It's always darkest before the dawn and the US property/casualty insurance industry's financial performance over the past year presents us with a vivid illustration of this point. Soaring underwriting losses and shrinking profits continue to cast a veil of darkness over this industry, while accelerating premium growth, rising investment income and widespread rate increases offer a tantalizing glimmer of hope. With the industry now standing at the threshold of recovery from a soft market that has lasted more than a decade, the year ahead is shaping up to be the most critical in the industry's recent history.
In the property/casualty insurance industry it has been night for a very long time. Return on equity has fallen short of the Fortune 500 benchmark every year since 1987. During the 1990s, the industry's return on equity averaged just 8.4% compared to 13% for the Fortune 500 group. For the first half of 2000, the industry's return sunk to just 5.6%. Growth, too, has proved to be an elusive quarry. While the economy expanded at an average annual pace of 3.2% (after adjusting for inflation) during the latter half of the 1990s, growth in net premiums written hobbled along at just 0.3%.
This situation cannot and will not persist forever in such a vital industry. The laws of economic physics will not permit it.
The case for recovery
After entombment in more than a decade's worth of dreary financial results, for the first time in many years a very compelling case can be made that the property/casualty insurance industry is emerging from the darkness. This assertion is based on far more than mere opinion, it is based on observation of increasing evidence and the simple fact that the industry's financial results have been so bad for so long that they could no longer persist. To statisticians this well-known principle is known as “reversion to the mean.” For property/casualty insurers and investors in this industry the practical implications of this statement are profound, yet can be expressed intuitively as “what goes down must come up.” The laws of economic physics are now hard at work on the property/casualty insurance industry.
Consider the following facts:
written premium growth is
accelerating, reaching 4.2% during the
first half of 2000. This follows
premium growth of just 1.8% and
1.9% in 1998 and 1999, respectively,
two of the slowest growth years since
the Great Depression.
Investment income is rising after
declining for two consecutive years.
Only once before in the past quarter
century had investment income
declined two years in a row.
Policyholder surplus shrank by 2.3%
during the first half of 2000, the
second decline in the past three
quarters. During 1999, policyholder
surplus grew just 0.9%, the smallest
increase in 15 years.
Those are the facts - now on to the physics that are working to turn this industry around.
Premium growth is accelerating
The physics of premium growth is simple. Accelerating premium growth is the direct result of additional premiums from new exposure, higher prices or both. Additional exposure is easy to document in a booming economy. New homes alone will add approximately $200 billion to the exposure base of the homeowners line in 2000. Auto insurers will find 19 million new vehicles in need of insurance this year - a record. Half of them will be expensive SUVs and light trucks - also a record. Workers' compensation insurers can expect as many as two million new workers to enter the labor force next year, adding tens of billions of dollars to the payroll base. Exposure growth across personal and most commercial lines will remain strong as long as the economy remains healthy. Despite rising petroleum prices, the US economy is expected to expand by 5.2% in 2000 and 3.5% in 2001.
Higher rates are an equally important part of the premium equation. Rate increases ranging between 2% and 4% were the rule throughout the commercial lines sector during the spring 2000 renewal season, the first across-the-board increases in many years. Summer 2000 renewals were twice that amount and pricing discipline appears to be intact for the important January 2001 renewal season.
The price war in the personal auto line is also abating. After falling by 6% over the past two years and with huge underwriting losses to show for it, automobile insurance rates are back on the rise. Moreover, the pricing of catastrophe risk is becoming more rational as the cost of insuring property in disaster-prone areas gradually becomes more consistent with the risk assumed. Even beleaguered reinsurers are seeing a boost with rates up approximately 10%, the first sustained increase since 1993.
Investment income is rising
The physics of investment income - which consists primarily of interest from bonds and stock dividends - is also simple. Bonds account for two-thirds of the industry's investment portfolio and currently yield between 5% and 7%. In contrast, dividends paid on the 20% of the industry's portfolio invested in stocks produce an effective yield of less than 1.5%. Changes in the interest rate environment therefore have a far greater impact on investment income than anything else. The Federal Reserve's shift toward an anti-inflationary bias in 1999 led to several rate hikes during the second half of 1999 and the first half of 2000, ultimately sending short-term interest rates sharply higher. The boost in yields and the expanding pool of funds available for investment (derived from faster premium growth) are leading directly to the recovery in investment income. The Federal Reserve is not expected to raise short-term interest rates before the presidential elections in November, but should inflationary pressures build, the Fed could be forced to act in early 2001.
Overcapacity is being purged
The laws of economic physics are also working their way through the return on equity calculation by slowing and ultimately shrinking the industry's surplus. Surplus (or capital) is synonymous with capacity. Capital that cannot earn a rate of return commensurate with investments of similar risk will eventually exit the industry. Last year's 0.9% increase in surplus, followed by the 2.3% ($7.6 billion) decline during the first half of this year signal a shift in that direction. Should capacity actually shrink in 2000, it would be the first such occurrence since 1984.
Wall Street analysts have estimated the industry's “excess” capital at $100 billion to $125 billion; so much more capacity must exit. 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 property/casualty insurance and generous policyholder dividends - but exit it must. In fact all of these factors are presently contributing to the decumulation of surplus and elimination of excess capital. Because return on equity is calculated by dividing profit into surplus, profitability will eventually be enhanced as the denominator in this equation shrinks.
Wall Street: seeing is believing
The persuasive evidence of recovery has made property/casualty insurer stocks (and insurer stocks in general) one of the best plays on Wall Street this year. As of this writing (mid-September 2000), the property/casualty group on a year-to-date basis had recorded a total return of 17.1% compared to virtually no change at all in the Standard and Poor's 500 index and a decline in the once-hot Nasdaq of 5.8%. The divergence is far more dramatic when measured from the Nasdaq peak on 10 March. Since the bursting of the tech bubble in early March, the Nasdaq has declined by 24% (through 15 September) compared to a gain of 45.3% for the property/casualty group, a performance gap of nearly 70 points. The results for life/health insurers, brokers and multiline insurers - which have posted gains of 52.1%, 53.8% and 57.1%, respectively are even more dramatic.
The industry's stock performance in 2000 contrasts starkly with its dismal performance in 1999, when property/casualty stocks lost 25.7% of their value (on a market-cap weighted basis), compared to a gain of 21% for the Standard & Poor's 500 index and a rise in the Nasdaq of more than 80%. Before the Nasdaq crash began in March, many insurer stocks were priced at their lowest levels in years.
Of course all eyes in 1999 and early 2000 were on the technology-laden Nasdaq. “Old economy” industries such as insurers, manufacturers and retailers lagged far behind the returns in so-called “New economy” industries related to the internet, telecommunications and biotechnology. What a difference a year can make!
The surge in investor interest in insurance stocks is being driven by several factors, including disappointing earnings (or total lack thereof) among the dot-coms and extraordinarily low valuations for insurance stocks. But many investors are being seduced by the most exciting prospect of all - that of making an investment at a point that could mark a turn in the insurance cycle and a return to improved profitability. If Wall Street is right, then 2001 should represent a new dawn for the property/casualty insurance industry.
Robert P. Hartwig is vice president and chief economist at the Insurance Information Institute.