Steve Wevodau

By Dr. Robert P. Hartwig, CPCU
President
Insurance Information Institute
bobh@iii.org

The property/casualty (P/C) insurance industry reported an annualized statutory rate of return on average surplus of 5.4 percent during the first half of 2008, down by nearly two-thirds from 13.1 percent during the first half of 2007 and by more than half from the 12.3 percent return for all of 2007. The sharp decline in profitability is partially attributable to a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the property/casualty insurance industry. The decline in profitability was led by a substantial deterioration in underwriting performance in those two segments, pushing the first-half combined ratio up to 102.1, more than 9 points above the 92.7 combined ratio for the same period last year and 6.5 points above the 95.6 combined ratio for full-year 2007. Excluding mortgage and financial guarantee insurers reveals declines of a more modest and cyclical nature, with return on average surplus coming in at 7.6 percent (compared to 12.8 percent in first-half 2007). Net written premium growth, which turned negative in 2007 for the first time since 1943 (down 0.6 percent), continued on its negative trajectory, falling once again by 0.6 percent (-0.7 percent excluding mortgage and financial guarantee insurers). Policyholders’ surplus, a measure of capacity, decreased for the third consecutive quarter, down 2.5 percent to $505.0 billion as of June 30 from $517.9 billion at year end 2007. The results were released by ISO and the Property Casualty Insurers Association of America (PCI).

Mortgage and Financial Guaranty Lines Drive Underwriting Results, Obscuring Modest Cyclical Deterioration and Impact of Catastrophes

Three key factors drove underwriting performance during the first half: the impact of the housing and credit crisis on mortgage and financial guarantee insurers and the resulting spillover into the overall property/casualty insurance industry sector’s financial results; the continuation of soft market conditions through much of the industry; and a surge in catastrophe losses. Each of these factors is discussed in detail below.

Underwriting: Separating Mortgage and Financial Guarantee Impacts
The financial performance of the property/casualty insurance industry for 2008 continues to require more explanation than usual. The credit crisis and ensuing economic downturn combined with falling interest rates, poor equity market conditions, mounting inflationary pressures and resurgent catastrophe losses—all amid a prolonged soft market—mean that each reporting period’s results must be examined carefully in order to assess the influences of these factors. Care must be taken to avoid overgeneralizations as the mix and intensity of factors influencing any one sector of the industry or any specific insurer will vary.

The first-half’s underwriting performance was influenced significantly by underwriting losses reported by many mortgage and financial guarantee insurers. While it is not unusual for results in any given quarter to be driven by the experience in a small number of lines or by a specific event (such as home and commercial property coverage after a major catastrophe), it is rare for lines that account for just a sliver of industry premiums to produce large-scale impacts on industry performance. The mortgage and financial guarantee lines—with $4.1 billion in net written premiums during the first quarter—accounted for just 1.8 percent of the $221.9 billion industrywide total. Nevertheless, according to ISO, the loss and loss adjustment expenses of this segment ballooned to $10 billion—an increase of 462.2 percent—propelling its combined ratio to an unprecedented 242.3 for the half compared to 74.1 during the first half of 2007. That was enough to add 2.9 points to the industrywide combined ratio, which finished the first half at 102.1—its highest level in six years.

Cyclical Considerations
The second most important factor influencing first-half underwriting performance was the continuation of the soft market, now well into its fourth year. As previously discussed, stripping out the mortgage and financial guarantee insurer results yields a combined ratio of 99.2, up from 93.0 in first half 2007 and 95.6 for all of 2007. The deterioration is generally in line with expectations and reflects the effects of a sustained, highly competitive pricing environment for most types of insurance, particularly commercial lines, as well as adverse claim frequency and/or severity trends in some key lines—not to mention higher catastrophe losses. According to the Council of Insurance Agents and Brokers, commercial renewals for larger brokered accounts were down 13.5 percent during the first quarter and 12.9 percent during the second. Of course, actual changes experienced by individual insurers can vary substantially and few commercial insurers are actually reporting premium declines of this magnitude. In contrast, pricing in personal auto insurance, which accounts for one-third of industry premiums, appeared to become somewhat firmer during both the first and second quarters. According to the U.S. Bureau of Labor Statistics, auto insurance prices averaged 1.7 percent higher during the first half of 2008 compared with the first half of 2007. This compares to an increase of 0.4 percent for all of 2007 relative to 2006. The pace of increase appears to be quickening. Through the first eight months of 2008, auto insurance prices averaged 2.0 percent higher than during the same period one year earlier. In fact, auto insurance prices were up 0.9 percent in January 2008 compared with January 2007 but were up 3.0 percent in August versus a year earlier. Pressure on auto insurance rates is driven primarily by rising claim cost severity (average cost per claim) and increasing claim frequency for some coverages in some states. The increases are still well below the general rate of inflation as measured by the Consumer Price Index, which exceeded a 5 percent annual rate of growth during the second quarter. The issue of rising gas prices and its impact on driving and claim frequency and costs will be discussed below.

