Financial and Market Conditions
THE TOPIC
JANUARY 2013
Many forces affect the price, availability and security of the insurance product. Some are external, such as the state of the economy, changes in interest rates and the stock market, regulatory activity, the number and severity of natural disasters, growth in litigation and rising medical costs. Others are internal, such as the level of competition.
The insurance industry is cyclical. Rates and profits fluctuate depending on the phase of the cycle, particularly in commercial coverages. The profitability cycle may be somewhat different for different types of insurance.
First Nine Months 2012 Financial Results: Profitability in the property/casualty insurance industry rebounded during the first nine of 2012, propelled chiefly by a sharp drop in catastrophe losses and a marked acceleration in premium growth. (Superstorm Sandy made landfall in the last week of October, the first month of the fourth quarter.)
According to ISO’s PCS unit, catastrophe losses plunged by more than half (51 percent, or $16.6 billion) to $16.2 billion in the first nine months of 2012 from $32.8 billion in the first nine months of 2011 — largely the result of diminished tornado activity, lower winter storm losses and mild hurricane losses through September 30. The low level of catastrophe losses together with rising premiums, which were up 4.2 percent, contributed to a combined ratio of 100.9 in the first nine months, down significantly from 109.8 a year earlier (and from 108.2 for full-year 2011). Underwriting losses shrank by 81 percent to $6.7 billion from $34.7 billion. The industry’s bottom line benefited commensurately as overall net income after taxes (profits) surged by 221.7 percent to $27.0 billion from $8.4 billion in the same period in 2011, pushing the industry’s return on average surplus up to 6.3 percent, from 2.0 percent in the first nine months of 2011 (and from just 3.5 percent for full-year 2011). Overall industry capacity (policyholders’ surplus) rose to a record $583.5 billion as of September 30, up $12.8 billion, or 2.2 percent, from the previous record high of $570.7 billion, as of March 31, 2012.
The industry results were released by ISO and the Property Casualty Insurers Association of America (PCI).
For more details on the First Nine Months 2012 financial results please click on the following link:
| Net Earned Premiums | $335.3 |
| Incurred Losses | 243.9 |
| (Including loss adjustment expenses) | |
| Expenses | 97 |
| Policyholder Dividends | 1.1 |
| Net Underwriting Gain (Loss) | -6.7 |
| Investment Income | 35.1 |
| Other Items | 2.1 |
| Pre-Tax Operating Gain | 30.6 |
| Realized Capital Gains (Losses) | 3 |
| Pre-Tax Income | 33.6 |
| Taxes | 6.6 |
| Net After-Tax Income | $27.0 |
| Surplus (End of Period) | $583.5 |
| Combined Ratio | 100.9** |
*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.
**Includes mortgage and financial guaranty insurers. Excluding these insurers the combined ratio was 100.0.
| Net Earned Premiums | $433.9 |
| Incurred Losses | 344.5 |
| (Including loss adjustment expenses) | |
| Expenses | 124.0 |
| Policyholder Dividends | 1.9 |
| Net Underwriting Gain (Loss) | -36.5 |
| Investment Income | 49.0 |
| Other Items | 1.2 |
| Pre-Tax Operating Gain | 14.8 |
| Realized Capital Gains (Losses) | 7.2 |
| Pre-Tax Income | 22.0 |
| Taxes | 2.9 |
| Net After-Tax Income | -$19.2 |
| Surplus (End of Period) | $550.3 |
| Combined Ratio | 108.2** |
*Figures may not add to totals due to rounding. Calculations in text based on unrounded figures.
