P&C Industry Review Nine Months 2007 — Strong Results Starting to Fade?
(December 4, 2007)
A BISM Online contribution from ALIRT Insurance Research, LLC

David Paul and Dan Hausmann are principals of ALIRT Insurance Research, Inc., a Windsor,CT based research firm offering customized credit analytics and competitive intelligence on insurance carriers and the broad insurance industry.

The P&C industry continued to report strong underwriting and operating profitability in the first nine months of 2007, and solid earnings and net capital gains drove strong surplus development, despite accelerating dividends paid out to parent organizations. However, accident year combined ratios continue to deteriorate (rise) despite a lack of substantial catastrophe losses, and prior year reserve releases were flat to slightly down in the third quarter. Most troubling is the continued weakness in the industry’s premium levels, with an actual decline in direct premiums written for the first nine months of 2007" the first since 1998.

All of this provides evidence that the current soft market cycle continues, reflected in the declining industry-wide pricing. Generally lower prices, while still profitable on an accident year (and likely ultimate) basis, may produce decreased profitability in the coming years, though it is still uncertain when reported combined ratios may rise back over 100%, and when the industry will again begin to feel earnings and balance sheet "pain", eventually leading to another turn in the market cycle.

Sub-Prime Mortgage Exposure

After a brief respite in September and October, the subprime mortgage issue roared back into the national consciousness when eye-popping aggregate losses were reported by a number of major commercial and investment banks with the release of nine-month GAAP results. These losses were catalysts for considerable equity market volatility (especially in the financial services sector), and a constriction of liquidity in the financial markets.

Though insurance stock prices deteriorated along with most of the publicly traded financial sector, it appears that insurers are presently more insulated than other financial services companies from material subprime losses. However, other developments tied to the current subprime crisis may affect property & casualty insurers. These include: 1) A sharp rise in losses reported by mortgage insurers, due to heightened homeowner defaults, 2) possibly large D&O claims, with Guy Carpenter recently predicting losses of $2 billion on claims filed in 2007, with total losses from future years expected to be substantially higher; and 3) the impact that a possible recession may have on general business across the industry¹.

Other Issues of Interest

Both the House and the Senate recently passed bills extending TRIA, which is set to expire on 12/31/07. The two bills differ on key components of the new TRIA program, including extension period, expanded coverage, retentions, and deductibles. The White House indicated that it would veto the House bill as it now stands, but is willing to consider a bill aligned more closely on Senate proposals. The two houses of Congress now move into conference to attempt to forge a workable compromise, with Rep. Barney Frank, the chairman of the House Financial Services Committee, arguing for an extension of the current program so that a compromise bill is not rushed by the impending 12/31/07 deadline.

Executive Summary: ALIRT P&C Composite Results

Below we provide nine month 2007 financial highlights for a composite of 50 large U.S. property & casualty insurers, representing approximately 50% of total industry net written premium (hereafter referred to as the ALIRT P&C Composite). All financials are drawn from the companies’ statutory filings.

