How Much Longer To P-C Nirvana?

Premium growth is up sharply this year (rising by 10 to15 percent for many major insurers); the combined ratio is down (to an estimated 108.5 from 110.5 last year); and profits are stabilizing (net income and return on equity are likely to increase for the first time since 1997).

Despite wonderfully refreshing news on the financial front, the p-c insurance industry will require approximately one more year (mid-2002) to arrive at its final destination–and once there, there will be no vacation, and precious little time to kick back and relax.

It has always been difficult for insurers to maintain their grasp once atop the precarious perch of profitability. The industry's return on equity exceeded that of the Fortune 500 group for just two years during each of the two past hard markets (which occurred during the mid-1970s and the mid-1980s).

Staying atop the perch will not be easy this time around either. While horrific underwriting results have forced insurers' hands for now, the industry remains ferociously competitive, made only more so in recent years with the debut of banks and the Internet as purveyors and peddlers of insurance.

Insurers will also find themselves coping with a weak economic and investment climate and recalcitrant regulators.

The current hard market is being erected upon three pillars: pricing, underwriting performance and capacity.

The first pillar–pricing–as stated above is surprisingly strong and, at 10 to 15 percent for the first half, greatly exceeds analysts' expectations of 7.4 percent for all of 2001.

The second pillar–underwriting performance–is sturdy and of sound design, but still under construction.

A survey of company-by-company results reveals not only significant price increases in key (especially commercial) lines, but also lines where huge blocks of business are not being renewed. In other words, insurers have walked away from billions in business that they would have spilled blood (red ink) over just 18 months ago.

Insurers are also in the process of getting tough with regulators, with skirmishes between insurers and their overseers becoming increasingly frequent.

Recent decisions by State Farm and American International Group to pull out of the New Jersey auto market and St. Paul's decision to transfer its medical malpractice book to a surplus lines subsidiary both drew the scorn of regulators, but did not cause the companies to back down.

Insurers' get-tough attitudes are beginning to bear fruit.

Net underwriting losses soared 41.1 percent in 2000 as years' worth of chronically-underpriced business assaulted the industry's income statement, but rose by a very modest 2.4 percent during the first quarter of this year.

The third pillar supporting the hard market–capacity–is having an impact that is at least as great as the other two.

One year ago I argued that significant amounts of capital would exit the industry over the next year. "The economic laws governing the efficient allocation of capital dictate this outcome. How the capital exits is another matter. It can exit chaotically through high underwriting losses and destruction of unrealized capital gains in the industry's investment portfolio, or in an orderly fashion through stock buybacks, investments in projects external to p-c insurance and generous policyholder dividends–but exit it must," I wrote.

Chaotic it was, but exit it has! Since peaking at $339.3 billion in June 1999, surplus has decreased by $35.6 billion to $303.7 billion, meaning that the industry has purged itself of a significant amount of excess capacity–28 percent to 36 percent–of the $100 billion to $125 billion in excess capital it holds.

By year's end, the industry could find itself with a leverage ratio (defined as the ratio of net written premiums-to-policyholder surplus) exceeding one for the first time since 1996.

Wall Street, which shunned insurer stocks for much of the 1990s, has become a great believer in the industry's recovery. Investors during the first half of this year appeared to be holding on to their insurance stocks while dumping just about everything else in their portfolios.

During the first half of 2001, the S&P 500 and Nasdaq indexes fell 7.3 percent and 12.6 percent, respectively, while p-c insurance stocks were down just 0.9 percent (on a market capitalization-weighted basis). Over the past twelve months, p-c stocks are up 41.0 percent while the S&P 500 and Nasdaq are down 14.1 percent and 45.6 percent, respectively.

From an investment perspective, the industry's Wall Street performance is truly exceptional. Over the past twelve months, for example, there is not a single category of mutual fund that would have outperformed a hypothetical market cap-weighted "fund" composed exclusively of p-c insurer stocks.

Financial services funds, the best performing mutual fund category over the past year, posted an average return of 30.7 percent. The average diversified stock mutual fund lost 9.7 of its value over the past twelve months while the average taxable bond fund gained just 6.4 percent over the same interval (see chart).

There will certainly be unanticipated bumps on the road on the way to p-c nirvana. The current economic slowdown, for example, could eventually pose problems, though the Fed's aggressive rate actions have helped credit sensitive sectors of paramount importance to p-c insurers such as new home construction and automobile sales.

With any luck, the p-c insurance industry will arrive in the land of profits and growth by the middle of next year. The questions is, can we stay for a while this time?

Robert P. Hartwig is vice president and chief economist for the Insurance Information Institute in New York. He can be reached at bobh@iii.org

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 30, 2001. Copyright 2001 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.

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