Seven Lessons from History As property-casualty operating results for2002 come into sharper focus, viewing insurer performance from along-term perspective illuminates the challenges and opportunitiesfacing insurers. Going forward, the success of each insurer and thehealth of the insurance industry will depend on the extent to whichinsurers heed the lessons of history.

We are in a hard market, and the hard market is spurringimprovement in insurers financial results.

Premiums grew 14.1 percent in 2002, with premium growth lastyear being the strongest since the 22.2 percent increase in1986.

Loss and loss adjustment expenses rose just 2.6 percent in 2002,as catastrophe losses receded from record levels inflated by thetragedy on September 11, 2001.

Reflecting the excess of growth in premiums over growth inlosses, net losses on underwriting fell to $30.5 billion in 2002from a record $52.6 billion in 2001.

Net income after taxes recovered to positive $2.9 billion lastyear from negative $7.0 billion in 2001.

We expect underwriting results and net income to improve furtherin 2003, as strong premium growth continues working its way down tothe bottom line.

But with history as our guide, there is little reason to expectresults will continue improving much longer. On the contrary,history suggests each improvement in insurers results brings us onestep closer to the day when disciplined underwriting gives way to amisguided drive for market share.

If premium growth remains at double-digitlevels this year, 2002 and 2003 will be the first consecutive yearsof double-digit growth since 1985 and 1986. And, since 1960, theindustry has enjoyed only one period when premium growth remainedat double-digit levels for more than two years.

These simple truths suggest the next soft market may not be faroff.

Lesson One: Transitory hard markets ultimatelytrigger a return to competitive excesses and deterioration inprofitability.

While insurers did enjoy five years of double-digit growth from1975 to 1979, that growth ultimately triggered a soft marketleading to the industrys worst-ever combined ratio.

During the 1970s, premium growth peaked at 22.0 percent in 1976,and the combined ratio then got as good as 97.1 in 1977. That year,the industrys rate of return on average surplus peaked at a record23.1 percent.

But competition then drove premium growth down to just 3.8percent in 1981, and growth remained below 5.0 percent through1983. As a result, the combined ratio deteriorated to a record poor118.0 in 1984, and return on surplus dwindled to 1.3 percent.

What followed was a knee-jerk recovery, with premium growthspiking to a record 22.2 percent in 1985 and 1986. Premium growthremained relatively strong in 1987 at 9.4 percent, and theindustrys combined ratio improved to 104.6 that year.

With the industrys return on surplus at 13.9 percent in 1987,one might have hoped for a period of stability in insurance marketsduring which insurers earned reasonable returns. But, once again, ahard market had sown the seeds of its own destruction, with theinsurance industry slipping into the most protracted soft market inits history.

In 1988, premium growth fell to just 4.4 percent, with the worststill to come. Unprecedented in the industrys history, premiumgrowth remained below 5.0 percent in 11 of the 12 years from 1988to 1999, with premium growth eventually hitting a record-low 1.8percent in 1998.

With premium growth virtually unchanged at 1.9 percent in 1999,the combined ratio worsened to 107.8 percent, and return on surplusfell to 6.5 percent.

Even those poor results, however, paint amisleadingly rosy picture of insurers profitability on an ongoingbasis, distorted as they were by year-to-year swings in catastrophelosses, environmental and asbestos losses on policies written longago, and deterioration in reserve adequacy. Adjusted forcatastrophes, environmental and asbestos losses and reservedeficiency, the combined ratio deteriorated to 109.0 in 1999 and114.4 in 2000.

And insurers financial performance in the late 1990s would havebeen worse if not for capital gains generated by booming stockmarkets.

Lesson Two: Insurers cannot rely on capitalgains to generate surplus.

The S&P 500 rose 15.3 percent per year on average during the1990s. Reflecting the strength in equity markets, insurers enjoyedcapital gains averaging $17.0 billion per year during thatdecade.

But for the three years ending December 31, 2002, the S&P500 fell an average of 15.7 percent per year, and insurers postedcapital losses averaging $11.8 billion per year.

In 2002, the industrys $21.7 billion in overall capital lossesdrove a $4.4 billion decline in surplus.

Insurers can neither rely on capital gains to generate surplus,nor can they rely on growth in investment income.

Lesson Three: Insurers cannot rely onever-increasing investment income to paper over underwriting lossesin the next soft market.

Growth in investment income dwindled from 18.7 percent per yearin the 1970s to 12.8 percent per year in the 1980s and 2.2 percentper year in the 1990s.

For the first three years of this decade, investment income hasfallen at an average rate of 1.9 percent per year.

Investment income grew each year from 1960 through 1991. But in1992, investment income fell for the first time on record. Andinvestment income has declined in six of the 11 years from 1992 to2002.

With investment income falling 7.3 percent in 2001 and another2.8 percent in 2002, insurers cannot depend on growth in investmentincome to offset growth in underwriting losses during the next softmarket.

Recent declines in investment income reflect declines in marketyields. The yield on 10-year Treasury notes fell to an average of4.6 percent in 2002–the lowest yield on 10-year Treasuries on anannual basis since 1965. With investment results dependent ondevelopments insurers cannot control, we come to lesson four.

Lesson Four: Each insurer must focus on what itcan control–underwriting, pricing, exposure management and lossadjudication.

Underwriting is risk assessment at the policy level–decidingwhether to write a policy based on the potential for loss.Underwriting and pricing should go hand in hand, as the premiumcharged for a policy should reflect the potential for loss underthe policy.

Exposure management–a necessary adjunct to solid underwritingand pricing–entails protecting an insurer from massive losses byguarding against concentrations of exposures and by usingreinsurance or other means to limit overall risk. Nonetheless, nomatter how careful the underwriting, losses will occur. When theydo, loss adjudication is key to an insurers success.