**Includes mortgage and financial guaranty insurers. Excluding these insurers the combined ratio was 106.4.
| 2007 | 2008 | 2009 | 2010 | 2011 | Percent change, 2010-2011 (1) |
|
|---|---|---|---|---|---|---|
| Revenue | ||||||
| Life insurance premiums | $138.3 | $142.8 | $120.5 | $100.2 | $122.8 | 22.5% |
| Annuity premiums and deposits | 310.4 | 323.0 | 225.4 | 286.3 | 327.0 | 14.2 |
| Accident and health premiums | 143.5 | 156.6 | 162.4 | 169.9 | 171.0 | 0.7 |
| Credit life and credit accident and health premiums | 2.2 | 2.1 | 1.6 | 1.6 | 1.6 | 1.0 |
| Other premiums and considerations | 16.8 | 0.8 | 0.5 | 23.1 | 2.1 | -91.0 |
| Total premiums, consideration and deposits | $611.2 | $625.2 | $510.4 | $581.2 | $623.9 | 7.3% |
| Net investment income | 168.0 | 162.2 | 156.6 | 164.1 | 167.3 | 1.9 |
| Reinsurance allowance | -22.4 | 17.8 | 61.5 | -29.3 | -16.3 | -44.5 |
| Separate accounts revenue | 22.9 | 21.2 | 20.4 | 23.4 | 26.1 | 11.7 |
| Other income | 35.3 | 18.3 | 27.8 | 33.9 | 34.0 | 0.2 |
| Total revenue | $815.1 | $844.7 | $776.7 | $773.3 | $835.0 | 8.0% |
| Expense | ||||||
| Benefits | 228.3 | 240.2 | 244.1 | 246.9 | 254.7 | 3.2 |
| Surrenders | 305.2 | 291.6 | 228.7 | 216.8 | 237.3 | 9.4 |
| Increase in reserves | 35.3 | 144.2 | 99.0 | 96.2 | 141.0 | 46.6 |
| Transfers to separate accounts | 66.1 | 22.7 | 11.1 | 29.3 | 32.4 | 10.8 |
| Commissions | 50.7 | 51.7 | 48.9 | 49.3 | 51.8 | 5.1 |
| General and administrative expenses | 52.1 | 53.6 | 54.2 | 56.8 | 58.5 | 3.0 |
| Insurance taxes, licenses and fees | 7.3 | 7.3 | 7.3 | 7.7 | 8.0 | 3.6 |
| Other expenses | 8.0 | 17.2 | 7.4 | 2.2 | 8.1 | 269.2 |
| Total expenses | $753.0 | $828.3 | $700.8 | $705.3 | $791.9 | 12.3% |
| Net income | ||||||
| Policyholder dividends | 17.5 | 17.7 | 15.0 | 15.0 | 15.1 | 0.8 |
| Net gain from operations before Federal income tax | 44.6 | -1.4 | 61.0 | 53.1 | 28.0 | -47.2 |
| Federal income tax | 11.5 | -0.1 | 10.7 | 9.0 | 5.1 | -43.3 |
| Net income before capital gains | $33.1 | $-1.4 | $50.3 | $44.1 | $22.9 | -48.1% |
| Net realized capital gains (losses) | -1.5 | -50.9 | -28.7 | -16.0 | -8.5 | -46.8 |
| Net income | $31.6 | -$52.3 | $21.5 | $28.0 | $14.4 | -48.8% |
| Pre-tax operating income | 44.6 | -1.4 | 61.0 | 53.1 | 28.0 | -47.2 |
(1) Calculated from unrounded data.
Source: SNL Financial LC.
BACKGROUND
The insurance industry is cyclical, particularly in the area of commercial coverages. The cycle of the early and mid-1980s was among the most severe that the industry has experienced. That cycle centered on liability insurance. The most recent hard market, which peaked in early 2004, was followed by an extended soft market, due in large part to the poor economy. Now rates are slowly edging up.
The Insurance Cycle: The property/casualty insurance industry has exhibited cyclical behavior for many years, as far back as the 1920s. These cycles are characterized by periods of rising rates leading to increased profitability. Following a period of solid but not spectacular rates of return, the industry enters a down phase where prices soften, supply of insurance becomes plentiful and, eventually, profitability diminishes or vanishes completely. In the cycle’s down phase, as results deteriorate, the basic ability of insurance companies to underwrite new business or, for some companies even to renew some existing policies, can be impaired because the capital needed to support the underwriting of risk has been depleted through losses. Cycles vary in their severity.
The insurance industry cycle is not unlike the cycle that occurs in agriculture, for example, in the wheat and beef markets. Demand for the product in both industries is relatively stable and is relatively unresponsive to price changes, while supply can vary from year to year. This means that when supply increases, lowering the price will not instantly "clear" the market of excess supply. If the price of auto insurance is cut in half, people will still buy only one policy, although they may increase the amount of coverage they purchase.
