Insurer Financial Results: 2001

Executive Summary

Net Income and Return on Net Worth
In 2001, the property/casualty industry experienced its first recorded net loss after taxes, as a result of sharply higher losses on underwriting and weaker investment results.[1]1. This study defines the U.S. property/casualty industry as all property/casualty companies domiciled in the United States, including excess and surplus insurers and domestic insurers owned by foreign parents. The data in this report excludes foreign subsidiaries of U.S. insurance groups. All figures are represented net of reinsurance, unless otherwise noted.The industry lost $7.9 billion last year, after earning $20.6 billion in 2000. The industry's GAAP[2]2. GAAP stands for Generally Accepted Accounting Principles, the accounting basis used by most industries. Unless otherwise stated, the figures in this report are based on Statutory Accounting Principles (SAP), the accounting basis used by insurers when preparing the Annual Statements they submit to regulators. rate of return on average net worth fell to –1.4% in 2001 from 5.9% the year before. (See Table 1.)

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Increased catastrophe losses, including those from the terrorist attack on September 11, 2001, were responsible for only part of the deterioration in underwriting results. Other contributing factors included growth in noncatastrophe loss and loss adjustment expenses (LLAE) in excess of growth in premiums.

The deterioration in investment results reflected a decline in investment income associated with lower interest rates and a drop in realized capital gains associated with weakness in major stock markets, as measured by indexes such as the Standard & Poor's (S&P) 500. The weakness in stock markets also led to unrealized capital losses on insurers' investments, but such losses do not affect reported income.

Underwriting Results
The industry's net loss on underwriting after dividends to policyholders ballooned by 69.7% to a record $53.0 billion in 2001 from $31.2 billion the year before. That sharp increase in the industry's net loss on underwriting occurred as overall loss and loss adjustment expenses rose 15.6% to $276.1 billion in 2001 from $238.8 billion the year before.

The industry's statutory combined ratio — a key measure of losses and expenses per dollar of premium — worsened by 5.9 percentage points to 116.0% last year from 110.1% in 2000. The combined ratio for 2001 was the third worst on record.

Estimates of the ultimate cost of the terrorist attack on September 11, 2001, range from $30 billion to $70 billion. Using the midpoint of that range, $50 billion, and excluding losses covered by foreign insurers, U.S. insurers may ultimately face $25 billion in net underwriting losses from the attack. But ISO's analysis of statutory financial statements indicates that U.S. insurers included only about $10 billion of net underwriting losses from the attack in their results through year-end 2001. The $10 billion consisted of roughly $9 billion in net loss and loss adjustment expenses and about $1 billion in additional reinsurance costs, primarily reinstatement premiums.[3]3. U.S. insurers and reinsurers were required to disclose information about their underwriting losses from the terrorist attack on September 11, 2001, in Note 20 of their statutory Annual Statements for 2001. ISO analyzed that information to determine the effect of the attack on insurers' reported results for the year. ISO's estimates for industrywide underwriting losses, loss and loss adjustment expenses, and additional reinsurance charges from the attack include amounts for both primary insurers and reinsurers domiciled in the United States. Reinsurance reinstatement premiums reduce insurers' net premiums earned and thereby reduce net underwriting gains or increase net underwriting losses.

Combining an estimated $9 billion in loss and loss adjustment expenses from the attack on September 11 with $7.5 billion in other catastrophe losses, insurers incurred $16.5 billion in catastrophe losses in 2001 — nearly four times the $4.6 billion in catastrophe losses incurred in 2000.[4]4. Data for insurers' GAAP rate of return on average net worth for years before 1971 is not available. Noncatastrophe loss and loss adjustment expenses rose 10.9% to $259.7 billion in 2001 from $234.2 billion the year before.

Other analyses in this report indicate that strengthening of the industry's LLAE reserves for losses other than environmental and asbestos (E&A) contributed to the growth in loss and loss adjustment expenses. ISO's preliminary analysis of LLAE reserves as of year-end 2001 suggests that the adequacy of reserves for losses other than E&A improved by between $1 billion and $7 billion in 2001, excluding any deficiency or redundancy in reserves for losses from the terrorist attack on September 11, 2001.[5]4. As of May 31, 2002, ISO's Property Claim Services® unit estimated that direct property and business interruption losses from the terrorist attack on September 11, 2001, will ultimately total $16.6 billion and that direct property and business interruption losses from all catastrophes during 2001 will total $24.1 billion.

