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

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

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

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

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

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

Lesson One: Transitory hard markets ultimately trigger a return to competitive excesses and deterioration in profitability.

While insurers did enjoy five years of double-digit growth from 1975 to 1979, that growth ultimately triggered a soft market leading 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 record 23.1 percent.

But competition then drove premium growth down to just 3.8 percent in 1981, and growth remained below 5.0 percent through 1983. As a result, the combined ratio deteriorated to a record poor 118.0 in 1984, and return on surplus dwindled to 1.3 percent.

What followed was a knee-jerk recovery, with premium growth spiking to a record 22.2 percent in 1985 and 1986. Premium growth remained relatively strong in 1987 at 9.4 percent, and the industrys 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 markets during which insurers earned reasonable returns. But, once again, a hard market had sown the seeds of its own destruction, with the insurance industry slipping into the most protracted soft market in its history.

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

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

Even those poor results, however, paint a misleadingly rosy picture of insurers profitability on an ongoing basis, distorted as they were by year-to-year swings in catastrophe losses, environmental and asbestos losses on policies written long ago, and deterioration in reserve adequacy. Adjusted for catastrophes, environmental and asbestos losses and reserve deficiency, the combined ratio deteriorated to 109.0 in 1999 and 114.4 in 2000.

And insurers financial performance in the late 1990s would have been worse if not for capital gains generated by booming stock markets.

Lesson Two: Insurers cannot rely on capital gains to generate surplus.

The S&P 500 rose 15.3 percent per year on average during the 1990s. Reflecting the strength in equity markets, insurers enjoyed capital gains averaging $17.0 billion per year during that decade.

But for the three years ending December 31, 2002, the S&P 500 fell an average of 15.7 percent per year, and insurers posted capital losses averaging $11.8 billion per year.

In 2002, the industrys $21.7 billion in overall capital losses drove 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 on ever-increasing investment income to paper over underwriting losses in the next soft market.

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

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

Investment income grew each year from 1960 through 1991. But in 1992, investment income fell for the first time on record. And investment income has declined in six of the 11 years from 1992 to 2002.

With investment income falling 7.3 percent in 2001 and another 2.8 percent in 2002, insurers cannot depend on growth in investment income to offset growth in underwriting losses during the next soft market.

Recent declines in investment income reflect declines in market yields. The yield on 10-year Treasury notes fell to an average of 4.6 percent in 2002–the lowest yield on 10-year Treasuries on an annual basis since 1965. With investment results dependent on developments insurers cannot control, we come to lesson four.

Lesson Four: Each insurer must focus on what it can control–underwriting, pricing, exposure management and loss adjudication.

Underwriting is risk assessment at the policy level–deciding whether to write a policy based on the potential for loss. Underwriting and pricing should go hand in hand, as the premium charged for a policy should reflect the potential for loss under the policy.

Exposure management–a necessary adjunct to solid underwriting and pricing–entails protecting an insurer from massive losses by guarding against concentrations of exposures and by using reinsurance or other means to limit overall risk. Nonetheless, no matter how careful the underwriting, losses will occur. When they do, loss adjudication is key to an insurers success.

Executing against core fundamentals is also the key to success in a volatile world marked by increasingly frequent extreme events.

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

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

Insurance markets have been hard pressed to absorb the volatility in catastrophe losses since 1989. That year, catastrophe losses quintupled to $7.6 billion. But, just as suddenly, in 1990, catastrophe losses fell by about two-thirds to $2.8 billion. The process repeated in 1992 and 1993, as annual catastrophe losses shot up to $23.0 billion as a result of Hurricanes Andrew and Iniki, but then fell just as suddenly to $5.6 billion. And the process repeated again as a result of the Northridge earthquake in 1994 and the terrorist attack on September 11, 2001.

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

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

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

Prospectively, hard-market swings mortgage the future of the commercial insurance business by driving more insureds to use alternative insurance mechanisms. Customers lost to alternative mechanisms do not return to the traditional market easily, even when rates soften.

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

As premiums failed to keep pace with costs, the average combined ratio deteriorated from 100.3 in the 1970s to 107.7 in the 1990s.

Reflecting deterioration over time in underwriting results, the industrys rate of return on average surplus dropped from an average of 13.7 percent in the 1970s to an average of 8.7 percent in the 1990s.

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

Failure to adhere to disciplined underwriting and cost-based pricing has also contributed to increases in the number of p-c insolvencies. The average number of insolvencies rose from 12 per year 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 far this decade.

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

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

Our assessment of developments last year suggests reserves may have 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 billion or more.

Under-reserving and under-pricing are two sides of the same coin; both reflect dangerous ignorance of, or disregard for, true costs. Under-reserving can also contribute to under-pricing in competitive insurance markets by creating the appearance that capacity is greater than it really is.

In sum, for each insurer and for the industry as a whole, these first six lessons from history show that solid execution against core fundamentals–solid underwriting, cost-based pricing, exposure management and loss adjudication–is the only path to sustainable success.

It is still too soon to tell whether last years substantial improvement in underwriting results will be sustained by a long-term focus on fundamentals or dissipated as the industry slips into the next soft market.

And there is a second reason few in the industry cheered as underwriting results improved in 2002: our seventh lesson from history.

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

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

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

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

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

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

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

Frank J. Coyne is the chairman, president and chief executive 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 serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.