Commentary on First Half 2000 Results

September 14, 2000

The property/casualty insurance industry reported a statutory rate of return of 5.6 percent (on an annualized basis) during the first half of 2000, down from 8.2 percent during the first half of 1999 and 6.6 percent for all of 1999. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

The first half 2000 financial results provide further evidence supporting the view that the financial performance of the property/casualty insurance industry is now passing through a trough and is presently in the early stages of a vigorous rebound.

Wall Street continues to signal this belief by sharply bidding up the stock price of most property/casualty insurers, a trend that began late in the first quarter. Positive developments in the first half results included:

• a 4.2 percent increase in net written premium (compared to full-year 1999 growth of 1.9 percent) ¨
• a 1.5 percent increase in net investment income (compared to a 3.3 percent drop in investment income in calendar year 1999) ¨
• a 2.3 percent decrease in surplus from end-1999 (compared to a decline of 0.2 percent through the end of the first quarter)

The 1.5 percent increase in net written premium is the result of both strong economic growth and greater pricing discipline on the part of insurers. More risk appropriate pricing in catastrophe-prone areas is also a factor.

Pricing is critically important to the industry’s turnaround. Conning & Company and several major investment banks report that spring and summer 2000 renewals for the commercial segment were up across the board for the first time in years. Workers compensation, the largest of the commercial lines and the line in the greatest need of relief, is leading the way. The commercial multiperil and general liability lines are also benefiting from a significantly improved pricing environment. Commercial auto, commercial property, umbrella, and excess and surplus lines also experienced significant improvements.

On the personal lines side, the price war in the personal auto line shows some signs of abating. The Insurance Information Institute estimates that personal auto rates fell 2.8 percent in 1998 and 3.2 percent in 2000 due, in part, to improving fundamentals but also to intense competition between insurers. The price cutting led to huge underwriting losses at many companies with personal lines operations and was a significant factor in the $6.9 billion (88.5 percent) increase in the first half’s net underwriting losses. These losses have compelled many insurers to hold the line on further decreases in many states and are compelling them to raise rates in others.

While the auto insurance market remains competitive, auto insurers are also benefiting from the strong economy. Auto manufacturers sold a record 18.3 million new vehicles last year, nearly half of which were relatively expensive light trucks and SUVs, also a record.

The nation’s housing boom is also working to the benefit of personal lines carriers. Homeowners continue to build new homes at a record pace, and may yet eclipse the 927,000 new homes constructed in 1999. New home construction could bring insurers $200 billion in new exposure this year alone. Improvements to existing homes should add billions more.

The 1.5 percent increase in investment income may at first appear to be unimportant, yet is actually one of the first quarter’s significant developments. Rising investment income during the first half indicates that the property/casualty insurers are on track to end a two-year slide in earnings on investments, which fell by 3.3 percent last year and 3.9 percent in 1998.

The Federal Reserve’s shift toward an anti-inflationary bias in 1999 led to several rate hikes during the second half of 1999 and the first half of 2000.

Underwriting losses during the first half of 2000 were sharply higher, despite the development of favorable pricing trends and catastrophe losses that were slightly lower than during the same quarter last year. The current high level of underwriting losses is a reflection of the intensely competitive pricing environment over the past few years and the accumulation of losses on underpriced business.

The full impact of higher prices for many property/casualty insurance products, which are only now being implemented, will not be felt for several quarters as rate increases take hold. Existing books of business, of course, can be repriced only as policies come up for renewal. There is also a lag between when premium is written and when it is earned.

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.

Of course all eyes in 1999 and early 2000 were on the technology-laden Nasdaq. “Old Economy” industries such as insurers, manufacturers and retailers lagged far behind the returns in so-called “New Economy” industries related to the Internet, telecommunications and biotechnology. The Nasdaq began to plummet, however, after reaching its peak of 5048.62 on March 10.

During the remainder of that month and through much of the spring, insurer stocks staged a strong comeback. Prior to the comeback, the prices of many insurer stocks were at their lowest levels in years.

By early September, the property/casualty group on a year-to-date basis had recorded a total return of 15.4 percent compared to a decline in the Nasdaq of 2.2 percent. The divergence is far more dramatic when measured from the Nasdaq peak on March 10. Since the bursting of the tech bubble, the Nasdaq has declined by 21.2 percent (though September 8) compared to a gain of 43.2 percent for the property/casualty group, a performance gap of nearly 65 points. The results for life/health insurers and brokers-which have posted gains of 51.6 percent and 52.4 percent, respectively, are even more dramatic.

The surge in interest in insurance stocks was driven by several factors, including disappointing earnings (or total lack thereof) among the dot-coms, extraordinarily low valuations for insurance stocks, and the prospect of investing at a point that could mark a turn in the insurance cycle leading to improved profitability.

Of lesser concern is the $7.6 billion decline in surplus since year-end 1999. The decline represents just 2.3 percent of industry surplus and does not represent a threat to insurer solvency. Moreover, analysts have estimated the industry’s “excess” capital at $100 billion to $125 billion (based on a premium-to-surplus ratio of 1.2 to 1).

If insurers are 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.

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