• The ALIRT P&C Composite reported a nine month 2007 combined ratio of 93.4%, a deterioration from the prior year period results (91.1%), but still strong. The Composite operating ratio was 82.3% and pretax return on earned premium was 17.3%, both modestly weaker than full year 2006 and six month 2007 results.
• Reported underwriting results were aided by $3.2 billion of net reserve releases in the first nine months of 2007, though releases actually narrowed slightly (-$200 million) in the third quarter. The nine month figure, however, approaches full year 2006 releases of $3.4 billion.
• The accident year combined ratio (which excludes the impact of prior year reserve development) was 95.2% for the first nine months of 2007, 2.2 percentage points worse than full year 2006 results. The accident year results have now underperformed reported results for six consecutive quarters, a reflection of reserve releases into earnings and a traditional indication of a soft market cycle.
• Nine month 2007 pretax operating income of $30.0 billion was 2.7% below earnings for the same period in 2006, a reflection of slowing but still robust underwriting income and lower net investment income. Composite pretax ROE fell 230 basis points to 14.4% (annualized) when compared to the full year 2006 ROE of 16.7%.
• For the first nine months of 2007, net investment yield declined 38 basis points to 4.21% (annualized), from 4.59% in 2006. This may be distorted by the timing of investment income, as well as sharp declines in investment income for some large insurers. Total return also declined to 7.09% (annualized), 118 basis points lower than full year 2006 levels, which reflected both the lower yield, and a reduction in capital gains for many insurers with large gains in 2006 (which boosted total return for the composite in that year).
• The Composite’s strong earnings combined with net capital gains of $12.7 billion to boost surplus 7.9% in the first nine months of 2007. If annualized, this would represent a 10.5% increase for the full year 2007, still strong but well below surplus gains of 18.1% in 2006. The weaker surplus growth is due in part to shareholder dividends paid of $13.2 billion, which were more than twice the composite dividends paid for the same period in 2006 ($6.2 billion).
• Year-over-year direct and net premium growth rates were essentially flat, at -0.7% and 0.7%, respectively, for the first nine months 2007. This is the first instance of a decline in direct premiums written for the Composite since the soft market year 1998. The low net premium growth corresponds with rates also last seen in 1998.
• Gross and net underwriting leverage ratios (gross and net premiums to surplus) continued to decline, as surplus growth once again exceeded premium growth. Annualized premium leverage ratios were 1.31 times (gross) and 0.82 times (net) for the first nine months 2007, versus 1.37 and 0.87, respectively, for 2006.

Capital and Surplus

Surplus rose 7.9% for the ALIRT P&C Composite in the first nine months 2007 (10.5 % when annualized), on after-tax operating earnings of $22.9 billion and net capital gains of $12.7 billion. Earnings for P&C insurers, already boosted by the lingering impact of the past hard market cycle pricing, were further helped by relatively light catastrophe losses of $4.5 billion (estimated) in the first nine months of 2007, and in particular an absence of significant U.S. hurricane activity.

Offsetting the strong earnings and net capital gains were shareholder dividends paid of $12.7 billion, approximately twice nine month 2006 dividends paid of $6.2 billion. As P&C insurers continue to bolster their surplus positions in the present strong earnings environment, and market pricing conditions are soft, the acceleration of shareholder dividends highlights a greater willingness to upstream funds that cannot be put profitably to use.

Individual Company Results

Seventeen composite companies reported surplus gains exceeding 10% in the first nine months of 2007, led by AIG subsidiaries Lexington Insurance Company (37.1%), Commerce & Industry Insurance Company (37.0%), and National Union Fire (16.4%), and Erie Insurance Exchange (16.2%), and Ace American Insurance Company (15.5%). Of these 17 companies, only Liberty Mutual Insurance Company saw surplus boosted by capital infusions ($951 million).

Only six companies reported declining surplus in the first nine months of 2007, with the largest declines seen at Motors Insurance Corporation (-35.8%), Safeco subsidiaries General Insurance Company of America (-29.3%) and Safeco Insurance Company of America (-22.1%), and Progressive Casualty Insurance Company (-26.7%). Almost all companies reporting flat or declining surplus positions through nine months 2007 paid sizeable dividends to parents, with Allstate Insurance Company (-3.1%) paying $4.0 billion and GM/FIM Holdings subsidiary Motors Insurance Company paying $1.3 billion.

Five companies reported surplus infusions in the first nine months of 2007, with only Liberty Mutual Insurance Company receiving a substantial amount ($951 million), most of which came in the first quarter. Not one Composite company reported an operating loss through 9/30/07, while seven companies reported net capital gains of over $500 million. These were led by State Farm Mutual ($4.4 billion or 35% of the total), National Union Fire ($1.4 billion), USAA ($886 million), Federal Insurance Company ($781 million), and Allstate Insurance Co. ($624 million).