In the 1950s and 1960s, cycles were regular with a three-year period of soft pricing followed by a three-year period of hard pricing in practically all lines of property/casualty insurance. In the 1970s and 1980s, there were only two cycles, one mainly affecting auto insurance in the mid-1970s and the other in the mid-1980s, affecting commercial liability insurance. The commercial liability insurance cycle gave rise to the "liability crisis," when certain types of commercial liability coverages, such as insurance for daycare centers, municipalities, ski resorts and any establishment selling liquor, became difficult to obtain. Since that time, with the exception of the difficulty in obtaining medical malpractice insurance in the early part of the last decade, the insurance cycle has had less of an impact on the public.
Elements in Financial Results: The combined ratio is a measure of underwriting profitability. It basically reflects what is paid out in losses and expenses compared with the premiums taken in. A combined ratio above 100 means that the industry is losing money on its underwriting operations. Besides underwriting, property/casualty insurance companies have a second source of income—investments. In a period when interest rates are very high, investment income can help offset underwriting losses. In the 1980s, for example, when interest rates were high, business could still be profitable even though the combined ratio was above 100. But for the past decade or more, interest rates have been low. In such an environment, the industry needs a combined ratio of below 100 to show a profit.
Investment gains come largely from interest on bonds, stock dividend and realized capital gains. When investment income is high, companies have an incentive to bring in more cash, and, in the competitive marketplace, they attempt to do this by cutting rates to attract new business. As investment income goes up, prices may decline. However, ultimately the combined ratio increases because what is coming in—premium revenue—is declining, or growing at a very slow rate, while what is going out—claims payments and expenses—is either unchanged or rising. When interest rates and stock market earnings drop, there is less investment income to offset underwriting losses. The insurance industry is one of the largest institutional investors.
Property/casualty insurers hold a large percentage of their investments in the form of bonds to protect their assets against precipitous stock market declines. Typically, about two-thirds of total investments are in bonds and about one-fifth are in common stock. The exact figure fluctuates according to stock market trends. The asset quality of the industry’s investments is high. Bonds in or near default (Class 6) generally account for a tiny percentage (much less than 1 percent) of all bonds owned by insurers.
A critical element in the relationship between investment and underwriting results is the time lag that sometimes exists between premium payment and the ultimate payment of claims, which enables insurers to earn interest income on the cash inflow from premiums before losses are paid. This is an important element in liability insurance, where the time lag between the occurrence of an insured event or accident, such as exposure to a toxic substance and the harm that it causes, can be many years. The illness may be developing in the body but may not be detected until long after the person was exposed to the substance. The kinds or "lines" of insurance where this time lag may occur, such as product liability insurance, are known as long-tail lines. Lines of insurance where the time lag between payment of premium and payment of a loss is short are known as short-tail lines. Fire insurance, where claims are filed almost immediately after a fire occurs and generally within the policy period, is an example of a short-tail line, as are most other property damage coverages.
Policyholders’ Surplus: Policyholders’ surplus is essentially the amount of money remaining after an insurer’s liabilities are subtracted from its assets. Policyholders’ surplus is a financial cushion that protects a company’s policyholders in the event of unexpected or catastrophic losses. In other industries it is known as “net worth” or “owners’ equity.” It is a measure of underwriting capacity because it reflects the financial resources (capital) that stand behind every policy written by the insurer. A weakened surplus can lead to ratings downgrades and ultimately, if the situation is serious enough, to insolvency.
Policyholders’ surplus is not transferable from one segment of the industry as a result of improved underwriting or investment performance to another. A large increase in surplus for auto insurers, for example, cannot be used by commercial lines companies to provide coverage to corporations against terrorism attacks. Likewise, surplus accumulated by a workers compensation insurer in Mississippi cannot be used to underwrite its homeowners insurance business in California.
Expense Ratios: Every industry's profitability is affected by the cost of doing business. In the property/casualty insurance industry, expenses are made up of commissions and other expenses such as salaries, rent and the cost of utilities. The expense ratio is calculated by dividing expense items (before federal taxes) by written premiums. Expense ratios tend to fluctuate with premium growth. While commissions move with changes in premiums, other expenses are fixed. Thus, when premiums are flat, fixed expenses tend to push up the expense ratio. For 1999 and the years leading up to it, the expense ratio was particularly high, rising to 28.0 percent from 26.0 or less, in part because of technology improvements and the cost of preparing for the year 2000.