Premium Growth Remains Negative
Net written premiums declined by 0.6 percent during the quarter. Excluding mortgage and financial guarantee, insurers produced a net decline of 0.7 percent. The premium decline is larger excluding mortgage and financial guarantee insurers because of that segment’s 5 percent increase in premiums written during the quarter. The overall decline comes on the heels of a 0.6 percent decline in calendar year 2007. Last year’s decline was the first in 64 years, when premium growth fell in 1943 in the midst of World War II.

Catastrophe Losses: First Half Total Exceeds All of 2007
As noted by ISO, insured catastrophe losses reached $10.3 billion during the first half, their highest level for any first half since 1994, when losses from the Northridge earthquake topped $14.5 billion. The first-half catastrophe losses were also higher than the 12-month totals for both 2006 and 2007, at $9.2 billion and $6.7 billion, respectively.

Catastrophe losses during the first half of 2008 were fueled primarily by record-breaking tornado activity, severe hail and wind losses (apart from tornadoes). During the second quarter, the Midwest suffered its most severe floods since 1993—which cost private insurers $600 million. While flooding is not covered under standard home insurance policies, private insurers do cover flooded motor vehicles (provided the policyholder carries comprehensive coverage) and some businesses purchase protection on commercial structures along with business interruption and contingent business interruption losses in some cases. Private crop insurance is also commonly purchased. It is important to note that crop (agricultural) losses are not included in the official catastrophe figures compiled by ISO’s PCS unit.

The losses have continued apace through the third quarter, historically the most expensive for insurers due to the fact that the peak of hurricane season occurs in September. The most significant catastrophe so far in 2008 was Hurricane Ike, which roared ashore in Galveston, Texas, on September 13 as a strong Category 2 storm. Official PCS insured loss figures were not available as of this writing, but by averaging the midpoint of independent catastrophe modeling firm estimates, insured losses from the storm appeared to total approximately $9.8 billion. If this figure holds, Ike will become the fourth most expensive hurricane in United States history. Ahead of Ike (stated in 2007 dollars) are Hurricane Katrina ($43.6 billion), Hurricane Andrew ($22.9 billion) and Hurricane Wilma ($10.9 billion). Because the range across all modeling firms’ estimates extends from a low of $7 billion to a high of $12 billion, Ike could potentially be ranked as the third most expensive storm in history. Much of the loss in Texas will be borne by the Texas Windstorm Insurance Association, which insures the majority of properties in the state’s coastal counties.

Hurricane Ike was not the only severe hurricane of the year. Hurricane Gustav caused $1.9 billion in insured losses, according to PCS, when it struck the Louisiana coast on September 1.

Investments
The first half of 2008 was a very volatile one for investment markets, which were roiled by waves of bad news about credit markets, skyrocketing oil prices and economic weakness. The Standard & Poor’s 500 Index lost 12.8 percent during the first half. With the S&P down 24.7 percent through September 29, stocks appear headed for their first losing year since 2002, when the Index lost 23.4 percent of its value. It is important to note that approximately 17 percent of P/C insurer invested assets are equities (stocks) while two-thirds are bonds. Bonds, of course, are sensitive to interest rates. The Federal Reserve cut its key federal funds rate on four occasions by the end of March, including twice by three quarters of a point—the first 75 basis point cut by the Fed since November 1994. By the end of the first quarter the fed funds rate stood at 2.00 percent compared with 4.25 percent on January 1 and has remained at that level through the second and third quarters.

The upshot of the volatility, according to ISO and PCI, is that the industry’s total investment gain slipped by 18.4 percent or $5.6 billion to $24.8 billion from $30.3 billion during the first half of 2007. Investment gains consist primarily of interest earned from the industry’s bond portfolio as well as realized capital gains and losses from investments, especially stocks. Contributing to the decline was a $1.1 billion realized capital loss compared to a $10.4 billion gain during the same quarter last year. Insurers realized $9.0 billion in investment for all of 2007. It is too soon to estimate realized investment gains or losses for the full year. Although markets were down further during the third quarter, they remain exceedingly volatile. Moreover, capital gains (and losses) are realized at the discretion of management. The last time insurers turned in an industrywide realized capital loss for a calendar year was 2002.