Underwriting Profitability

The ALIRT P&C Composite reported a combined ratio of 93.4%, up from 91.1% in the prior year period, the deterioration reflecting in part a 1.2 percentage point increase in the loss ratio. Taking into account investment results, the industry composite reported an operating ratio of 82.3%, continuing the strong operating earnings trend witnessed over the past four years. Below we detail profitability metrics for the composite over the past six years and the first nine months of 2007. The vast improvement in the combined and operating ratios since 2001 clearly illustrate the positive impact of the hard market cycle which extended into 2004².

Catastrophe losses were modest in the first nine months of 2007, aiding earnings. According to the ISO Property Claim Service estimates, the U.S. Property & Casualty industry reported estimated catastrophe losses of $1.1 billion in the third quarter 2007, for a total of $4.5 billion for the first nine months of 2007. This marks the third lightest third quarter and nine month catastrophe losses in the last 10 years (see table below), bested only by 2000 and 2002. These losses compare favorably to notable third quarter losses in 2001, 2004, and 2005. The California wildfires in mid-October, which produced estimated losses of $1.6 billion thus far, will appear in the fourth quarter and full year 2007 results.

Despite the lower catastrophe losses, the accident year combined ratio deteriorated in the first nine months of 2007. While still strong at 95.2%, the deterioration illustrates the impact of falling rates and is a leading indicator of the creep into earnings of current soft market pricing.

Individual Company Results

Fourteen of the Composite companies reported combined ratios below 90% in the first nine months of 2007, while two insurers reported combined ratios of under 80%, including perennial top performer Factory Mutual Insurance Company (69.6%), and excess and surplus lines writer Lexington Insurance Company (69.9%). Ten of these 14 carriers are commercial lines predominant, indicating the disproportionately positive impact of the last hard market cycle on this sector of the industry.

Seven companies reported combined ratios of over 100% in the first nine months of 2007, led by Employers Insurance Company of Wausau (114.4%), Continental Casualty Company (111.0%), Liberty Mutual Insurance Company (104.3%), Sentry Insurance (103.7%), and State Farm Fire and Casualty Company (102.4%).

Loss Reserve Adequacy

The table below shows prior year loss reserve development for the ALIRT P&C Composite over the past seven years and the first nine months of 2007. In 2006, companies sharply reduced reserve strengthening for the soft market years 1997-2001, ostensibly marking an end to the severe balance sheet impact of the last soft market cycle. We do, however, note a sharp increase in prior year reserve additions for pre-2004 accident years, from $420 million in the first six months of 2006 to $2.4 billion currently³. The largest jump in pre-2005 prior year reserve additions were seen at Hartford Fire Ins. Co. and Hartford Accident & Indemnity ($426 million and $336 million, respectively), and Zurich American ($382 million).

The composite reported combined ratio improved 1.8 percentage points due to prior year reserve releases of $3.2 billion in the first nine months of 2007. It is still too early to estimate reserve redundancy for accident years 2005 and 2006, though results thus far " including an additional $1.6 billion reserve release for accident year 2006 in the third quarter alone - demonstrate that these redundancies will likely contribute handsomely to reported results for the full year 2007.

Operating Earnings

The table below provides profitability metrics for the ALIRT P&C Composite for the past seven years and the first nine months of 2007. Pretax and after-tax operating earnings and returns (excluding net capital gains) through nine months 2007 dipped slightly from the seven year highs reported in 2006, but were still very strong. The continued solid earnings reflects still strong (though deteriorated) pricing fundamentals, aggregate reserve releases, decent net investment income, and moderate catastrophe losses in the first nine months of 2007.

Given the results through nine months, it is unlikely that full year 2007 results will match or exceed those reported in 2006, marking perhaps the start of an earnings decline. Certain factors will continue to influence the level of earnings, including current year pricing, catastrophe losses, reserve redundancies, and economic conditions, both in terms of how they affect revenue growth and impact investment results.

Individual Company Results

Thirteen companies reported annualized pretax returns on earned premium (ROP) exceeding 25% in the first nine months of 2007, led by Lexington Insurance Company (43.2%), Hartford Fire Insurance Company (37.0%), and Factory Mutual Insurance Company (36.4%).

