At first blush, the financial performance of the property-casualty insurance industry during the first nine months of 2006 was generally excellent. After all, profits–in the form of net income after taxes–increased 50.1 percent ($15.1 billion) to $44.9 billion in the first nine months, compared to the same period in 2005.

The question, however, is how long the good times will last. As you'll see, there are a number of red flags ahead indicating potential trouble on the horizon for p-c carriers.

First, the good news.

While the ebb in catastrophe losses is commonly cited as the primary reason for the surge in profits, strong underwriting results are being reported in virtually every key line of insurance–including those not significantly affected by catastrophic loss such as auto insurance, workers' compensation and commercial liability coverages.

Consequently, the p-c industry reported an annualized statutory rate of return on average surplus of 13.4 percent through the first nine months of 2006, up from 9.8 percent through the third quarter of 2005, according to results released by the Insurance Services Office and the Property Casualty Insurers Association of America.

Profitability in this range, if maintained, would lead insurers to their best financial performance in nearly 20 years.

However, although profits measured in dollar terms will set a new record in 2006, aggregate dollar amounts of profit (or loss) are not particularly meaningful statistics for comparative purposes. The standard measure of financial performance across all industries is ROE, and industry margins may still fall short of those realized by the Fortune 500 group of companies–which is expected to turn in an average return on equity of about 14.5 percent in 2006.

Even at this late date, there still remain a few profitability wildcards whose impacts will not be fully revealed until insurers report fourth-quarter and full-year results during the first quarter of 2007. These include:

o Reserve charge-offs.

o The realization of investment gains or losses (or lack thereof).

o Fourth-quarter catastrophe losses.

o The magnitude of policyholder's surplus growth.

Of all these, it is likely that a rapid run-up in policyholder's surplus will temper ROE prospects in 2006 and possibly in 2007 as well. This is a situation much like that described in the preceding example.

Indeed, it is now quite possible that the p-c industry's ROE for full-year 2006 will fall short of the Fortune 500 standard for the 19th consecutive year–coming in below 14 percent and perhaps as much as 100 to 125 basis point (1 to 1.25 percentage points) below the Fortune 500 benchmark.

Profits also increase the industry's tax obligations. Indeed, tax payments by insurers to the federal government increased to $18.7 billion during the first nine months–an increase of 99 percent, or $9.3 billion, over the same period in 2005. It is likely that federal tax payments for all of 2006 will approach a record $25 billion.

Put into perspective, the industry's tax bill in 2006 is larger than the losses paid on all but two of the most expensive natural or man-made disasters in world history–Hurricane Katrina (at $41 billion) and the Sept. 11 terrorist attacks (at $32.5 billion).

In fact, the 2006 federal taxes paid are so large that they will exceed the $22.6 billion in insured losses from Hurricane Andrew (expressed in 2006 dollars), the second most expensive natural disaster in history.

Increased profitability and the drop in catastrophe losses mean that 2006 was a rebuilding year for the p-c industry. Profits will bolster policyholder's surplus–a key measure of claims paying capacity or capital–and provide an additional buffer against the mega-catastrophes that lie ahead.

An improved capital position will also help insurers meet the higher capital requirements imposed on them in the wake of Hurricane Katrina by ratings agencies–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.

Notable is the fact that most of the profits generated by insurers in 2006 will be reinvested in the industry. Billions of additional dollars will be reinvested by carrying over unrealized capital gains into 2007. In fact, from year-end 2005 through Sept. 30, 2006, policyholder's surplus increased by $41.8 billion to $467.7 billion, a gain of 9.8 percent, according to ISO.

After-tax net income (profits) of $44.8 billion through nine-month 2006 equates to 93 percent of the increase in industry surplus over the same period.

By year-end 2006, insurers will likely have invested or reinvested between $55- and $60 billion, bolstering industry claims-paying resources in advance of what is already predicted to be an above-average 2007 hurricane season.

Rising profitability is also intensifying competition throughout most of the p-c industry, and buyers of insurance are the unambiguous winners when it comes to reaping the benefits of lower premiums.

Drivers, homeowners and businesses in most parts of the United States will be left with more cash in their pockets as insurance costs fall in absolute terms, or at least relative to income growth and growth in Gross Domestic Product–the sole major exception being insurance for property coverages in hurricane-exposed areas.

The bottom line is that falling insurance prices are lowering the cost of doing business, driving a car or owning a home for most Americans.

For example, countrywide auto insurance expenditures are expected to fall 0.5 percent in 2007–the first drop since 1999. Businesses will see price declines of 5 percent or more in 2007 across their entire insurance program, on top of similarly sized decreases in 2006.