Profitability and Capacity
Strong profits over the past several years gave insurers the opportunity to make significant reinvestments in the industry. Profits bolster the industry’s policyholders’ surplus—a measure of claims-paying capacity or capital—and provide an additional buffer against the mega-catastrophes that lie ahead. The improved capital position also helped insurers meet the higher capital requirements imposed on them by ratings agencies in the wake of Hurricane Katrina; requirements that oblige insurers to demonstrate an ability to pay claims arising from more than one major catastrophe per year in order to maintain and improve financial strength ratings. Recent turbulence in the financial markets is another reminder of the importance of healthy profits. Insurers must maintain the financial resources to pay record size mega-catastrophe claims no matter how low interest rates fall or how far or fast stock markets plunge.

Net income after taxes (profits) during the first half of 2008 fell $18.8 billion or 57.4 percent from $32.7 billion during 2007’s first half. The decline is attributable to the previously discussed deterioration in underwriting and investment performance. Losses at mortgage and guarantee insurers are another key factor. Excluding those insurers would imply a smaller reduction in net income of 38.8 percent, according to ISO/PCI.

Because profits fell more quickly than policyholders’ surplus, return on average surplus declined to 5.4 percent during the first half, down from 13.1 percent during the same period one year earlier and 12.3 percent for all of 2007. Excluding mortgage and financial guarantee insurers yields a return on average surplus of 7.6 percent during the first half compared with 12.8 percent in the period a year earlier.

Policyholders’ surplus decreased in the first half by $12.9 billion, or 2.5 percent, to $505.0 billion from $517.9 billion at year-end 2007. The decline is the third consecutive quarterly drop in policyholders’ surplus, which recently peaked at $521.8 billion during the third quarter of 2007. The net $16.8 billion decline in surplus represents a reduction of 3.2 percent in the industry’s capital base. Surplus increased by 6.2 percent in 2007, 14.3 percent in 2006, 8.2 percent in 2005, 13.4 percent in 2004 and 21.6 percent in 2003, following declines in 2000, 2001 and 2002. The return to negative capital accumulation is attributable to several causes, the largest and most obvious being declining prices for financial assets. During the first half, insurers recorded unrealized capital losses totaling $18.5 billion in addition to $1.1 billion in realized capital losses. Some insurers also continue to return capital to shareholders through dividends and share buybacks. Share buybacks reached a record $23.2 billion in 2007.

The Global Financial Crisis: Implications for Insurers

The credit crunch that began with the subprime mortgage meltdown in mid-2007 has precipitated a broader economic crisis in the United States and abroad that has challenged every industry in ways that were not foreseen a year ago—insurers included. The insurance industry’s financial performance in 2008 has been bruised by the bloodshed on Wall Street. That being said, insurance has remained the most resilient of the financial services segments.

The scope of destruction arising from the nation’s credit crisis is both frightening and breathtaking. Amid the wreckage are all five of the nation’s investment banks—all highly levered institutions that made too many bad bets in risky subprime mortgages and related securities. Lehman Brothers, having survived innumerable crises over its 158 years of existence, filed for bankruptcy on September 15. Back in March, Bear Stearns was effectively bankrupt before the Federal Reserve agreed to take $29 billion in risky debt of its books while at the same time forcing it into the arms of JPMorgan Chase. Merrill Lynch saw the writing on the wall after Lehman’s bankruptcy and on that same day sold itself to Bank of America for about $50 billion—half its value of just a year earlier. With their stock under siege and their operating models badly damaged by the seizure of credit markets, the two remaining investment banks, Morgan Stanley and Goldman Sachs, successfully petitioned the Federal Reserve to convert to bank holding companies—effectively ending in a span of less than six months the Wall Street model that had reigned since the Great Depression.

That was not all, not even by a long shot. The year has borne witness to some of the largest bank failures in United States history. The September 26 bankruptcy of Washington Mutual—with $307 billion in assets—was by far the country’s largest. On July 12, the government seized IndyMac Bank, with $32 billion in assets, ranking the collapse as the third largest (now the fourth) of all time. On September 29, Wachovia (the sixth largest US bank by assets) narrowly averted bankruptcy through an FDIC-assisted purchase by Citigroup.