In recent years, swings in catastrophe losses, E&A losses, and possible changes in the adequacy of reserves for other losses have all had a significant effect on insurers' reported financial results. When ISO adjusts reported data for catastrophes, E&A losses, and changes in reserve adequacy, the industry's recent financial results appear notably better. The industry's adjusted combined ratio improved to 109.9% in 2001 from 114.4% in 2000, as the combined ratio based on reported results rose to 116.0% from 110.1%. The industry's adjusted GAAP RONW in 2001 was 2.7% — 4.2 percentage points better than the –1.4% GAAP RONW based on reported results.[6]6. Throughout this report, figures may not balance due to rounding.

Reported underwriting results deteriorated even though premium growth accelerated to 8.1% in 2001 from 5.3% in 2000, 1.9% in 1999, and a record-low 1.8% in 1998. Data about rates on renewals from ISO MarketWatch™ indicates that broad-based firming in commercial insurance markets has contributed to the acceleration in premium growth, with commercial markets beginning to firm in mid-1999 and increases in rates on renewals gathering momentum ever since. In particular, rates on renewals for the ISO MarketWatch basket of commercial lines[7]7. ISO MarketWatchTM tracks rate changes on renewals for commercial auto liability, commercial auto physical damage, products liability, premises/operations liability, businessowners, commercial fire, and commercial allied lines by class and geographic location. fell an average of 2.3% in 1998, but then rose an average of 0.1% in 1999, 5.2% in 2000, and 8.9% in 2001.

These countrywide composite numbers mask significant differences by line, location, and class of business. ISO MarketWatch data shows that, by line, rate increases in 2001 ranged from 6.6% for businessowners to 11.6% for commercial auto liability. By state, rate increases for the ISO MarketWatch lines in 2001 ranged from 2.5% in Hawaii to 12.5% in Wisconsin.

Data from ISO Market ProfilerTM shows that commercial lines premium growth over the past five years has varied significantly by standard industrial classification (SIC) code.[8]8. For eleven commercial lines of insurance, ISO Market ProfilerTM provides market segmentation information, including insurance premium and loss statistics and business demographics for more than 900 industries at the county, state, and countrywide levels. For example, from 1997 to 2001, commercial lines premiums for the SIC codes representing a range of "old economy" industries, such as textile mill products, coal mining, and forestry, decreased between 2.1% and 7.8% per year. Premiums for the SIC codes representing "new economy" industries, such as engineering and management services, security and commodity brokers, and business services, rose between 4.9% and 11.0% per year. Differences in experience by line, location, and SIC code likely contributed to differences in the results of individual insurers.

Investment Income and Capital Gains
Compounding the effects of sharply higher underwriting losses, the industry's investment results deteriorated in 2001. Net investment income fell a record 8.9% last year to $37.1 billion. Realized capital gains decreased 57.5% to $6.9 billion, despite the pressure that some insurers may have felt to realize gains to bolster reported income and surplus. Combining the $6.9 billion in realized capital gains and $17.7 billion in unrealized capital losses, insurers' overall capital losses on investments in 2001 amounted to $10.8 billion — nearly five times the $2.3 billion in overall capital losses experienced in 2000.

The 8.9% decrease in net investment income in 2001 is the result of two developments. The yield on insurers' cash and invested assets fell to 4.7% last year from 5.1% in 2000, as market interest rates declined. And, insurers' average holdings of cash and invested assets declined 0.9% to $786.7 billion in 2001 from $794.2 billion the year before. The industry's investment income has declined in just four other years, and all five declines have occurred in the past ten years. Reflecting these declines, the average annual rate of growth in the industry's investment income since 1990 is just 1.4% per year — far less than the 12.8% average annual rate of increase during the 1980s and the 18.7% average annual rate of increase during the 1970s.

The industry's overall capital losses on investments in each of the past two years reflect declines in stock prices. Insurers' holdings of common stocks depreciated 8.2% last year and 2.3% the year before, as the S&P 500 dropped 13.0% in 2001 and 10.1% in 2000. That experience contrasts with the industry's $133.2 billion in overall capital gains from 1995 to 1999. During that period, insurers' holdings of common stocks appreciated 17.6% per year, as the S&P 500 rose 26.2% per year.