Overall, the share of p-c premiums relative to the overall economy will shrink by about 2.5 percent in 2006 and 3.1 percent in 2007.

Improved profitability across the industry does not, however, mean property insurance and reinsurance rates will fall in most hurricane-prone areas.

Homeowners insurance, commercial property, business interruption, and energy and marine prices are still inadequate relative to the risk insurers and reinsurers are being asked to assume. Consequently, rates are likely to continue to rise in 2007.

Adverse court decisions could also put upward pressure on prices–including a pair of decisions in Louisiana in late 2006 that would, if not overturned on appeal, hold insurers responsible for flood losses clearly excluded under the regulator approved language in the policies.

The ISO/PCI industrywide results report indicate an adjusted growth rate in net written premiums of 3.8 percent through the first nine months of 2006 (and 5.1 percent before adjustment), beating analysts' expectations of 2.8 percent for full-year 2006. The difference is likely due primarily to stronger-than-expected growth in property-related insurance premiums in hurricane-exposed areas.

There is, however, a consensus among analysts that premium growth will slow precipitously in 2007.

The average forecast from the Insurance Information Institute's “Early Bird” forecast calls for an increase in net written premiums of just 1.5 percent in 2007–which would be the second-slowest rate of growth for p-c insurers since 1998, during the depths of the last soft market. It represents a near halving of the estimated figure for 2006.

The deceleration in premium growth in 2007 is a direct result of a virtual across-the-board softening in the personal and commercial lines pricing environment–again with hurricane-exposed property insurance coverages the sole major exception.

Other factors include a general economic slowdown that is negatively impacting exposure growth through declines in home building, new vehicle sales and business investment in new plants and equipment, as well as slower wage and salary growth.

Premium growth peaked during the most recent cycle at 14.6 percent in 2002 before dropping to 9.8 percent in 2003. It is also worth noting that premium growth in 2006–per the 2007 Early Bird survey–will come in well below the average analyst expectations from a year ago. In last year's Early Bird survey, the consensus estimate was for net written premium growth of 4.7 percent.

For insurers, the current premium growth pattern is eerily reminiscent of the soft market of the late 1990s, when the industry recorded growth of 2.9 percent in 1997 and 1.8 percent in 1998. Those years presaged some of the worst years in insurance industry history, with combined ratios rising from 102 in 1997 to nearly 116 in 2001.

Fortunately, with an expected combined ratio of 97.6 in 2007, the comparison–at least so far–appears to be superficial, or at least, premature.

The p-c industry's underwriting results are not only superb but robust, with a nine-month combined ratio of just 91.5–down from 99.9 for nine-month 2005 (and 100.7 for calendar-year 2005).

Were the industry to maintain a combined ratio of 91.5 through year's end, it would be the best annual result in nearly 60 years–since the 91.2 combined ratio recorded in 1948.

The Early Bird survey revealed an average combined ratio estimate of 94.3 for the year–nearly three points above the actual nine-month result.

Because fourth-quarter 2006 results will compare favorably to fourth-quarter 2005 (which suffered from significant catastrophe losses associated with Hurricane Wilma), the actual 2006 combined ratio will almost certainly come in well below expectations, and represents just the second underwriting profit since 1978 (the industry recorded a small underwriting profit in 2004).

Indeed, even the most optimistic of analysts polled in the survey estimated a 92.0 combined ratio for 2006, while the most pessimistic estimate topped out at 98.1.

The combined ratio is projected to rise to 97.6 in 2007–a deterioration from an estimated 94.3 in 2006.

The estimate for 2007, of course, assumes “normal” catastrophe losses. It should be noted, however, that underwriting profits in 2007 will likely fall by approximately 50 percent from 2006 levels. The considerably slimmer margin of underwriting profitability will be eliminated entirely if catastrophe losses return to 2004/2005 levels.

While the survey results indicate fundamentally sound underwriting performances in 2006 and 2007, the anticipated 3.4 point deterioration in the combined ratio for 2007 begs questions about 2008 and beyond.

A similar deterioration in 2008 would leave the industry with a 100 combined ratio–well below what is necessary to generate returns that are competitive with the Fortune 500 group, given current investment conditions.

At that point, the industry will be paying out exactly the same amount in claims and associated expenses as it earns in premiums.

As a stern reminder of the importance of generating substantial underwriting profits, the 100.7 combined ratio in 2005 produced a ROE of just 10.4 percent.

