’s a nice time to be writing private passenger auto insurance in California. Looking at the positive trends in the data—average premiums increasing each month, production up, claims indemnity payments down—I am confident that blue skies are ahead.

Dick Hoye, CPCU, ARP, AIAF, ARe, is president of Actuarial Services and Compliance for Arrowhead General Insurance Agency, Inc.