Each year the Insurance Information Institute (I.I.I.) invites a panel of Wall Street stock analysts and industry professionals to review the prospects for the industry in the current and coming year.
The survey reveals that 2002 was another tough year for insurers and that the industry’s underwriting and profit woes, while easing substantially in 2003, are far from over. The survey also reveals a curious split in the analyst community over the pace of growth in the industry in 2003, with some analysts forecasting accelerating growth while others foresee stable or slowing growth. Given the current state of investment markets, the survey results also seem to suggest that the hard market cannot end in 2003, at least if the industry expects to post reasonable rates of return by 2004.
Premiums: Strong Growth, But Some Easing Expected
The average forecast calls for an increase in net written premiums of 12.3 percent in 2003, resulting chiefly from increased prices and to a lesser extent from higher demand. While the increase is high by recent historical standards, it represents a material deceleration from the 13.6 percent average gain estimated for 2002—the first such deceleration since 1998.
The Hard Market—Why It Has to Last
The dramatic acceleration in premium growth from their post-World War II lows in the late 1990s, the similarly impressive improvement in underwriting performance and the relatively short duration of previous hard markets (three to four years) suggest that the end of the hard market must be near. But lurking just below the surface is a far more disturbing and sobering picture—one that suggests that if the current hard market ends anytime soon, it will end badly. The chart at the end of this report shows exactly why this is the case. The 3 to 4 percent return expected in 2002—while a marked improvement over 2001’s worst-ever performance—is still dreary, even when compared to today’s recession-reduced ROE expectations for American industries generally of about 10 percent. Moreover, for at least 12 consecutive years, profitability (as measured by return on equity) in the property/casualty insurance industry has managed to trail the industry’s cost of capital—often by a wide margin. [The cost of capital is that rate of return required by investors, given the risks assumed and the alternative investments available]. Looking ahead, the forecast combined ratio of 103.3 in 2003 doesn’t come close to generating the 10 to 15 percent ROE investors expect. In the current investment environment, combined ratios must fall below 95 before the industry’s financial performance approaches consistency with the risks it assumes. In short, 2003 is way too soon for the hard market to end for most insurers.
Combined Ratio: Moving in the Right Direction but a Long Way to Go
The combined ratio, which is the ratio of losses and expenses to premiums, for 2003 is projected to be 103.3, down from an estimated 106.3 in 2002 and well below the terrorism-impacted 115.7 result in 2001.
While the results show continued improvement, the bottom line is that the industry will still be paying out $1.03 for very $1.00 it takes in. The estimate obviously assumes no major insured losses from terrorist acts in 2003 as well as “normal” catastrophe activity.
The Legend of the Price Gouging Insurer: Urban Legend for 2003 Rising prices and tougher underwriting are essential elements of the insurance industry’s recovery. Yet full recovery is proving to be a slow and difficult process as insurers continue to be battered by unrestrained jury awards, surging asbestos claims, soaring medical inflation, high catastrophe losses, the crisis in corporate governance, loss of critical capacity, a weak investment environment and, of course, the extreme risk of terrorist attacks. Although higher prices and tighter underwriting are entirely necessary and justified in this environment, accusations of opportunism and price gouging are on the rise.
Truth be told: Insurance, by almost any measure, has become more affordable than it was a decade ago. Commercial net written premiums as a percentage of gross domestic product (GDP) fell from 2.3 percent in 1988 to 1.5 percent in 2000, a 35 percent decline, before rising to an estimated 1.8 percent of GDP in 2002 (see chart). According to the Risk and Insurance Management Society, the cost of risk for businesses relative to revenues fell by 42 percent between 1992 and 2000. Even with the increases of the past two years, businesses are still paying an estimated 13 percent less to manage risk than they were a decade ago. The actual decline is greater still because terms of coverage were substantially broadened during the 1990s.
What about personal lines? Same story—insurance has become more affordable. The price of homeowners insurance relative to the cost of the median purchase of an existing home, for example, fell 13 percent between 1994 and 2002 (see chart). Hence, even though home prices continue to skyrocket, homeowners insurance has become a better bargain than ever.
Critics of the property/casualty insurance industry are also fond of citing the crashing stock market as the principal reason insurers are raising rates today, though few have bothered to note that stocks accounted for just 21 percent of the industry’s invested assets in 2001. Nevertheless, it is true that the price of insurance is directly related to return on investment. No one (including consumer advocates) seemed to mind during the 1990s when expectations of high rates of return on investments pushed the cost of insurance downward, but it must be recognized that this is a two-way street. If investment returns diminish, then any change in underlying costs must be offset by price increases and tighter underwriting.
That being said, p/c insurers still managed to realize an investment gain (consisting primarily of investment income, realized capital gains/losses and stock dividends) of 8.7 percent of earned premium in 2001. While down from the 10-year average gain of 10.1 percent, most people would gladly trade the performance of the industry’s portfolio for the double-digit negative returns experienced by most investors over the past few years.
Compiled by Robert Hartwig, senior vice president & chief economist.
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