Tumbling Prices, Yields Put Profitability At Risk

In this article, Fitch Ratings looks at p-c results for 2004 and considers several areas that will be key determinants of the market's profit potential going forward.

2004 Results Recap–A Rare Underwriting Profit

The accompanying table lists some key industry aggregate financial items from 2001 to 2004 compiled by Fitch from the National Association of Insurance Commissioners' Annual Statement Database via National Underwriter Insurance Data Services/Highline Data.

The table reveals how far the industry has come from a profit perspective since 2001, which represented the only time in history that the industry reported a net after-tax loss. The market was then reeling from an extended and severe soft market, losses from the Sept. 11 event, and investment losses due to the stock market downturn. Among the key findings:

o Net written premium growth moderated significantly in 2004 for the p-c insurance industry, increasing by only 4.8 percent compared with 9.2 percent in 2003 and 14.4 percent in 2002.

o The p-c industry produced its first underwriting profit since 1978 in 2004, reporting a combined ratio of 98.1 This result compares favorably with a 100.2 combined ratio in 2003, 107.0 in 2002 and 115.6 in 2001.

This performance is mainly attributable to the impact of successive rounds of price increases and tighter underwriting terms and conditions in nearly all market segments that commenced in 2000, accelerated greatly following the tragic events of Sept. 11, 2001, and continued through to year-end 2003.

o The combined ratio improvement was mainly due to calendar-year loss ratio improvements, reflecting improvement in current accident-year loss experience as well as reductions in adverse reserve development from prior underwriting periods.

o Expense ratios have improved modestly in recent years mainly due to the impact of a larger premium base.

o Investment income grew modestly for most insurers in 2004, reflecting continued growth in invested assets due to strong recent operating cash flow but offset by continued reductions in investment yields.

o Net income increased to a record $39.9 billion–a 31 percent increase from the prior year.

o The industry's return on statutory surplus improved to 10.3 percent from 9.3 percent in the prior year. The industry's policyholders' surplus increased by 15.7 percent in 2004 to a record $416 billion.

Unfavorable Pricing Trends Accelerating

Following a series of sharp rate increases from 2001 to 2003, pricing momentum in the market has shifted. The Council of Insurance Agents & Brokers' second-quarter 2005 Commercial Market Index Survey reported a 9.7 percent average decline in commercial account pricing. This represents the sixth-consecutive quarter that the index has declined and rates continue to decline at an increasing rate.

Commercial property rates continue to drop faster than casualty lines. The only segment not experiencing rate decreases recently, according to the CIAB, is medical malpractice.

It is important to recognize that hard markets are rare and fleeting, and that underwriting conditions in 2002-2003 represented the strongest market in many years. The end of hardening market conditions was inevitable at some point due to competitive factors and market resistance to further rate increases.

Fitch's market intelligence encouragingly does not indicate any recent rampant deterioration in policy deductibles/retentions and other terms and conditions.

While difficult to predict the direction of pricing in the future, there is clearly momentum for further rate declines in the near term. Longer-term pricing trends will largely be dictated by shifts in underwriting capacity and competition.

Insurers have generated considerable surplus in the last two years, and capacity has also increased due to newer entrants in primary insurance and reinsurance segments–including investments in (re)insurers from hedge funds.

It will be interesting to see if capital moves out of the p-c sector as attractive underwriting opportunities diminish, or if underwriting discipline deteriorates promoting further rate declines.

Adverse Reserve Development Diminishing

Property-casualty industry earnings have been adversely impacted by unfavorable loss-reserve development for the last four years. However, the level of adverse development has been declining.

Prior-period adverse reserve development was $9.4 billion in 2004 (adding 2.3 percentage points to the calendar-year incurred loss ratio). Though disappointing, this reserve development is considerably less than the $14.0 billion of adverse development reported in 2003 (3.6 percentage points) and $21.3 billion in 2002 (6.0 percentage points).

Unfavorable reserve development has been concentrated in longer-tail casualty lines in the 1997-2001 accident years, which represents the nadir of the last soft market, as well as older asbestos exposures. Encouragingly, the 2002 and 2003 accident years, though relatively immature, have developed favorably thus far.

One of Fitch's primary challenges in the rating process continues to be determining whether companies that have reported significant reserve development are adequately reserved or may require further measures.

Fitch believes the industry still has a significant reserve deficiency that will dampen earnings going forward and that select individual insurers will periodically report significant reserve related charges, such as American Re's $1.6 billion second-quarter 2005 reserve increase.

Will Catastrophe Loss Levels Revert To Mean?

Property-casualty insurers experienced record catastrophe losses in 2004 due to the four hurricanes that struck Florida and the Southeast in the third quarter. Some insurers with international exposures also reported losses from the fourth-quarter South Asia tsunami.

The Property Claim Services unit of the Insurance Services Office reported that p-c insurers paid $27.3 billion (6.5 percent of net earned premiums) in catastrophe losses in 2004. This is more than double the amount of catastrophe losses in 2003 and exceeds the $26.5 million of losses experienced by U.S. insurers in 2001, which included the tragic events of Sept. 11. (Over the most recent 10 calendar years, annual catastrophe losses have averaged $11.4 billion according to PCS.)

