The stars were aligned for the U.S. property-casualty insurancemarket in 2006, as the industry reported record profitability forthe third consecutive year. While much attention centered on themodest natural catastrophe losses experienced in 2006 relative tothe previous two years, the market's 2006 operating performance isalso a function of several other important factors--includingcontinued favorable insurance pricing across a large segment of theindustry and recent improvements in insurers' loss-reserveposition.

Questions linger regarding the sustainability of this level ofperformance, given the market's highly competitive nature andhistorical volatility.

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

The accompanying table lists some key industry aggregatestatutory financial items from 2002-to-2006 compiled by Fitch usinginformation available from Highline Data, a National Underwriteraffiliate.

The industry's statutory earnings reached record levels for thethird consecutive year in 2006, as net income increased by 41percent relative to the prior year to a record $66.7 billion. Theseprofit levels correspond to a 14.4 percent return on policyholders'surplus--representing the industry's highest returns since1986.

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

Underwriting performance improved dramatically as the marketproduced a strong underwriting profit and a combined ratio of92.4--the best reported since the 1940s.

Investment earnings declined modestly as reductions in realizedinvestment gains outpaced growth in interest and dividend incomefor the year.

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

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

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

Fitch estimates that net insured catastrophe losses represented2.1 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 bya shift in prior-period loss reserve development trends. For thefirst time in six years, loss reserves developed favorably,promoting a 1.6 point reduction in the industry combined ratioversus a 0.1 point increase from adverse reserve development in2005.

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

Fitch believes industry earnings are likely to continue tobenefit from favorable loss reserve development in the nearterm.

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

o First, insurance pricing remains adequate across nearly allmarket sectors.

The industry continues to experience the effects of the sharpimprovement in commercial insurance rates and more restrictivepolicy terms and conditions that followed the large losses from theSept. 11, 2001 terrorist attack.

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

o Second, loss-cost trends are relatively stable.

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

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

In the current investment environment, insurers need to producea strong underwriting profit to generate an adequate return oncapital, and insurers have gradually recognized this requirementover time.

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

Looking ahead, the results of 2006 are unfortunately notsustainable over the long term. While the resilience of favorableloss-cost trends is difficult to predict, rate adequacy is expectedto deteriorate.

Recent market success and the increase in market underwritingcapacity from recent earnings are adding pressure to an alreadycompetitive market. Premium rates are declining, promoting moremodest growth in net written premium.

As insurers look to more fully deploy their capital, pricingdeterioration will accelerate and underwriting profit opportunitiesdiminish.

Although underwriting terms and conditions appear to be holdingup reasonably well, a few warning signals of market deteriorationare evident.

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

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

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

After a long lull, acquisition activity is also increasing inthe p-c insurance market. With more limited organic growthopportunities, insurers are more frequently considering merger andacquisition opportunities.

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

Fitch views p-c insurer acquisitions cautiously. While reserveand balance sheet concerns have lessened more recently, there arestill risks of overpaying for an acquisition and difficulty inrealizing potential synergies.

Also, in response to more limited growth opportunities and apotential offset to competitive pricing pressure, insurers are morefrequently giving capital back to their owners through sharerepurchases and higher dividend payments.

While insurers need to balance the expectations of shareholderswith holding adequate capital to support risk exposures, returningfunds to shareholders may be the most prudent use of capital for anumber of firms in this environment.

For 2007--barring above-average catastrophe-related losses--thep-c insurance industry is expected to earn a significantunderwriting profit, although net earnings will decline somewhatfrom 2006 levels. First-quarter reported financials indicate thatresults 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 likelyfurther deteriorate going forward--creating greater uncertainty forprofitability in 2008 and beyond--the more extreme and long lastingsoft-market operating environment of the late 1990s is not likelyto recur.