How does an expense ratio in the property/casualty industry compare with other industries? Because industries differ, there are conceptual and technical problems in comparing expenses across industries. For example, in hairdressing, which is a basic service business, expenses are close to 100 percent of sales since all costs are in the expense area. By contrast, expense ratios for crude oil production are usually low. Once a well is pumping, very little expense is incurred in storing and transporting the oil to market.
Risk Management
The insurance industry is conservative. A conservative approach permeates almost every aspect of the business from statutory accounting practices, which emphasize a company’s present solvency, see report on Insurance Accounting, to the requirement that the risk assumed in issuing insurance contracts (policies) is in line with the insurer’s capital or surplus account.
Three hallmarks of insurance company risk management separate the insurance industry from other financial services. First, in general insurers do not borrow to make investments or pay claims. So when some investments perform poorly, the effect is not magnified as it is when investments are highly leveraged. Second, insurers use historical experience and sophisticated modeling techniques to match risk to price and, as mentioned above, they limit the aggregate amount of risk they assume to the capital they have on hand. Third, insurers keep the risk they assume on their own books. Even when they lay off some of the risk to reinsurers, typically the reinsurer will require the primary company to keep a portion of the risk. Having “skin in the game” acts as a strong incentive to underwrite carefully. Inattention to underwriting can lead to reduced profits.
Market Conditions
As in any other industry, the price and availability of insurance are governed by insurers' assessments of profitability. However, unlike most other industries, this assessment is also governed by the regulatory climate and geographical considerations.
Catastrophes: As commercial and residential development along the Atlantic and Gulf coasts mushroomed in the 1980s, insurers' exposure to hurricane losses soared. A study by AIR Worldwide estimated that the value of insured coastal property exposed to hurricane losses at $10.2 trillion in 2012 or 37 percent of the value of all property in coastal states. In Florida alone, a state with coastal properties that amount to 79 percent of its total property values, insured coastal properties were valued at more than $2.8 trillion. New York was a close second.
The buildup of property values coincided with a lull in hurricane activity. But Hurricane Andrew (1992) and the Northridge earthquake (1994) and an unusually high number of major hurricanes in the 2004 and 2005, culminating with hurricanes Katrina, Wilma and Rita, which together caused close to $56 billion in insured property damage according to ISO, have drawn attention to the risks the insurance industry now faces. Sophisticated modeling of disaster scenarios suggest that a major hurricane hitting Miami could cost insurers as much as $80 billion. Before Hurricane Andrew, the outside range of insured damage from a major disaster was thought to be about $8 billion.
The buildup in insurable values in coastal states together with predictions of greater losses is causing insurance companies and their reinsurers to reassess the magnitude of their loss exposure in these areas and to limit growth in geographical markets where their exposure to loss is too great. They are also requiring policyholders in the riskiest parts of the country to share more of the loss through larger deductibles, generally a percentage of the insured value of the dwelling. In addition, the price of property insurance along the Atlantic seaboard is increasing as reinsurers, the insurers of insurance companies, raise their prices for coverage and primary companies reassess their risk exposure in light of new information on potential losses.
Also contributing to rising prices are new demands from the rating agencies that assess insurance companies’ financial health. Rating agencies now require insurers to boost their capital to be able to deal with the higher catastrophe risk they are now seen to be assuming. Until recently, rating agencies looked at a company’s exposures to losses relative to a 100-year catastrophic event, meaning that the likelihood of such a storm occurring in any given year was slight, at 1.0 percent. But events that were once thought to be relatively rare are occurring with increasing frequency. As a result, agencies have raised the threshold for capital adequacy to an event that is expected to occur once in 250 years. In addition, they are looking at potential losses from catastrophes in the aggregate—two megadisasters in quick succession, for example—and requiring a company’s estimates of its probable maximum loss to include such items as demand surge. Demand surge in this context is the increase in the cost of labor and materials as demand rises for building contractors to repair damage after a natural disaster. This pushes up the size of claims. Not surprisingly, since the 2005 hurricane season, many insurers have adopted more conservative approaches to managing their exposure to catastrophic losses. Those that do not may face rating downgrades, which in turn affects their costs of raising capital and, if the downgrades are severe enough, their ability to attract new business.
