P-C Net Income Could Be Negative For 2001

Despite significant growth in premium volume in 2001, the U.S. p-c insurance market continued to report deteriorating operating results in the first half of the year.

According to industry results compiled by the Insurance Services Office in New York, net written premium on a statutory basis increased by 10 percent over the first half of 2000, and earned premium increased by 8 percent, reflecting the impact of continued positive pricing trends in nearly all market sectors.

However, the combined ratio deteriorated to 111.2 for the period relative to 108.8 in the first half of 2000.

Catastrophe losses were a major driver of this deterioration in underwriting performance. Record high second-quarter 2001 catastrophe losses, attributable mainly to Tropical Storm Allison, led to estimated catastrophe losses by ISO of $6.6 billion for the first half of 2001, compared with $3.4 billion in the prior year period.

Excluding catastrophe losses, the combined ratio was 106.9 in the first half of 2001, modestly worse than 106.4 for the same period in 2000.

Likewise, operating earnings deteriorated for the period as well with a reported pretax loss of $1.9 billion from operations. Realized capital gains offset this loss to produce net income of $2.5 billion for the period versus $10.5 billion in the first half of 2000.

Policyholders surplus declined by 6.0 percent in the first half of 2001 to just under $300 billion due to the poor operating results and unrealized investment losses. This reduction follows a 5.1 percent decline in policyholders surplus for the full-year 2000, which marked the first year since 1984 that surplus declined for the p-c industry.

In Fitchs report, "Review & Outlook: 2000/2001 Property-Casualty Insurance" published in January 2001, we projected a modest improvement in the industrys combined ratio in 2001 to 109.2 from 110.1 in 2000. In making this projection, we believed that positive rate increases would begin to translate into improved underwriting performance.

We also believed, however, that improvements would be tempered by continued higher loss cost trends, particularly due to medical cost inflation; potential for adverse reserve development for prior underwriting periods; and modestly higher catastrophe losses relative to the favorable experience of 2000.

Given the magnitude of catastrophe losses related to the terrorist attack that will be incurred in the second half of 2001, actual combined ratios will greatly exceed the January projection.

There is still great uncertainty in estimating the total insured losses incurred related to the attack, how much of the loss will be retained in the domestic market and whether portions of the losses are reported after 2001. In general, it has taken the industry at least two quarters for losses from large property catastrophes such as hurricanes to fully develop. Given the magnitude and complexity of the attack losses, which encompasses many lines of business, the development period will likely be longer.

Analysts total industry aggregate loss estimates for the attack remain in a very wide range with recent approximations ranging between $30-$70 billion. Determining a more precise figure will take some time, and some losses may never be reported due to a number of organizations use of finite risk reinsurance. (This issue was addressed in depth in a Fitch press release published on Oct. 5, 2001.)

To date, over $20 billion of estimated insured losses have been reported by p-c insurers. The number of companies issuing revised estimates has slowed, but upward adjustments continue to emerge.

Fitch has not provided a formal aggregate loss estimate for the attacks. However, assuming that the actual loss is nearer to the low-end estimate of $30 billion, the amount of attack-related and other catastrophe related losses relative to full-year earned premium in 2001 would approximate 8 percent. (This further assumes that approximately two-thirds of these losses are retained in the domestic market and that other catastrophe-related losses are modest for the rest of the year.)

The only year that this ratio was higher was 1992, at 10.1, due mainly to Hurricane Andrew, previously the most costly catastrophe event in history.

If the combined ratio excluding catastrophe losses remains around first-half levels, the full-year combined ratio will be approximately 115 assuming a $30 billion aggregate attack loss.

With this underwriting performance, the industry will report its largest annual underwriting loss ever and a pretax operating loss for the year. Whether net income is positive or not will depend on reported second-half 2001 realized investment gains, which may prove illusive given recent weak capital markets performance.

Also, assuming that all currently reported estimates of losses for the attack are incurred in the third quarter, the third-quarter 2001 combined ratio could reach 125 or higher. This figure would exceed the 123.5 and 122.8 combined ratios reported for the fourth and third quarters of 1992, respectively, in the aftermath of Hurricane Andrew.

In addition to attack losses, Fitch believes that 2001 underwriting results may also be unfavorably impacted by adverse loss reserve development from prior accident years. At year-end 2000, Fitch believes that there was a significant reserve deficiency for the industry, particularly in the 1997-99 underwriting periods for commercial lines and for asbestos and environmental exposures.

Since 2001 underwriting results will be poor, companies may have an added incentive to recognize prior reserve deficiencies before year end to improve balance sheet quality and foster improved underwriting results in future periods. Aggregate reserve strengthening for the industry was surprisingly modest in the first half of 2001.

