The stars were aligned for the U.S. property-casualty insurance market in 2006, as the industry reported record profitability for the third consecutive year. While much attention centered on the modest natural catastrophe losses experienced in 2006 relative to the previous two years, the market's 2006 operating performance is also a function of several other important factors--including continued favorable insurance pricing across a large segment of the industry and recent improvements in insurers' loss-reserve position.

Questions linger regarding the sustainability of this level of performance, given the market's highly competitive nature and historical volatility.

The market is now at a cyclical operating peak. Profitability is expected to decline going forward but remain favorable relative to historical norms at least for 2007, with returns on capital more likely to fall below required levels in 2008.

The accompanying table lists some key industry aggregate statutory financial items from 2002-to-2006 compiled by Fitch using information available from Highline Data, a National Underwriter affiliate.

The industry's statutory earnings reached record levels for the third consecutive year in 2006, as net income increased by 41 percent relative to the prior year to a record $66.7 billion. These profit levels correspond to a 14.4 percent return on policyholders' surplus--representing the industry's highest returns since 1986.

Premium growth has slowed considerably from the early hard market years 2002 and 2003. Net earned premium revenue for the industry aggregate increased by 4.6 percent in 2006, to $441 billion.

Underwriting performance improved dramatically as the market produced a strong underwriting profit and a combined ratio of 92.4--the best reported since the 1940s.

Investment earnings declined modestly as reductions in realized investment gains outpaced growth in interest and dividend income for the year.

Capital and surplus increased by over 14 percent in 2006 to $500 billion.

While strong earnings were the major contributor to this growth, the market also benefited from larger unrealized investment gains tied to strong stock market performance, and was offset somewhat by larger stockholder dividends paid to parent holding companies from insurance company subsidiaries.

This improvement in underwriting performance is attributable in large part to more benign natural catastrophe activity in 2006 relative to 2005's three major hurricane landfalls--including Hurricane Katrina, which produced the largest insured losses from one event in history.

Fitch estimates that net insured catastrophe losses represented 2.1 percent of net earned premium for the industry in 2006, compared with 8.6 percent in 2005.

Calendar-year 2006 underwriting performance was also boosted by a shift in prior-period loss reserve development trends. For the first time in six years, loss reserves developed favorably, promoting a 1.6 point reduction in the industry combined ratio versus a 0.1 point increase from adverse reserve development in 2005.

The industry's loss reserve adequacy has improved significantly in recent years as insurers recognized the deficiencies of past underwriting periods and established reserves in a more conservative fashion in more recent hard market accident years.

Fitch believes industry earnings are likely to continue to benefit from favorable loss reserve development in the near term.

There are also a number of underlying fundamental factors behind this strong underwriting performance.

o First, insurance pricing remains adequate across nearly all market sectors.

The industry continues to experience the effects of the sharp improvement in commercial insurance rates and more restrictive policy terms and conditions that followed the large losses from the Sept. 11, 2001 terrorist attack.

Although prices have declined recently, rate reductions are now from what has proven to be an adequate base, and terms and conditions continue to hold reasonably firm.

o Second, loss-cost trends are relatively stable.

The industry has benefited from reductions in claims frequency in disparate lines such as personal auto, workers' compensation, and directors and officers liability. Meanwhile, claim-severity trends, though positive, have not created recent undue surprises.

o Finally, despite recent increases, interest rates remain low relative to historical norms.

In the current investment environment, insurers need to produce a strong underwriting profit to generate an adequate return on capital, and insurers have gradually recognized this requirement over time.

In previous high-interest-rate and inflationary periods, "cash-flow underwriting"--by which marginal insurers focused more on generating premium revenue to boost invested assets than on underwriting quality and results--drove industry profitability downward.

Looking ahead, the results of 2006 are unfortunately not sustainable over the long term. While the resilience of favorable loss-cost trends is difficult to predict, rate adequacy is expected to deteriorate.

Recent market success and the increase in market underwriting capacity from recent earnings are adding pressure to an already competitive market. Premium rates are declining, promoting more modest growth in net written premium.

As insurers look to more fully deploy their capital, pricing deterioration will accelerate and underwriting profit opportunities diminish.

Although underwriting terms and conditions appear to be holding up reasonably well, a few warning signals of market deterioration are evident.

o For one, underwriters are pricing newly gained accounts more aggressively than retained business.

o For another, insurers seeking new avenues for growth are more frequently venturing into new product or geographic segments.

Besides new product lines, diversification can also take the form of middle-market insurers pursuing small-commercial accounts, or admitted carriers entering into the excess and surplus lines market. Venturing into new segments creates uncertainty as to whether an insurer has the appropriate underwriting and claims expertise to succeed outside of core markets.

After a long lull, acquisition activity is also increasing in the p-c insurance market. With more limited organic growth opportunities, insurers are more frequently considering merger and acquisition opportunities.

A key reason for the previous slowdown in p-c merger deals was that nearly all transactions completed in the more active period of the late 1990s were unsuccessful due to integration challenges and the existence of significant reserve deficiencies within acquired entities.

Fitch views p-c insurer acquisitions cautiously. While reserve and balance sheet concerns have lessened more recently, there are still risks of overpaying for an acquisition and difficulty in realizing potential synergies.

Also, in response to more limited growth opportunities and a potential offset to competitive pricing pressure, insurers are more frequently giving capital back to their owners through share repurchases and higher dividend payments.

While insurers need to balance the expectations of shareholders with holding adequate capital to support risk exposures, returning funds to shareholders may be the most prudent use of capital for a number of firms in this environment.

For 2007--barring above-average catastrophe-related losses--the p-c insurance industry is expected to earn a significant underwriting profit, although net earnings will decline somewhat from 2006 levels. First-quarter reported financials indicate that results are on track thus far.

Fitch's rating outlook continues to be stable for the U.S. commercial lines and personal lines sectors.

The rating outlook considers that although pricing will likely further deteriorate going forward--creating greater uncertainty for profitability in 2008 and beyond--the more extreme and long lasting soft-market operating environment of the late 1990s is not likely to recur.

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