Surplus and Leverage
The property/casualty industry's surplus declined 8.7% to $289.6 billion at year-end 2001 from $317.4 at year-end 2000. Deductions from surplus last year included the $7.9-billion net loss after taxes, $17.7 billion in unrealized capital losses, $10.9 billion in dividends to shareholders, and $2.8 billion in miscellaneous charges against surplus. Those deductions were only partially offset by a record $11.6 billion in new funds paid in. (See Table 2.)

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The 8.7% decline in surplus in 2001 follows a 5.1% decline in 2000. Those back-to-back declines in surplus were the first since 1984, when surplus declined 3.1%, and the largest since 1974, when surplus declined by 23.9%.

Effective January 1, 2001, the National Association of Insurance Commissioners' Codification of Statutory Accounting Principles affected surplus. ISO estimates that those accounting changes reduced surplus by about $4.9 billion as of the start of 2001. ISO also estimates that, as of the end of 2001, the Codification of Statutory Accounting Principles caused surplus to be about $2.5 billion higher than surplus would have been without those accounting changes.

Leverage ratios, such as the premium-to-surplus ratio and the LLAE-reserves-to-surplus ratio, provide a simple measure of how much risk each dollar of surplus supports. Last year, the industry's premium-to-surplus ratio rose to 1.12 from 0.94 in 2000 and a near-record low of 0.86 in 1999. The industry's LLAE-reserves-to-surplus ratio also rose in 2001, increasing to 1.29 from 1.12 in 2000 and 1.08 in 1999.

Despite recent increases, both leverage ratios remain lower than they were during each of the twenty-three years from 1973 to 1995. Data going back to 1959 indicates a downward trend in the industry's premium-to-surplus ratio from a peak of 2.75 in 1974. Though the industry's LLAE-reserves-to-surplus ratio dropped only slightly from its peak of 2.13 in 1974 to 2.09 in 1990, the ratio has fallen 38.6% over the last eleven years.

The long-term declines in both leverage ratios suggest that the industry's financial condition has improved over the years. But interpretation of leverage ratios is not straightforward. The downward trends in the premium-to-surplus ratio and LLAE-reserves-to-surplus ratio may also reflect declining prices in insurance markets during much of the 1990s and deteriorating reserve adequacy through 2000, rather than improvement in the industry's financial condition.

ISO estimates that the industry's reserves for losses other than E&A were deficient by between $25 billion and $45 billion as of year-end 2001, excluding any deficiencies or redundancies in reserves for losses from the terrorist attack on September 11, 2001. Using an estimate near the middle of that range and allowing for taxes, the premium-to-surplus ratio at year-end 2001 would have been 1.23 if the industry's loss reserves were adequate. The LLAE-reserves-to-surplus ratio at year-end 2001 would have been 1.55 if reserves were adequate.

The long-term decline in the LLAE-reserves-to-surplus ratio may also reflect a change in insurers' mix of business. The percentage of premiums attributable to the long-tailed lines declined from 55.7% in 1992 to 48.6% in 2000, the latest year for which complete data is available.[9]9. For purposes of this analysis, the long-tailed lines of insurance comprise commercial auto liability, general liability (including products liability), medical malpractice, personal auto liability, workers' compensation, and reinsurance. Because claims for those lines of business take a relatively long period of time to settle, insurers hold proportionately more reserves for those lines.

Operating Cash Flow
Operating cash flow[10]10. Operating cash flow is the sum of net premiums collected, net investment income received, other underwriting income received, and other income received, minus net loss and loss adjustment expenses paid, other underwriting expenses paid, policyholder dividends paid, and taxes paid. (OCF) indicates the rate at which basic underwriting and investment operations generate cash to fund new investments, dividend payments to shareholders, or other activities. ISO estimates that the industry's OCF fell to $8.5 billion in 2001 from $9.0 billion in 2000 and a cyclical peak of $31.0 billion in 1997.[11]11. ISO estimated the industry's operating cash flow for 2001 based on the historical relationships between items on insurers' income and cash flow statements.

In 2000, insurers accounting for 37.2% of industry premium had negative operating cash flows. The widespread deterioration in results in 2001 suggests that the market share of insurers with negative operating cash flows increased last year. In 1984, the bottom of the worst underwriting cycle in the industry's history, insurers with negative operating cash flows accounted for 22.5% of industry premium.

