Whether they realize it or not, property-casualty insurers are experiencing the closest thing to a Golden Age that the first half of the 21st century is likely to offer. Amid a severe credit crunch, housing collapse and threat of recession, p-c insurers find themselves in an era of relative prosperity. As always, there are challenges ahead, but insurers in 2008 are more in charge of their own destiny than at any time in a generation.

Make no mistake, this is no Camelot. But at least insurers can say that where they go from here and where they end up two-to-three years from now will largely be the result of their own decisions.

Indeed, the thorniest problems confronting the industry today--such as sluggish premium growth, excess capital accumulation, the degree of exposure to catastrophic loss and future reserve adequacy--are largely under insurer control.

Insurers finished 2007 high atop a pillar of financial strength, and are riding a powerful tide of momentum into 2008.

Operating, regulatory and legislative challenges abound, but in most states and in most lines insurers have discovered the elixir for sustained profitability--underwriting discipline. The only question is whether they can sustain it.

Industry profits--overall net income after taxes--last year totaled an estimated $60-to-$65 billion, on par with 2006's record profits. Return on average surplus--a measure of profitability--remained strong by recent historical standards, falling to about 13 percent last year from 14 percent in 2006.

The fact that the financial performance of the p-c industry for 2007 (and 2006, for that matter) turned out to be significantly better than was anticipated bodes well for 2008.

Last year's estimated 93.8 combined ratio was one of the top-12 best underwriting performances over the 88-year period beginning in 1920, and implies an underwriting profit of approximately $24 billion.

The estimated 2007 combined ratio represents a deterioration of just 1.3 points from the 2006 result, which was the sixth-best over this same span of time. And it is substantially better than the consensus estimate of 97.6 analysts held going into the year, based on the Insurance Information Institute's December 2006 "Early Bird Survey." The combined ratio for 2008 is projected to be up 3.5 points--to 97.3.

If, as predicted, the combined ratio comes in under 100 both this year and next, that would be just the third and fourth underwriting profits in the p-c industry since 1978, and the longest period of sustained underwriting profitability in a half century.

Although the industry's fundamental underwriting results are strong, there is justifiable concern that stalling premium growth will erode the bottom line.

Unfortunately, the temptation for some analysts, investors and industry management in 2008 will be to fixate on the top line, when it is the bottom line that matters most.

Growth-at-all-cost strategies have seldom worked out well for insurers, yet it is easy to envision a clamoring for growth in the year ahead.

The consensus analyst forecast calls for negative growth in net written premiums in 2008 of 0.3 percent--a slight deterioration from the zero growth (0.0 percent) estimate for 2007.

The 0.3 percent decline in premium growth that analysts project for 2008, if accurate, would represent the first decline in annual premiums since 1943, when premium volume declined by 2.4 percent in the midst of World War II.

Premium growth has decelerated steadily since peaking at 15.3 percent in 2002, and is primarily the result of an across-the-board softening in the personal and commercial lines pricing environment.

A weakening economy, leakage of premium to government-operated (re)insurers, and strong interest in alternative forms of risk transfer are also contributing to the slowdown.

Overall, the share of p-c insurance premiums relative to the overall economy shrank by about 4.9 percent in 2007, and will shrink by another 4.3 percent in 2008.

It is notable that the premium growth estimate for 2008, though slightly negative, represents a leveling out of growth rather than a continuation of the sharp deceleration trend that began in 2003. This suggests that analysts expect pricing discipline to be a key element in the complex dynamics at work in insurance markets in 2008.

Historically, the travel time from the cyclical peak of premium growth to the cyclical trough has been five-to-six years. Reaching a trough in 2008 would be consistent with historical experience.

However, history paints two distinctly different pictures for the years immediately following a trough. During the hard market of the mid-1970s, premium growth peaked in 1975, hit a trough in 1981 and peaked once again in 1985/86. The next trough was effectively reached by 1992, after which the industry experienced very slow growth through the remainder of the 1990s.

The current drought in premium growth is 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 the insurance industry's history, with combined ratios rising from 102 in 1997 to nearly 116 in 2001.

Fortunately, with an expected combined ratio of 93.8 in 2007 and 97.3 in 2008, the comparison--at least so far--appears to be superficial, or at least premature.