No composite company reported an operating loss in the first nine months of 2007, while only two companies reported a pretax ROP below 5%, including Liberty Mutual Insurance Company (2.5%) and Farmers Insurance Exchange (2.8%).

Four of the Composite companies reported pretax returns on equity over 30%, including Lexington Insurance Company (41.5%), Progressive Direct (32.4%), Pacific Indemnity Company (29.2%), and Progressive Casualty Insurance Company and Government Employees Insurance Company (both 28.8%). With the exception of Lexington, each of these carriers has well above average net premium leverage, helping to boost ROEs.

Premium Income

In the first nine months of 2007, direct written premiums fell 0.7%, while net written premiums grew just 0.7%, relative to the same period in 2006. This is the first instance of a decline in direct premium written for the composite since the soft market year 1998, while the low net premium growth also corresponds with rates last seen in 1998. This is perhaps the strongest indication yet of the current soft market cycle.

Further testimony to rapidly softening pricing is seen in a number of broker surveys, graphed below. Annual renewal rates for the first nine months of 2007 fell by an average of 9.8%⁴. Assuming an average 5.0% decline for CLIPS (using the 2nd quarter figure), this would represent the largest quarterly drop since the soft market onset in mid-2004.

With continued surplus growth and competition accelerating among both existing market players and new market entrants, we are unlikely to see a sharp reversal in price declines soon. Much discussion has turned on reinsurance markets, which have softened appreciably as excess capacity raised after the 2004-2005 hurricane seasons shifts from coastal property to other geographies and lines of business.⁵

As the graph on the following page shows, over the last thirteen years (including a soft and hard market cycle), reinsurance ceded to non-affiliated reinsurers declined in the harder market years (1995-1996, 2002-2004), as primary insurers retained more business on their books (= higher reinsurance prices & more profitable business). However, as pricing softened (1997-2001), the amount ceded to non-affiliated reinsurers grew sharply. A chicken-and-the-egg argument applies here, i.e. whether the softening market is the result, at least in part, of more competitive (cheaper) reinsurance rates.

In the last three years we have seen ceded rates to non-affiliated reinsurers grow again, though this is in part owing to substantial price increases for coastal property. Whether cheaper reinsurance leads to additional price softening waits to be seen. There is anecdotal evidence " supported by our research " that primary writers are still retaining more net premium risk due to strong capital positions, lack of growth opportunities, and still technically profitable pricing.

Investment Mix

Invested assets rose 5.7% for the ALIRT P&C Composite in the first nine months of 2007 (7.6% when annualized), a decline from the asset growth rate reported for the first six months of 2007, but still reflecting solid earnings and investment returns (especially unrealized capital gains).

The overall mix of invested assets for the composite shows a decline in bond holdings through nine months 2007, offset largely by an increase in affiliated stocks. This reflects in part the acquisition by three Liberty Mutual subsidiaries of affiliate holdings in the third quarter, tied to the acquisition of Ohio Casualty in late August. Schedule BA asset holdings increased $4.5 billion (0.5 percentage point jump as a percent of assets) for the ALIRT P&C Composite in the first nine months of 2007, while cash and short-term assets declined by 40 basis points.

Investment Results

Net Investment Yield

As shown in the on the following page, net investment yield for the Composite fell 38 basis points in the first nine months of 2007 to 4.21% (annualized), from 4.59% at year end 2006. The decline reflected in part sizeable decreases in yield at a number of insurers, including Peerless Insurance Company, Fireman’s Fund, Liberty Mutual, Berkley Insurance Company, and Travelers Indemnity.

The general pattern shows yield falling from 2000 to 2004, as underlying interest rates declined throughout the same period (Federal Funds rate falling from 6.25% to 1.00%). In the period 2004-2006, portfolio yield began to improve as the Federal Reserve raised its key rate 425 basis points. Recently, in reaction to market turmoil, the Federal Reserve has eased rates which should again put downward pressure on portfolio yields.

