Record catastrophe losses will weigh heavily on 2005’s underwriting results, pushing what would have been the industry’s largest underwriting profit ever into a loss situation, according to the Insurance Information Institute’s recent Earlybird Forecast Survey.
The survey of Wall Street stock analysts and industry professionals also indicates that the industry will bounce back in 2006 with a strong underwriting performance sufficient to generate a small underwriting profit. The analysts surveyed also uniformly expect premium growth to accelerate in 2006 to roughly double their estimates for 2005.
A Katrina-inspired ‘mini hard market?’
The average forecast calls for an increase in net written premiums of 4.7 percent in 2006, up from an estimated 2.5 percent in 2005. The 2006 forecast is a near doubling of the estimated figure for 2005 but is nearly identical to the actual growth figure in 2004. The spike in premium growth in 2006 is a direct result of analyst expectations that record catastrophe losses in 2005, totaling some $57 billion, have severely crimped capacity and caused insurers to reassess risk in catastrophe-prone regions of the Unites States.
Analysts also expect that demand for insurance and reinsurance will increase even while supply is falling. The resulting supply/demand imbalance, it is reasoned, should spark a “mini-hard market,” pushing insurance and reinsurance prices for some types of coverage upward – property insurance and property catastrophe reinsurance coverage in particular.
Some analysts believe that hard market conditions could spill over into casualty lines as well (e.g., general liability, workers’ compensation), stabilizing pricing if not pushing prices upward. Commercial property insurance and reinsurance coverage rates had been falling in year prior to Hurricane Katrina and homeowners insurance rates in most parts of the country were rising by only low single digits.
Expectations for a hard market in 2006 are quite muted relative to recent historical growth in premiums. Premium growth peaked during the most recent cycle at 14.6 percent in 2002 before dropping to 9.8 percent in 2003. It is also worth noting that premium growth in 2005 will come in well below even the most pessimistic of analysts’ expectations from a year ago.
In last year’s Early Bird survey the consensus estimate was for net written premium growth of 3.4 percent and the lowest estimate of the 13 respondents was 1.1 percent, nearly a full point above the current estimate of 2.5 percent. Actual growth in 2005 will likely fall well below even the 2.5 percent estimate, given that recent data show that actual net written premium shrank by 0.5 percent through the first nine months of 2005.
Combined ratio: much better than it appears
The combined ratio, which is the ratio of losses and expenses to premiums, for 2006, is projected to be 98.0, down substantially from an estimated 105.3 in 2005 but virtually identical to the actual combined ratio of the 98.3 recorded in 2004. Results released subsequent to the Earlybird Survey were much better than expected, indicating an actual combined ratio of 100.0 through the first nine months of 2005, which includes the effects of Hurricanes Katrina, Rita and Dennis (Wilma occurred during the fourth quarter). The strength of the actual 9-month results suggests that 2005 will show an underwriting profit for the full-year. If the combined ratio in 2005 comes in under 100, it would mark only the second underwriting profit in the property/casualty insurance industry since 1978.
The expectation for a third consecutive underwriting profit in 2006 is, of course, predicated on the belief that catastrophe activity will return to more “normal” levels. Because of the demonstrated resilience of the property/casualty insurance sector in 2005, however, estimates of the 2006 combined could be revised downward, which in the current survey range from a low of 94.0 to a high of 100.3. Were the combined ratio to finish 2006 in the neighborhood of 95, it would be at its lowest level since 1972.
While the survey results indicate expected improvements, the bottom line is that the industry will still be paying out almost exactly the same amount in claims and associated expenses as it earns in premiums, thereby increasing the importance of generating substantial underwriting profits. Indeed, the 98.3 combined ratio in 2004 produced an ROE of just 10.5 percent while the 100.0 combined ratio through the first nine months of 2005 is associated with a 9.5 percent return on average surplus. Considering the tremendous risk assumed by investors who back major insurance and reinsurance companies, these returns are woefully inadequate. It is clear that Fortune 500-level returns on equity in the neighborhood of 13 to 14 percent cannot be generated without a substantial contribution from underwriting despite the recent rise in interest rates and increases in investment income.
2006: Looking relatively good, but concerns are mounting
What are the biggest potential downside risks for 2006?
High on the list are exposure to catastrophic loss, which has superseded loss of pricing and underwriting discipline as the chief concern. Insurers also run the risk of overestimating the impact of 2005’s record catastrophe losses on the price and availability of coverage in 2006. Differing views on the scope and intensity of insurer pricing power in the year ahead likely explain most of the disparity among analysts’ forecasts for net written premium growth in 2006, which range from 1.1 percent on the low end to 6.5 percent on the high side. The catastrophe factor has greatly overshadowed concerns about pricing and underwriting discipline, the industry’s historical nemesis.
Among major external risks, tort costs remain among the factors that most significantly affect insurer financial performance, despite the passage of the Class Action Fairness Act of 2005 and traction on medical malpractice reform.
Asbestos remains perhaps the largest single legislative disappointment for insurers, who generally oppose the government’s current trust fund proposal.
Terrorism also remains a key concern, despite the two-year extension of the Terrorism Risk Insurance Act signed by President Bush on Dec. 22. The extension, which has a new expiration date of Dec. 31, 2007, pushed considerably more risk onto private insurers, who have consistently maintained that large-scale terrorism events are not privately insurable. For example, individual company deductibles rise from 15 percent of direct earned premiums in 2005 to 17.5 percent in 2006 and 20 percent in 2007. Likewise, industry aggregate deductibles are raised from $15 billion currently to $25 billion in 2006 and $27.5 billion in 2007.
2006 will likely feature far fewer screaming headlines announcing investigations into various insurance industry practices such as broker compensation and finite reinsurance. That being said, insurers will need to come to grips with the very real possibility of a Gov. Eliot Spitzer following elections in November of this year.
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