On September 7 federal regulators also seized Fannie Mae and Freddie Mac, the nation’s largest mortgage lenders, which collectively own or guarantee $5.4 trillion in mortgages—about half of the U.S. total.

These events and many others persuaded Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and President Bush (not to mention presidential candidates John McCain and Barack Obama) that an emergency “bailout” plan was necessary in order to shore up shaky financial institutions, restore the flow of credit and avoid a total financial collapse. After much effort, the Emergency Economic Stabilization Act of 2008 was put to a vote in the U.S. House of Representatives on September 29 but failed. The “Troubled Asset Relief Program” proposed within the bill would have created a mechanism for financial institutions to sell to the government as much as $700 billion in problem mortgage-related assets. The failure of the bill led to a drop of nearly 800 points on the Dow Jones Industrial Average—the largest drop in history.

On a global scale, governments have worked to try to contain the financial contagion by injecting liquidity. In an unprecedented move on September 29, the governments of Belgium, the Netherlands and Luxembourg nationalized Fortis, a bank and insurance conglomerate that is one of Europe’s largest financial institutions, with an injection of 11.2 billion Euros ($16.4 billion). Fortis suffered from its exposure to certain structured credit assets and a loss of confidence among investors.

The AIG Rescue Package
One of the most dramatic moments in the financial crisis to date, and certainly the event that would have had the greatest impact on the insurance industry on a global scale, was the near bankruptcy of American International Group (AIG). AIG suffered a severe liquidity crisis at the holding company level (not in its insurance subsidiaries) and was only able to avert bankruptcy at the eleventh hour when the Federal Reserve agreed to loan AIG $85 billion to allow it time to conduct an orderly sale of certain assets. The company intends to sell non-core assets in order to repay the loan. AIG’s problems arose primarily at a non-insurance financial products subsidiary based in London. Its 71 US-domiciled insurance subsidiaries, according to statements made by the company and state regulators, were at all times solvent and held capital that met or exceeded requirements in every jurisdiction in which they operated. In exchange for the two-year loan for which the Fed will earn a return of 850 basis points over LIBOR on sums borrowed, the government received a 79.9 percent majority ownership stake in the company, and also installed a new CEO.

Are Insurance Companies a Pillar of Strength in the Financial Services Sector?

A case can be made that the property/casualty insurance industry has fared relatively well since the beginning of the global credit crisis in mid-2007. Investment portfolios are generally conservatively managed. Although AIG made big headlines when it appeared headed toward bankruptcy, insurance regulators throughout the United States and abroad made it clear that the insurance subsidiaries they supervise were solvent and that the problems arose in non-insurance operations. As discussed previously, there have indeed been severe problems at several financial guarantee and mortgage insurers.

More fundamentally, insurance companies have avoided most of the problems of the investment banks and many other financial institutions because of their superior risk management model. Specifically insurers have done a better job of ascertaining and underwriting risks. Many banks “gave away the pen” and allowed mortgage brokers to peddle loans to people with increasingly poor credit characteristics. Because these mortgages could be pooled and sold as mortgage- backed securities, originators of mortgages had little or no “skin in the game” and consequently no stake in the long-term performance of the loan. This separation of underwriting and risk bearing contrasts sharply with insurers’ approach to underwriting and risk management. Insurer control over underwriting authority is much tighter. And although insurers spread risk through the use of reinsurance, they always retain some share of the losses.

Insurers are also much less dependent on borrowed money than are banks and investment banks. Most of the major investment banks in the United States borrowed 25 to 30 dollars for every dollar they held in capital. Large debt burdens are uncommon in the insurance world.

The reality is that throughout its nearly 200-year history in the United States, the property/casualty insurance industry has endured every conceivable economic circumstance and crisis and managed to persevere. Financial panics, deep recessions and war plagued the country throughout the nineteenth century and well into the first half of the twentieth. Since then inflation, stagflation, stock market bubbles and gyrating interest rates have made their presence known, but ultimately insurers have managed their way through each of these challenging periods. Experience has demonstrated that insurers, unlike banks, rarely run into deep financial trouble because of poor economic conditions. Instead, it is deficient loss reserves and inadequate pricing that historically account for the lion’s share of insurer impairments.

The Weak Economy and Credit Crunch: Implications for Insurers

While the economy may have averted sinking into an official recession during the first half of 2008 (defined as two consecutive quarters of negative real GDP growth), a steady stream of bad economic news, from slumping home prices and sales to record oil prices to rising unemployment have begun to take their toll on the wallets and confidence of consumers and the businesses that depend on them. Some of the key impacts of the economic downturn for insurers are reviewed in the sections below.