The below shows the steep drop in Treasury yields as investors recently sought a safe haven during the market upheaval driven by the subprime mortgage troubles. If sustained, this also could have a negative impact on future period portfolio yields.

However, risk-adjusted yields, as illustrated by the spread between corporate AAA bonds and corresponding federal treasury bonds (see graph on following page), have diverged sharply in the past several months. Wider spreads on corporate bonds could help portfolio yields of insurers, which are generally large investors in such instruments.

It is also interesting to note that the spread of AAA to non-investment grade investment bonds (BB) has actually narrowed thus far in 2007 (see graph on following page), despite the increasing difficulties with subprime mortgages. This may be an indication that the possibility of contagion to the non-subprime related bonds is being discounted by the market. However, if the general economy moves in a recessionary direction, this would likely cause these yield spreads to widen again (see 2000-2002) as investors demand greater risk premiums for lower rated bonds.

Total Return

Net total investment return for the Composite declined 118 basis points from 8.26% in 2006 to 7.09% (annualized) in the first nine months of 2007, reflecting lower net yield, and a reduction in year-over-year capital gains for many insurers with outsized gains in 2006 (Continental Casualty, Hartford Fire, Govt. Employees, Nationwide Mutual, One Beacon). Equity market returns thus far in the fourth quarter 2007 were extremely volatile (and weaker on balance), driven by the subprime mortgage loan and liquidity issues, and absent a recovery in December, full year 2007 net total returns may decline further from nine month levels.

Given the continued low interest rate environment and uncertain equity market performance going forward, it seems unlikely that p&c insurers will recklessly engage in cash flow underwriting in the near term.

Conclusion

Nine month 2007 results for the P&C Industry demonstrate continued strong earnings, though down modestly from the peak cyclical profitability reported in 2006. While surplus continues to grow, insurers are accelerating dividend payments to parent organizations, an indication that there exist few good business opportunities to put "excess" capacity to work. Flat revenue growth serves as a further indication of the ongoing general downward movement in pricing.

Barring an enormous catastrophe in the waning weeks of 2007, the industry’s full year combined ratio is likely to fall within the mid-90’s. Accident year underwriting profitability should continue to under-perform reported results, however. Remaining reserve redundancies for accident years 2003-2006 will play a decisive factor in whether accident year and reported year results continue to diverge in 2008.

Current financial market turmoil, driven by the subprime mortgage and credit market issues, could have a negative impact on the property & casualty market, partially as a result of heightened D&O and mortgage insurer claims. While insurers’ balance sheet exposure to subprime residential mortgage-backed securities and subprime-related CDOs seems relatively light, insurers could suffer further revenue shortfalls should the economy weaken or fall into recession, or if equity markets go into a protracted decline.

On the political front, TRIA has a strong chance of passing " or at least being temporarily extended " before its expiration at year end. As for other issues, such as the industry gaining federal help in resolving regional catastrophe exposure or establishing an alternative federal regulator for insurance, these seem much less likely to gain traction in the near term.

¹ For more in-depth information on insurer exposure to the subprime mortgage issue, see our recent release: Update of Subprime Mortgage Related Losses for Select U.S. Insurers: As of Nine Month 2007 GAAP Reporting (November 19, 2007)
² While prices began softening in 2004, there is an earnings lag as reserves from those strong accident years are released into later calendar year earnings. Also, current year rates are based in part on the trended results from the nearest prior year experience, which also helps account for the continued strong accident year results.
³ Due to statutory filing restrictions, we are unable to determine on a quarterly basis to what prior years these reserve additions apply. We will, however, be able to determine this with the year-end filings.
⁴ Overall results may be somewhat overstated as results for CLIPS (Commercial Lines Insurance Pricing Survey), which are generally more conservative, are not yet available for the third quarter.
⁵ The legislative decisions in Florida to provide more state-sourced, underpriced reinsurance also robbed private reinsurers of a portion of an important market.