Currently, the United States is suffering through what some say is the most challenging economy since the Great Depression. Major financial institutions that many thought were bulletproof have gone out of business, been sold or gone into partnership with the government.
At the same time, the insurance industry is well into a soft market cycle and is starting to feel the effects of substantially reduced pricing. Deteriorating underwriting results and lower investment returns are beginning to take their toll.
What does the future hold for the insurance industry?
Insurance Cycles
The insurance industry is cyclical, but it generally runs independently of other business cycles. Insurance companies make money in one of two ways: underwriting profits and investment income.
An underwriting profit is achieved when losses plus all expenses are less than premiums. When the former is divided by the latter, the result is called the combined ratio. A combined ratio of less than 100 percent means there is an underwriting profit, and a combined ratio of more than 100 percent means there is an underwriting loss. The industry generated an underwriting profit in three of the last four years, but it remains to be seen if 2008 generated an underwriting profit.
Insurance companies collect premiums and set aside reserves to pay future claims. The insurance industry generates investment income from the policyholders’ surplus. During periods of substantial investment returns, insurance companies may be willing to underwrite at a loss because they can recoup the deficit on the investment side.
In addition to being set aside to pay future claims, surplus determines how much premium an insurance company can write safely. If the ratio of premium to surplus is too high, the insurance company’s credit rating (as quantified by the A.M. Best Company and other rating agencies) ultimately could impair its ability to operate.
While demand for insurance remains relatively constant, supply fluctuates. If surplus or supply drops, rates tend to rise. Similarly, if surplus rises, rates tend to drop. The industry’s surplus has increased approximately 85 percent since 2002, which has caused insurance pricing to go down—in some cases dramatically.
The insurance industry competes with every other industry for capital. To attract investment dollars, the insurance industry must demonstrate an acceptable return on equity. (Most investors seek approximately 15 percent.) Historically, the insurance industry has underperformed in this area; however, results have improved dramatically in recent years, with 2006 being one of the industry’s best years to date.
The industry’s operating results, however, have begun to deteriorate. Premiums actually decreased in 2007 and are projected to decrease further in 2008. This rarely happens in the insurance business.
At the same time, combined ratios are climbing. Preliminary indications put the overall combined ratio for the first half of 2008 at 102.1 percent. This is a result of continued soft pricing, challenging market conditions, unusually high catastrophic losses and significant underwriting losses.
Pre-tax operating income also has declined. Net income after taxes for the first six months of 2008 fell more than 50 percent from what was reported in 2007. This is attributable to deteriorating underwriting results as well as declining investment returns.
Finally, return on equity, after peaking in 2006 at 13.9 percent, dropped to 12.1 percent in 2007, and is estimated to drop to 8.7 percent in 2008.
What Effect Will This Have on Rates?
For the last five years, rates have decreased significantly on almost all lines of coverage, with the exception of coverage for coastal properties on the Gulf Coast and in Florida, as well as other catastrophic-type lines of coverage, such as earthquake coverage.
Workers’ compensation rates are a major factor in the recent rate decreases. In California, for example, comp rates peaked in the second half of 2003. The average rate per $100 of payroll was $6.46. Rates hit bottom in the second six months of 2007, dropping nearly 62 percent. Rates flattened out during the first six months of 2008, and will probably increase in 2009.
Standard & Poor’s Ratings Services revised its outlook on the U.S. commercial lines property and casualty insurance sector from stable to negative, citing concerns about two issues: the ongoing decline in pricing for commercial lines and decreases in investment income.
Fitch Ratings also believes the market has reached a tipping point in the underwriting cycle because industry returns on capital for current accident year business have slipped to inadequate levels. Fitch anticipates the marketplace will deteriorate further.
Still, 2009 should be a positive year for insurance buyers. Although the industry is trending down, strong market capacity and competitive factors are decreasing pricing in many areas.
Rates for the construction industry have hit bottom, and further rate decreases are unlikely in 2009.
Developers and Contractors General Liability
Underwriting for this class of business has not changed significantly. Most construction-related policies still have significant exclusions in addition to the standard exclusions found in the ISO Commercial General Liability Policy Form. Almost every policy excludes multifamily housing, and may exclude prior work or damage, subsidence, mold, silica, electromagnetic fields and construction defects such as exterior installation and finish systems.
Professional Liability
Rates have trended down significantly for architects, engineers, accountants, attorneys and other professionals during the last five years. Despite the soft market, these programs are carefully underwritten. It is imperative that a contractor’s annual application for coverage accurately reflects the firm’s attributes. Insurance costs are only one element in a company’s total cost of risk (i.e., what an organization pays to identify, manage and transfer the risk). In the long run, the only way to lower the total cost of risk is to lower the underlying losses that drive those costs.
Whether it’s a hard or a soft market cycle, a well-run company continues to seek ways to lower the frequency and severity of its loss exposures. When rates are decreasing, it’s easy to lose focus on risk management efforts. However, this is not the time to stop investing in risk control programs.
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Friday, September 3, 2010