The most important question facing the industry today is whether this painful and destructive cycle can be broken, and with it the commensurate surge in insurer impairments that invariably occur.

History does not imply destiny, of course, and there are some indications that aggressive capital management, sound reserving strategies, expense controls as well as disciplined underwriting and pricing--combined with judiciously timed realization of accumulated capital gains by insurers--may be making a difference, leading to a shallower market cycle and a more modest dip in profitability.

Insurance CEOs continue to vow that it will be different this time around, and 2008 is quickly shaping up to be the year when the industry's fortunes will be cast.

There is no question that the p-c industry can prosper even as it shrinks relative to the size of the overall economy.

Judging by the large number of modest-sized centenarian insurance companies, constant or rapid growth is not an operational imperative in this industry. Growth is a cyclical phenomenon, and over time opportunities for growth will reemerge.

Disintermediation, one of the greatest threats to the industry, negatively impacts growth--although it is not cyclical but rather structural in nature.

Disintermediation in the industry today implies that insurers and reinsurers can and are effectively being removed, excluded from or simply left out of the core function of risk transfer that insurers have performed for centuries.

Examples of disintermediation of (re)insurers include rapid growth in captives, self-insurance, risk retention groups and large-deductible programs.

Meanwhile, many commercial risks have found that "investing" in a large insurance retention is economically efficient because the return on that investment meets or exceeds that company's internal hurdle rate for any investment.

At the same time, huge pools of (mostly foreign) capital circumnavigate the globe in search of alternative investment opportunities, increasing the demand for risk securitization while eroding the bread and butter business of reinsurers.

The loss of premiums and market share to government-run property insurers and reinsurers is another form of disintermediation that will not be easily reversed.

In contrast to disintermediation, overcapitalization is a cyclical phenomenon. Capital today (in the form of policyholder surplus) is accumulating on insurers' books faster than they can put it to work with some prospect of earning a risk-appropriate rate of return.

This is not the "embarrassment of riches" that it might appear. Holding capital in excess of what is needed or can be productively invested is inefficient. Profitability drops because profits grow more slowly than the rate of capital accumulation.

Property-casualty insurers held an estimated record $530 billion in policyholder surplus as of Dec. 31, 2007. Estimates are that as much as $100 billion of this amount is excess capital.

In an era of mega-catastrophes, jackpot jury awards, and credit and stock market mayhem, the term "excess capital" would appear to be an oxymoron, but the fact of the matter is that in 2007, insurers earned just $0.81 (estimated) for every $1 they held in surplus. This is three cents less than the all-time record low premium-to-surplus ratio of $0.84-to-1 set in 1998.

By contrast, during the peak of the most recent hard market in 2002, insurers pulled in $1.29 for every dollar in surplus.

Far from benign, dips in the premium-to-surplus ratio signal excess capacity in the market. Historically, some insurers have sought to put that capital to work by seeking growth at any cost.

Favored strategies in the past have included bloody battles for market share that eventually lead to enormous underwriting losses (reducing capital by virtue of its destruction) and expensive acquisitions that often never live up to expectations.

The dominant strategy in 2007 was to return capital to owners in the form of increased dividends and share repurchases. Indeed, share repurchase activity in 2007 shattered all previous records and constituted a return of 4.5-to-5.0 percent of industry capital to owners.

According to Credit Suisse, through the third quarter of 2007, $17.4 billion in share repurchases had been transacted--a figure that was already 133 percent above the previous record of $7.1 billion for all of 2006. It is likely that total share repurchases exceeded $20 billion by the end of 2007.

The new millennium has tested every industry, and p-c insurers are no exception. Yet through the centuries insurers have risen to meet the economic and operating environment challenges they face.

Increased competition, from within or from alternative forms of risk transfer, are variations on ancient themes.

Disciplined capital management is a well-established and fundamental business principle, while managing changes in the external regulatory and tort environments is part and parcel of what it means to be an insurer.

Execution is critical to the success of individual insurers, but the industry as a whole retains its trademark resilience, ready and able to grow and thrive through whatever challenges the next decade may bring.

Special Reports /

While Industry Faces Big Challenges, Insurers Can Master Their Own Destiny

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