The underwriting profits earned in 2006 will also help insurers earn their cost of capital (the rate of return necessary to retain and attract capital) for just the second time in many years, while industry profitability as a whole will finish the year with a ROE in the neighborhood of 14 percent.

While up substantially in 2006, insurer profits remain highly volatile. In fact, just five years earlier, in 2001, insurers suffered their worst year ever, with negative profits for the year.

Considering the tremendous risk assumed by investors who back major insurance and reinsurance companies, the returns in most years are woefully inadequate. It is clear that Fortune 500-level ROEs in the neighborhood of 13-to-15 percent cannot be generated consistently without a substantial contribution from underwriting, given the murky interest rate situation going forward and continued stock market volatility.

In the final analysis, insurers will need to find ways to generate adequate rates of return not only to compensate investors for the risk they assume and to preserve their claims-paying capital, but also to maintain their financial strength and credit ratings and to avoid regulatory sanctions.

A financially weak insurance industry is of no use to anyone, including policyholders–millions of whom depend on the industry to pay hundreds of billions of dollars in claims each year.

The industry's net investment gain actually fell by $2.0 billion–down 4.8 percent to $38.9 billion during the first nine months of 2006. According to ISO/PCI survey figures, the loss consisted of a 2.4 percent increase in net investment income (primarily interest on bond holdings and stock dividends) and a 66.2 percent drop in realized investment gains.

Surprisingly, the deterioration in realized capital gains during the first half of 2006, during which the S&P 500 Index was up just 1.8 percent, continued through the third quarter, even though year-to-date gains expanded to 7.0 percent as of Sept. 30.

The fact that realized capital gains are tumbling in 2006, despite the rise in stock prices, suggests that insurers are effectively “banking” unrealized capital gains and holding them to boost profits as underwriting margins shrink in the years ahead.

Additional opportunities to realize capital gains developed during 2006's fourth quarter. As of Dec. 26, the S&P 500 index was up 13.5 percent–nearly doubling in just one quarter the total return through the first nine months.

The markets have been reacting favorably to strong corporate earnings reports, to the Fed's decision this summer to (at least temporarily) halt the series of rate hikes initiated in June 2004, as well as to falling energy prices.

It is important to keep in mind, however, that p-c insurers hold just 17 percent of invested assets in the form of common stock, so upside from a rally in stocks is limited.

The interest rate situation going forward is somewhat murky for insurers. The direction of interest rates is critically important for p-c insurers because 68 percent of all invested assets are held in the form of bonds.

The average yield on 10-year U.S. Treasury notes was 5.07 percent during the second quarter of 2006, but slipped back to just 4.63 percent as of Dec. 22–almost identical to the 4.73 yield in June 2004 (when the Fed began to raise rates).

The yield curve has once again become inverted. While short-term interest rates are much higher than they were at the beginning of the Fed's campaign to raise rates (the three-month T-bill yielded 1.29 percent in June 2004), the yield as of Dec. 22 was 4.99 percent–26 basis points above the yield on the 10-year note. Indeed, the 30-year Treasury bond on the same date yielded just 4.76 percent.

This situation leaves chief investment officers at insurance companies with a difficult choice–lock in long-term rates now, lest they fall further, or stick with shorter-term instruments because of the higher yield.

The decision to go long is fraught with interest-rate risk. It is easy to envision situations (such as an oil-induced inflation shock or a war) that drive interest rates sharply higher in the years ahead–a development that would push the price of bonds down.

On the other hand, rates could trend down further, perhaps for years. Indeed, there is a substantial likelihood that the Fed will lower rates if the economy begins to falter in 2007. If the yield curve then returns to its normal shape, going long today is the right strategy.

Securities investors appear to be sending a signal that they expect intermediate and long-term interest rates to decline. The traditional explanation for this is an expectation of economic weakness in the months and years ahead.

When the full-year figures are calculated, the financial and underwriting performance of the p-c industry for 2006 is expected to be strong–aided substantially by catastrophe losses that were far below those experienced in 2004 and 2005.

Insurers, however, face a variety of challenges unrelated to catastrophe losses, including increasing price pressure that could erode underwriting performance–and profitability–in the quarters ahead.

One cause for concern is that projected top-line growth for 2007 is just 1.5 percent and is, in fact, negative on an inflation-adjusted basis.

Another is the rapid accumulation of capital on insurer balance sheets. The current slow-growth environment means that insurers face very difficult capital allocation decisions over the next several years.

Special Reports /

Insurer Profits Soar, But P-C Industry Concerned About Potential Red Flags

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