Executing against core fundamentals is also the key to successin a volatile world marked by increasingly frequent extremeevents.

Based on inflation-adjusted data going back more than half acentury, there have been 28 catastrophes causing $1 billion or morein losses. Of those 28, all but seven have occurred since 1989, theyear of Hurricane Hugo and the Loma Prieta earthquake.

Prior to Hurricane Hugo, billion-dollar events were rare. SinceHugo, weve suffered an average of about two per year.

Insurance markets have been hard pressed to absorb thevolatility in catastrophe losses since 1989. That year, catastrophelosses quintupled to $7.6 billion. But, just as suddenly, in 1990,catastrophe losses fell by about two-thirds to $2.8 billion. Theprocess repeated in 1992 and 1993, as annual catastrophe lossesshot up to $23.0 billion as a result of Hurricanes Andrew andIniki, but then fell just as suddenly to $5.6 billion. And theprocess repeated again as a result of the Northridge earthquake in1994 and the terrorist attack on September 11, 2001.

Each upward surge in catastrophe losses has led to disruptionsin property insurance markets.

Lesson Five: Market disruptions and failure toadhere to disciplined underwriting and cost-based pricing havetaken a tremendous toll on insurers.

Availability problems and wild swings in premiums as insurancemarkets lurched from soft to hard have spurred commercial insuredsuse of alternative insurance mechanisms, such as captives,risk-retention groups and self-insurance. In 1986, suchalternatives accounted for about a quarter of the U.S. commercialinsurance market. Today, they account for about half.

Prospectively, hard-market swings mortgage the future of thecommercial insurance business by driving more insureds to usealternative insurance mechanisms. Customers lost to alternativemechanisms do not return to the traditional market easily, evenwhen rates soften.

But failure to adhere to stable, cost-based pricing anddisciplined underwriting has hurt insurers in many ways. Inparticular, premium growth slowed from an average of 12.1 percentper year in the 1970s to 8.7 percent per year in the 1980s and 3.2percent per year in the 1990s.

As premiums failed to keep pace with costs, the average combinedratio deteriorated from 100.3 in the 1970s to 107.7 in the1990s.

Reflecting deterioration over time in underwriting results, theindustrys rate of return on average surplus dropped from an averageof 13.7 percent in the 1970s to an average of 8.7 percent in the1990s.

Thus far this decade, premium growth has recovered to 8.7percent per year, but the combined ratio has averaged 111.1 andreturn on surplus has averaged just 1.7 percent.

Failure to adhere to disciplined underwriting and cost-basedpricing has also contributed to increases in the number of p-cinsolvencies. The average number of insolvencies rose from 12 peryear in the 1970s to 27 per year in both the 1980s and the 1990s,and there have been an average of 33 insolvencies per year so farthis decade.

Lesson Six: Cost-based pricing requires knowingand acknowledging the true costs of business.

ISOs two primary techniques for analyzing loss and lossadjustment expense reserves indicate reserves were deficient by $63billion to $72 billion at year-end 2001, excluding deficiencies inreserves for E&A losses.

Our assessment of developments last year suggests reserves mayhave been deficient by as much as $75 billion at year-end.Factoring in potential deficiencies in reserves for E&A losses,reserves at year-end 2002 may have been deficient by $100 billionor more.

Under-reserving and under-pricing are two sides of the samecoin; both reflect dangerous ignorance of, or disregard for, truecosts. Under-reserving can also contribute to under-pricing incompetitive insurance markets by creating the appearance thatcapacity is greater than it really is.

In sum, for each insurer and for the industry as a whole, thesefirst six lessons from history show that solid execution againstcore fundamentals–solid underwriting, cost-based pricing, exposuremanagement and loss adjudication–is the only path to sustainablesuccess.

It is still too soon to tell whether last years substantialimprovement in underwriting results will be sustained by along-term focus on fundamentals or dissipated as the industry slipsinto the next soft market.

And there is a second reason few in the industry cheered asunderwriting results improved in 2002: our seventh lesson fromhistory.

Lesson Seven: What may have been good enough inthe past wont necessarily be good enough going forward.

At 107.2 in 2002, the industrys combined ratio was 8.6percentage points better than its combined ratio for 2001. And forthe first time this decade, the combined ratio was better than theaverage combined ratio for the 1990s or the 1980s.

Still, last years combined ratio of 107.2 wasnt nearly asprofitable as the industrys 108.1 combined ratio for 1986.

The industrys rate of return on average surplus was a mere 1.0percent in 2002. In 1986, with a combined ratio nearly a fullpercentage point worse, the industrys return on surplus was 15.1percent.

The difference between return on surplus for 2002 and return onsurplus for 1986 reflects changes in the investment environment. Inparticular, yields on investments have declined, as exemplified bythe fall in the yield on 10-year Treasury notes from 7.7 percent in1986 to 4.6 percent in 2002. And strength in equity markets hasgiven way to weakness, with the S&P 500 rising 14.6 percent in1986 but declining 23.4 percent in 2002.

With investment results like those in 2002, it would take acombined ratio of 92.2 to get to the 15 percent return on surplusthat so many Wall Street analysts would like. Unfortunately, basedon records back to 1959, the industry has never come close toachieving a combined ratio that healthy. The closest was the 96.2for 1972, more than 30 years ago.

The insurance industrys history of boom and bust cycles is, initself, evidence of missed opportunities to learn from history.Will history repeat itself, or will insurers take advantage ofcurrent opportunities and write a whole new chapter?

Frank J. Coyne is the chairman, president and chiefexecutive officer of Insurance Services Office Inc. in Jersey City,N.J.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, June 2, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.