When measured relative to net written premium, the industry's OCF looks even worse. In 2001, the industry's OCF ratio fell to 2.6% — less than half of industry's 7.1% OCF ratio in 1984 and its lowest level since before 1980, the earliest year for which ISO has OCF data.

With the industry's OCF ratio having fallen to its lowest level in more than twenty years, the acceleration in premium growth last year and the ISO MarketWatch data about rate changes on renewals for commercial insurance coverage suggest that some insurers who need to raise cash are reunderwriting or repricing their books of business.

Comparisons with Other Industries
The Fortune 500 consists of the 500 largest industrial and service corporations in the United States. ISO estimates that the median GAAP RONW for Fortune 500 companies in 2001 was 11.0%. That contrasts with the –2.8% RONW earned by large insurers[12]12. This study classifies an insurer as "large" if the insurer accounts for more than 0.5% of the industry's net written premium in a given year. In 2001, thirty-seven large insurers each wrote more than $1.6 billion in premiums. and the –1.4% RONW earned by the property/casualty industry overall.

Though longer-term data indicates that insurers have a history of being less profitable than the Fortune 500, the gap between insurers' rate of return and the Fortune 500's was much larger than normal in 2001. From 1983 to 2001, the median RONW for the Fortune 500 averaged an estimated 13.8% — 5.1 percentage points more than the 8.6% average RONW for large insurers and 5.4 percentage points greater than the 8.4% average RONW for the entire property/casualty industry.

Analyses in this report also compare insurers' profitability with that of firms in a broad array of other industries, using COMPUSTAT data obtained from Standard & Poor's Institutional Market Services. During the ten years from 1991 to 2000 (the latest year for which complete COMPUSTAT data was available), the RONW for 138 noninsurance industries averaged 12.0% — 3.9 percentage points higher than the insurance industry's 8.1% average RONW for the period. In a ranking from most to least profitable during that ten-year period, insurance ranked 99 out of 139 industries. The results were similar when ISO lengthened the analysis to include the ten years from 1981 to 1990.

The Performance of Insurance Stocks
Insurers' capacity to provide financial protection to policyholders depends on insurers' ability to attract and retain the capital necessary to bear risk. For stock insurers, the ability to attract and retain capital depends, in turn, on their ability to offer attractive rates of return to investors.

In this report, ISO compares the performance of the S&P property/casualty insurance index to the performance of the S&P life/health insurance index, the S&P financial services index, and the S&P 500 — a widely used measure of the stock market overall — to assess how investors in property/casualty insurance stocks have fared.[13]13. As of year-end 2001, the S&P property/casualty index was based on data for nine insurers that collectively accounted for 15.6% of total industry net written premium in 2001 and 22.2% of total stock company net written premium in 2000 (the latest year for which separate data on stock company premiums is available). ISO also compares the recent performance of the Goldman Sachs (GS) index for the property/casualty industry overall and the GS indexes for various sectors of the property/casualty industry to assess how investors in different segments of the industry fared last year.

In 2001, investors in the S&P property/casualty index earned a total rate of return (capital gains plus dividends) of –8.1%. That is, one hundred dollars invested in the stock of the insurers in the S&P property/casualty index on December 31, 2000, would have dwindled to about $91.90 on December 31, 2001. Investors in the S&P life/health index earned a total rate of return of –7.8% in 2001.

The S&P financial services index includes the stocks in the S&P insurance indexes, as well as the stocks of companies in a broad array of other financial service industries. The S&P 500 includes all the stocks in the S&P financial services index, as well as stocks in wide spectrum of nonfinancial industries, such as manufacturing and retail trade. In 2001, investors in the S&P financial services index experienced a total rate of return of –8.9%, while investors in the S&P 500 experienced a total rate of return of –11.8%. On balance, even though investors in the S&P property/casualty index lost money last year, they fared better than investors in either the S&P financial services index or the S&P 500. The relative strength in the S&P property/casualty index's performance last year may reflect investor expectations that accelerating premium growth and a return to normal catastrophe losses will lead to improved profitability.