Exposure Impacts
While property/casualty insurers are by no means immune from the effects of the current economic downturn, the impacts in terms of growth and profitability will be somewhat muted. In terms of revenue, P/C insurers are distinct from more economically vulnerable sectors such as homebuilders or carmakers. This is because approximately 98 to 99 percent of insurer exposure growth (measured in units) is tied to renewal business. In contrast, 100 percent of a homebuilder’s or car manufacturer’s growth, for example, comes from new business. The relationship between insurance and the overall economy is actually more akin to that of the utility sector or the consumer staples segment. Insurance is, in effect, an economic necessity, not a discretionary purchase. Homes, cars, businesses and workers all need to be insured irrespective of the state of the economy. To be sure, the precipitous 54 percent decline in new home construction from 2.07 million units in 2006 to an estimated 0.94 million units in 2008 will hurt growth prospects for homeowners insurers, but only on the margins. The reality is that the aggregate stock of housing grows by less than two percent annually even in the best of times. Likewise, the 11.2 percent drop in new car and light truck sales from 16.9 million in 2005 to about 15.0 million this year will have little impact on the total number of insured vehicles on the road, as older cars are simply kept on the road a bit longer. Again, the influence is at the margins: slightly fewer cars on the road with somewhat lower average premiums than would otherwise be the case if the economy had not soured. Other marginal impacts include workers compensation, where the combination of rising unemployment (up to 5.5 percent in May) and minimal wage gains will stunt payroll growth (and therefore premium growth) in 2008, as was the case during the last recession in 2001. The economy has already shed 605,000 jobs this year (January through August) compared to total job losses of 2.7 million between January 2001 and August 2003. Despite the job losses over that 32 month period, workers compensation premium growth never declined.

Frequency and Severity Impacts
Economic downturns can impact frequency and severity trends in addition to exposure growth. According to the National Council on Compensation Insurance, for example, lost time workplace injury incidence rates declined during each of the past four economic downturns.

Apart from the subprime and credit crises, most of the discussion related to the economy, especially in recent months has centered on record high oil prices and rising inflation. Historically both have had significant impacts on the industry.

Rising Energy Prices and Personal Auto Insurance Claim Behavior
Americans have a love affair with the automobile and it takes a lot to keep them from getting behind the wheel. It seems that $4 per gallon of gasoline was the straw that broke the camel’s back for many car owners. As gasoline breached that record price late in the first quarter and into the second, miles driven in the United States began to decline for the first time in 30 years.

In 1973/1974 and again in 1979/1980, oil shocks sent gasoline prices to record highs—if it was available at all. People drove less and consequently were involved in fewer motor vehicle accidents. According to ISO Fast Track data records for the period coincident with the Arab oil embargo of 1973/1974, personal auto claim frequency for collision, property damage liability and bodily injury coverages fell by 7.7 percent, 9.5 percent and 13.3 percent, respectively. After the embargo was lifted and gas prices began to fall, claim frequency rebounded almost immediately, reaching pre-crisis levels within two to three years.

Claim severity, in contrast, tended to increase after the oil shocks. The reason is that the increase in oil prices drove inflation for most goods and services higher, pushing up repair, replacement and labor costs. Medical costs and ultimately tort costs were also driven higher.

The analogy between the energy price shock today and the 1970s is not a perfect one. Gasoline is available today, whereas that was not always the case during the supply crises of the 1970s. Congress also lowered the speed limit to 55 miles per hour in 1974 as part of the Emergency Highway Energy Conservation Act (authority to regulate speed limits on highways was returned to the states in 1995). The act contributed to the reduction in accident frequency. No such legislation is currently before Congress.

Summary

Economic turbulence has had an impact on the financial and underwriting performance of the P/C insurance industry during the first half of 2008. The sharp decline in profitability is primarily attributable to a spillover of the housing and credit bubble collapse into the mortgage and financial guarantee segments of the property/casualty insurance industry. Excluding this segment reveals a much more modest decline in profitability more in keeping with the pace normally associated with cyclical downturns. Volatile investment markets also contributed to the decline. One continued cause for concern in 2008 is that premium growth remains in negative territory and is, in fact, severely negative on an inflation-adjusted basis.

Fundamentally, however, the property/casualty insurance industry remains quite strong financially, with policyholders’ surplus close to all-time record highs.

A detailed industry income statement for the first half of 2008 follows: