Most Signals Green For Auto Insurers

Worsening severity trends the only flashing yellow on road tocontinued profits

Private passenger auto insurers--the beneficiaries of favorablefrequency trends--say their efforts to price business moreaccurately with sophisticated models have also helped to pushindustry loss ratios down nearly 13 points in the last threeyears.

And while premium growth is slowing, experts say the flavor ofcompetition is different this time around, predicting that profitswill remain in the line for awhile.

For the industry, the overall net private passenger autoinsurance loss ratio was 58.0 in 2004, down from a high of nearly71 in both 2000 and 2001. The individual components of theline--liability and physical damage--showed similar improvements.(See bar chart, page 21).

For the top 25 insurers (ranked by direct written privatepassenger premium volume in 2004), only one--ZurichInsurance--reported worse overall direct and net (of reinsurance)private passenger loss ratios in 2004 than in 2003. And everysingle one of the top 25 insurers reported better combined ratiosin 2004, with more than half posting combined ratios of 95 orless.

Across the industry, the aggregate net combined ratio--whichreached a high of 111.4 in 2000 during the six-year period analyzedby NU--fell under 100 for the first time in 2003 (coming in at98.6), and dropped another 4.5 points to 94.1 in 2004.

While the 13-point loss ratio drop since 2000 drove most of thecombined ratio improvement, the loss adjustment expense ratio alsoimproved by one point. In 2004, the ratio of LAE to net earnedpremiums for private passenger auto was just over 12, compared to13 in 2000 and 2001.

While there is a two-part explanation for the lower loss ratiosin recent years--higher prices and lower loss levels--themeaningful improvement in loss trends has been the focus ofanalysts and market participants. As illustrated on the graph onpage 21, industrywide direct losses for personal auto, which grew11 percent in 2000 and 9 percent in 2001, began to flatten in2002--growing only 1 percent in that year. The low-growth trendcontinued in 2003, and actually reversed in 2004, with lossesfalling 2 percent compared to 2003.

Frequency Trends Start To Flatten

Experts point to declines in claims frequency (the number ofclaims per car) to explain the favorable loss trends. And there areseveral factors behind the falling frequencies, Michael LaRocco,president of product, underwriting and claims for Seattle-basedSafeco Insurance Companies, told NU during an interview in New Yorkat the Independent Insurance Agents and Brokers of America annualconference last week:

o The aging of the population

o Smart cars

o Drunk-driving laws

o Teenaged-driver restrictions

o Better highways

o Increased deductibles

With the baby boomer generation coming of age over the past 10years, there are more people aged 40 to 60 who are better drivers,Mr. LaRocco said. Meanwhile, "global positioning systems andelectronic stability controls are clearly making a difference," headded.

Mr. LaRocco said graduated driving restrictions have "been ahuge factor" pushing down claims. He explained that theserestrictions limit the amount of time that young people can driveat certain times of day and require adult passengers.

Commenting on the impact of increasing deductibles, he said: "Inmy father's day, people had $0 or $100 deductibles. When I came toSafeco [in 2001], over 80 percent of the customers had $250 orless. Now over 80 percent have $500 deductibles, eliminating thelower impact-type claims."

Although he said that a negative frequency trend remainsevident, he doesn't see this continuing: "It has really started toflatten, and that's a clear indication [that] it will start turningslightly positive."

As for the notion that higher gas prices might further improvetrends, Mr. LaRocco said, "Historically, we've never seenthat."

"Having said that, this is a unique spike," he added, notingthat thresholds like $3 per gallon for gas, and $50 to fill a tank,are "outrageous numbers" that haven't been studied. Intuitively, "Ican see this affecting seniors who can choose not to drive, oryoung people who can take a train," he said.

However, he added, "the families are going to still have to takethe kids to school," predicting a "short-term blip" that couldcause a temporary slowdown in claims. "But they'll ultimately bemoving slightly positive."

Severity: The Next Story?

More than a month before Hurricane Katrina sparked the latesthike in gas prices, Glenn Renwick, president and chief executiveofficer of Progressive Corp., said the personal auto trend to keepan eye on was severity. While he didn't predict any dramaticupsurge in auto insurance prices, Mr. Renwick did say that pricingwould likely respond to shifting loss trends, which show increasingseverity outstripping declines in frequency.

"I think we're probably going to enter into a period, in somenumber of months--it's certainly not on the immediate horizon, butI don't think it's more than a year-and-a-half [away]--where wewill see a little bit more positive-type rate action in the marketto respond to some of the trends," he said.

The remarks came during a conference call held a day after theMayfield Village, Ohio-based insurer filed its second-quarter 2005report with the Securities and Exchange Commission, revealing a 2percent increase in income and a 7 percent jump in net premiums forthe quarter.

Referring to "positive" and "plus" trends throughout the call,what he was describing was an environment that will initially beless favorable for auto insurers, which will suffer compressedprofit margins as loss costs tick upward. Ultimately, however, itwill be less favorable for consumers, now enjoying the benefits ofcompetitive pricing.

"The real story is severity," he said, putting average severityjumps in the 5-to-6 percent range. He said that such percentagesare "not extreme by any stretch" and also "not unexpected in ourindustry." But they are notable in that they come after a period ofdeclines in overall loss costs (the product of frequency andseverity trends together).

At Safeco, Mr. LaRocco is reading similar tea leaves. "We'veseen severities generally in that mid-single-digit positive area,and generally it's been offset by frequencies being down. Butthere's no question that we see a continuing trend in severitygoing up," he said. "The main reason is medical inflation. Thebiggest severity jumps to date have been in bodily injury claims,and medical inflation is clearly the number-one driver there."

While some analysts worry that worsening loss trends--togetherwith price competition--could spell trouble for auto insurers, Mr.LaRocco said he hasn't seen evidence of irrational market behavior."We are seeing rate decreases. I think there is clearly a trend totake some rates down. [But] we're not seeing any across-the-boardsignificant rate declines like the industry has been prone to do inthe past," he said.

He said aggressive behavior is confined to three areas, withadvertising being the most pronounced, followed by incentives toagents and a loosening of underwriting guidelines. Insurers mightbe paying on a per-application basis, or giving away trips toencourage agencies to choose them, he said.

On the underwriting front, he said, a risk previously thought ofas standard by an insurer might now be classified as preferred--ora risk that used to be thought of as non-standard would now beconsidered standard.

Morgan Keegan, a Memphis-based equity research firm, alsodoesn't see a return to unsound price competition of the late1990s. "The adoption of risk segmentation/price-tiering by some ofthe laggard giants in the industry--particularly State Farm--arguesfor an incremental measure of rational competitive behavior goingforward," the firm said in a report published last week.

Sophisticated Models

Mr. LaRocco, who touts the use of "automated multivariateunderwriting and pricing models" at Safeco, said there's a widerange of sophistication around the concept of tiering.

"You can have a simplistic underwriting model that takes severalfactors, adds them, scores people from zero to 100, splits thatinto 10 tiers and say you have tiering. But it's very simplistic,"he said, contrasting multivariate models that examine how factorscorrelate with one another.

Giving an example, he said insurers historically surcharge adriver that has an accident, but "if you've had an accident andyou're in your 20s, your future behavior is different than ifyou're in your 50s. That's multivariate--taking those two factors,correlating them together and charging the 50-year-old driverdifferently."

Putting Progressive and Allstate among the best competitorsusing such models, he said multivariate models can rely ontraditional factors--violations, age, gender, marital status--andnew ones, such as lapse in insurance, education and occupation.

While many models consider credit scores, he said they aren'tbroken when insurers lose credit-scoring battles in various states."We have models that include credit, and models that don't," hesaid, noting that there is no issue in states where there's a levelplaying field.

In some states, however, direct writers that don't use creditfor underwriting might only solicit to risks with good creditscores. "They gain a competitive advantage, and to independentagents, that's just unfair," he said.

Page 14==Top 25 Chart

Flag: Second Straight Industry Profit

Head: Private Passenger Automobile Results--Top 25 Writers($000)

With an overall industry combined ratio of 94.1, 21 of the 24largest private passenger auto insurers recorded underwritingprofits in 2004, and the industry posted its second-straightfull-year underwriting profit. Although the largest auto writer,State Farm, did not grow last year, double-digit growth atProgressive and GEICO (Berkshire) helped push industrywide growthto about 4.0 percent.

Page 20==Bar graph "Net Pure Loss Ratios"

Flag: Results Improve

Head: Private Passenger Net Pure Loss Ratios

The industry's net pure loss ratio for private passenger autohas fallen nearly 13 points since 2000 and 2001. Both the liabilityand physical damage components improved over the period.

Page 21==Bar graph "Private Passenger Direct Industry Data"

Flag: Losses Drop

Head: Private Passenger Direct Industry Data

The line plotting private passenger loss ratios has gone in onedirection--down--since 2001. Even as premium growth began tosubside in 2004 (falling to 4.7 percent from 9.0 percent a yearearlier), lower claims frequencies meant continuing favorable losstrends. The level of incurred losses actually fell 2.4 percent in2004, compared to 2003.