In addition to the heightened risk of natural disasters, the insurance industry now faces the risk of terrorist attacks. The Terrorism Risk Insurance Act of 2002 (TRIA) was renewed at the end of 2005 for two years and at the end of 2007 for a further seven years. Rates for terrorism insurance have fallen significantly over the past few years, with the result that an increasing portion of businesses are purchasing the coverage, see report on Terrorism Risk and Insurance.
Distribution Systems: According to the Independent Insurance Agents & Brokers of America, Inc., the number of independent insurance agencies has fallen over the last decade. In 1992 there were 46,000 and in 2010 there were 37,500, as agencies declined in number but grew in size. About two-thirds of commercial insurance is sold by companies that use independent agents and about two-thirds of personal insurance is sold directly or through captive agents that work for a single company.
However, an increasing number of auto insurance companies are experimenting with multiple distribution channels. Several major companies in both personal and commercial lines business now use or plan to use both insurance agents and direct sale methods to reach consumers, including the Internet and phone. New insurance-related entities are springing up on the Internet. Some provide quotes from many insurance companies, others act as a conduit to insurance agents. Employers are also expected to become major distributors of insurance products, offering auto insurance and other coverages through payroll deduction plans. Various organizations also distribute insurance to their members. Affinity sales, or selling through groups, represent a growing distribution channel, according to a study by Conning Research & Consulting. In addition, banks are increasingly selling property/casualty insurance to their banking clients.
The Marketplace: A gradual change is occurring in the property/casualty insurance marketplace. There are fewer multiline companies—those that sell both personal lines of insurance (auto and homeowners) and commercial insurance for businesses. Several personal lines companies are now selling products that used to be sold exclusively by other sectors of the financial services industry and many banks and some stock brokerage firms are selling insurance products. Some companies that used to distribute their products through their own employees are also using all distribution systems, including direct response and independent agents. In addition, many companies, large and small, are directing their attention to specialized market niches. And, as the large commercial lines insurers seek overseas markets, there is a growing divergence between these companies and small insurers with a more regionalized approach.
Sophisticated commercial customers in recent years have turned increasingly to captives and other alternative markets. Overall more than 40 percent of commercial lines premium has now left the traditional insurance market, according to the A.M. Best Co. The hard market at the beginning of the 2000s may have encouraged additional companies to explore other ways of financing risk. Property coverages represent the smallest percentage, in part because of their generally lower cost. Where once only the largest corporations used nontraditional mechanisms, middle-market companies are now joining purchasing or "affinity" groups in an attempt to obtain better terms and prices, or self-insuring some risks.
Federal Taxation of Insurance Companies: Up to the end of 1986 insurance companies paid 46 cents to the federal government on nearly every dollar of taxable income. Under the current tax code, insurance companies are taxed at a rate of 35 cents on the dollar, the basic rate for all businesses. Because property/casualty companies have significant interest income from tax-exempt state and local government bonds, taxable income usually is lower than net income as reported in financial statements. A variation between taxable income and net income is not unique to the insurance industry. Indeed it is not unique to corporations, as taxpayers will recognize from experience in filling out their income tax forms.
In property/casualty insurance, the basis for computing income for tax purposes is the statutory Annual Statement, submitted annually to the state insurance departments. While maintaining statutory accounting for most purposes, the 1986 federal Tax Reform Act made several changes in the way taxable income is computed for federal income tax assessments. These include discounting loss reserves; reducing the size of unearned premium reserves, thus increasing income; taxing a portion of interest from otherwise tax-exempt bonds; and eliminating some previous provisions that helped reduce the impact of catastrophic losses for mutual insurance companies. Statutory accounting as it is now, which is more conservative than GAAP accounting, is likely to undergo some changes in the years to come as insurance accounting globally undergoes more standardization, see report on Insurance Accounting.
State Premium Taxes: In addition to federal taxes, insurers pay taxes to each state based on premiums paid by policyholders. Premium taxes totaled $16.4 billion in 2011. On a per capita basis, this works out to $53 for every person living in the United States. Premium taxes accounted for 2.2 percent of all taxes collected by the states in 2011.
KEY SOURCES OF ADDITIONAL INFORMATION
The I.I.I. Fact Book, Insurance Information Institute, published annually.
I.I.I. Web Site: http://www.iii.org.
© Insurance Information Institute, Inc. - ALL RIGHTS RESERVED