The hurricane season began with a flourish in 2005, with Hurricane Dennis striking the Florida panhandle, Alabama and Mississippi, and Hurricane Emily hitting in Mexico and venturing into Texas. These events will likely produce significant losses but fortunately will be less severe than earlier forecasts.

PCS has recently projected insured losses of $900 million from Dennis, which is lower than the losses produced from any of the four storms that occurred in 2004. Still, hurricane season 2005 remains in its early stages, and it is impossible to predict what events may transpire.

Investment Income Dampened By Continued Low Interest Rates

As interest rates have declined over the last few years and continue to remain near 40-year lows, p-c insurer portfolio investment yields have declined considerably as higher-yielding investments have matured.

The industry's investment yield has declined to a current level of approximately 4.0 percent, down from 5.1 percent in 2000. At best, portfolio investment yields will remain flat in the near term.

In this environment, it is imperative for insurers–including long-tail business writers–to produce an underwriting profit to earn an adequate return on capital.

Based on this investment yield, Fitch estimates that a p-c insurer with industry average operating leverage, asset leverage and effective tax rates will need to produce approximately a 94 combined ratio to generate a 12 percent statutory operating return on surplus, which we believe approximates the equity cost of capital.

Where Will Industry Investigations Ultimately Lead?

The other significant source of uncertainty for the p-c insurance market going forward relates to the spate of investigations by legal and regulatory authorities that commenced in 2004 regarding alleged bid-rigging and conflicts of interest tied to contingent commissions for insurance brokers, and potential accounting irregularities and other improper activity with the sale or purchase of finite risk reinsurance.

Nearly all of the larger p-c insurers in the United States have received subpoenas and information requests related to these probes from state and federal authorities, including the New York attorney general's office and the U.S. Securities and Exchange Commission.

Thus far, probes related to the brokerage business have led to material financial settlements from several brokers–most notably Marsh & McLennan and Aon. Several insurers have had individual employees face charges related to the bid-rigging allegations.

The finite-reinsurance investigations have had broader implications for p-c insurers. The most significant outcome thus far was the departure of Maurice Greenberg, the longtime chairman and chief executive officer of American International Group. AIG's investigation of its practices as part of these probes led to various accounting restatements that reduced year-end 2004 shareholders' equity by approximately $2.2 billion.

Internal and external reviews have led other insurers–including ACE Ltd., CNA and RenaissanceRe Holdings–to make more modest accounting restatements related to finite-risk reinsurance transactions.

In addition, RenRe Chairman and CEO James Stanard recently received a Wells Notice from the SEC. The notice recommends a civil enforcement action against Mr. Stanard, alleging violations of federal securities laws linked to the company's restatement of financial results completed with the reporting of year-end 2004 results.

It is difficult to ascertain whether many other insurers will be required to make accounting adjustments or face more serious legal actions as a result of investigatory findings. However, Fitch foresees greater risk for companies found to have either:

o Used secret side agreements to negate the risk-transfer provisions of a finite-reinsurance contract.

o Used spurious assumptions in their calculations to achieve risk-transfer accounting that is not justified.

o Ignored accepted standards altogether and recorded a transaction as risk transfer when it clearly did not meet accounting guidelines.

Outlook

It is likely that 2004 was the peak year for underwriting results and profitability in the current cycle. Net written premium growth is likely to be only 2-to-3 percent in 2005.

In addition, while the market overall is expected to produce another underwriting profit in 2005, deterioration in core accident-year loss experience is not expected to be completely offset by a return to more normalized catastrophe losses and less severe prior-period reserve development.

Looking further out to the market's profit potential in 2006 and beyond is more challenging. However, the trend for loss costs in most segments continues to be upward, while competitive pressures are likely to promote further premium rate reductions. These factors point to less favorable earnings prospects for the industry over the longer term.

Fitch's Rating Outlook continues to be stable for the U.S. commercial lines and personal lines sectors, reflecting an expectation that the number of rating downgrades will roughly equal rating upgrades in the future for both sectors.

The Rating Outlook considers that although pricing will likely further deteriorate going forward, the aggressive pricing environment of the late 1990s is unlikely to return in the foreseeable future. A sudden return to this environment would likely lead to a reassessment of a number of p-c insurer ratings.

Also, the market is expected to remain in a state such that more proficient underwriters are able to produce adequate returns on capital.

James Auden is a senior director of Fitch Ratings in Chicago, Ill.

Quotebox, with mug:

"It is important to recognize that hard markets are rare and fleeting, and that underwriting conditions in 2002-2003 represented the strongest market in many years. [Still,] Fitch's market intelligence encouragingly does not indicate any recent rampant deterioration in policy deductibles/retentions and other terms and conditions."

James Auden

Caption for Table

Flag: By The Numbers

Head: Premium Growth Keeps Slowing

Despite seeing the rate of net premium growth fall almost in half, insurers managed to cut their combined ratio below the breakeven point and push up net income by nearly one-third.

(if there's room in Rankings)

Worth Noting

In the current investment environment, Fitch estimates that an average p-c insurer will need to produce approximately a 94 combined ratio to generate a 12 percent statutory operating return on surplus.

For page 12:

Head: Guide To Premium Rankings:

Top 20 Insurance Groups (with detailed company breakdown) 14, 15, 17

Top 100 Insurance Groups 18

Top 100 Insurance Companies 19