Fitch expects a number of companies to report charges in the third and fourth quarter of 2001 with multiple elements, including catastrophe-related losses, reserve changes for prior underwriting periods and asbestos and environmental exposures, and various restructuring costs. It is also possible that companies with weaker balance sheets and less financial flexibility may have a motivation to defer loss reserve strengthening until a future period in which the strengthening is offset by current earnings.

A combined ratio of 115 would be among the highest in industry history, only exceeded by 1984, which produced a 118 combined ratio, 1985, at 116.3, and 1992, at 115.7.

If actual losses from the attacks escalate closer to the middle or higher end of analysts estimates, or significant reserve strengthening materializes in the second half of the year, the combined ratio could exceed these historic high levels, making 2001 the worst year in history for underwriting performance.

Following this poor operating performance in 2001, questions arise regarding the p-c industrys ability to return to a more profitable footing going forward. Based on historical experience from these other unusually poor underwriting periods, the industry is likely to post better underwriting results in the aftermath of 2001.

However, improvement will likely be gradual and it will take a few years to reach a favorable operating result that would support adequate returns on capital (generally defined by Fitch as a statutory combined ratio of 101-104 and an operating ratio, after the impact of investment income, of 90-93). Fitch plans on providing a more complete estimate of 2002 underwriting results in its "Review & Outlook 2001-2002″ report that will be published in January 2002.

Previous market developments may aid in promoting a swifter improvement in future underwriting performance. As indicated earlier, measures taken to respond to the overly competitive pricing and undisciplined underwriting practices of the late-1990s have not materially impacted the bottom line. Still, positive pricing trends in nearly all market segments in 2000 and 2001 will provide momentum for future rate actions. These pricing trends will likely accelerate dramatically in 2002, particularly in the property, property catastrophe and aviation lines.

Policy terms and conditions will also tighten further, with insurers and reinsurers exercising greater caution in overall risk assessment and in defining policy terms and risk exposures. Insurers will also actively mitigate risk through greater use of higher deductibles, policy exclusions, policy limits and sublimits in insurance contracts.

There are other factors that may inhibit improvements in future underwriting performance.

First, it is likely that losses from the terrorist attack will continue to be reported into 2002, particularly in liability and reinsurance lines where it is more difficult to assess loss exposures. Further loss exposure could also materialize in areas where issues regarding coverage and policy terms have not been fully resolved. Also, as mentioned earlier, recognition of previous loss reserve deficiencies from prior underwriting periods will also dampen profitability whenever these deficiencies flow into earnings.

Another uncertain element that will widely impact industry results going forward is the effect of anticipated increases in reinsurance pricing and reductions in reinsurance/retrocessional capacity.

These reinsurance market changes will impact pricing and availability of coverage in primary markets as reinsurance rate increases in some segments may exceed primary market rate increases.

Higher reinsurance costs will hinder primary writers that significantly rely on reinsurance to improve underwriting results going forward.

One imminent change for the industry is that exclusions for terrorist-related incidents are likely to become a standard element of commercial policies. Reinsurers are indicating that they will no longer cover these exposures due to an inability to quantify and price this risk exposure. With reinsurers balking at this exposure, primary insurers will follow suit.

There is much discussion regarding the formation of a government-sponsored reinsurance pool with industry participation, similar to Pool Reinsurance Co. Ltd. in the United Kingdom. Due to the unavailability of coverage under standard commercial policies going forward, some mechanism will need to be created for coverage of these events, or there could be some serious economic repercussions, particularly in areas such as commercial real estate sales and construction and other core infrastructure investments.

Given uncertainty related to the ultimate losses from the terrorist attack, Fitch recently placed a large number of p-c insurers and reinsurers on Rating Watch Negative due to significant exposures to the event. A smaller number of insurers were downgraded recently as well, typically due to a combination of factors, including continued unfavorable operating results, uncertainty regarding reserve adequacy and significant exposure to losses from the terrorist attack.

Since these Rating Watch announcements, Fitch has concentrated on gathering more specific information regarding companies exposure to the terrorist attacks and their strategy for restoring their balance sheet position to prior levels following these losses. A comment describing this process in more detail was issued on Oct. 16, 2001.

Fitch will continue to monitor events related to the terrorist attack closely. While the property/casualty insurance industry faces considerable challenges in responding to this recent tragedy, Fitch believes that the industry has the resources to absorb losses related to the attack.

While 2001 will prove to be a highly unfavorable underwriting period, the industry should show significant signs of improved profitability in 2002 and 2003, barring other unusual catastrophe loss experience.

James Auden is a senior director for Fitchs Insurance Ratings Group in Chicago.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 5, 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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