But, based on the performance of the S&P indexes over the past twenty years, investors in property/casualty stocks have not done as well as other investors. From year-end 1981 to year-end 2001, investors in the S&P property/casualty index earned a compound average annual total rate of return of 14.0%. During the same period, investors in the other S&P indexes discussed in this report earned average total rates of return that ranged from 15.0% per year for the S&P life/health index to 16.0% per year for the S&P financial services index.[14]14. Investors in the S&P 500 index earned an average total rate of return of 15.2% per year from year-end 1981 to year-end 2001. The lower long-term returns earned by investors in property/casualty stocks may reflect property/casualty insurers' relatively low GAAP rates of return compared with those of firms in other industries.

All of the companies in the S&P 500 have large market capitalizations, and, in 2001, investors showed a preference for smaller companies. As the S&P 500 fell 13.0% in 2001, the S&P MidCap 400 declined 1.6%, and the S&P SmallCap 600 rose 5.7%. The Goldman Sachs (GS) property/casualty index is based on data for 34 insurers, including some in the S&P MidCap 400 and the S&P SmallCap 600. Investors' preference last year for smaller companies explains in part why the GS property/casualty index rose 7.3% in 2001, as the S&P property/casualty index fell.

Goldman Sachs subdivides its property/casualty index into a personal property/casualty index, a commercial property/casualty index, and a reinsurance index. In 2001, the GS personal property/casualty index climbed 16.7%, as the GS commercial property/casualty index increased 2.2%, and the GS reinsurance index rose 2.6%.

Mergers, Acquisitions, and Market Concentration
Based on data compiled by Conning & Company, the number of mergers and acquisitions in the property/casualty insurance industry declined to 41 in 2001 from 52 in 2000 and a record 117 in 1998. The reported dollar value of property/casualty mergers and acquisitions fell to $1.2 billion last year from $8.9 billion in 2000 and a record $55.8 billion in 1998.[15]15. The number and value of the property/casualty mergers and acquisitions exclude the 1998 merger of Travelers Group, Inc. with Citicorp Inc., a noninsurer, and Citigroup Inc.'s acquisition of Associates First Capital Corporation in 2000. The 41 mergers and acquisitions in 2001 compares with an average of 61 per year from 1988 to 2001. The reported $1.2-billion value of mergers and acquisitions last year compares with an average of $11.6 billion per year from 1988 to 2001.

Factors that may have contributed to the decline in merger and acquisition activity last year include:

Despite the 853 property/casualty mergers and acquisitions from 1988 to 2001, quantitative measures based on long-term data show that the industry has been consolidating slowly over time. Based on standards established by the U.S. Department of Justice, countrywide data indicates that the industry remains far from concentrated.

1. This study defines the U.S. property/casualty industry as all property/casualty companies domiciled in the United States, including excess and surplus insurers and domestic insurers owned by foreign parents. The data in this report excludes foreign subsidiaries of U.S. insurance groups. All figures are represented net of reinsurance, unless otherwise noted.

2. GAAP stands for Generally Accepted Accounting Principles, the accounting basis used by most industries. Unless otherwise stated, the figures in this report are based on Statutory Accounting Principles (SAP), the accounting basis used by insurers when preparing the Annual Statements they submit to regulators.

3. U.S. insurers and reinsurers were required to disclose information about their underwriting losses from the terrorist attack on September 11, 2001, in Note 20 of their statutory Annual Statements for 2001. ISO analyzed that information to determine the effect of the attack on insurers' reported results for the year. ISO's estimates for industrywide underwriting losses, loss and loss adjustment expenses, and additional reinsurance charges from the attack include amounts for both primary insurers and reinsurers domiciled in the United States. Reinsurance reinstatement premiums reduce insurers' net premiums earned and thereby reduce net underwriting gains or increase net underwriting losses.

4. As of May 31, 2002, ISO's Property Claim Services® unit estimated that direct property and business interruption losses from the terrorist attack on September 11, 2001, will ultimately total $16.6 billion and that direct property and business interruption losses from all catastrophes during 2001 will total $24.1 billion.

5. If U.S. insurers ultimately incur $25 billion in net underwriting losses from the terrorist attack on September 11, 2001, then reserves for losses from that attack may have been deficient by $15 billion as of year-end 2001.

6. Throughout this report, figures may not balance due to rounding.

7. ISO MarketWatchTM tracks rate changes on renewals for commercial auto liability, commercial auto physical damage, products liability, premises/operations liability, businessowners, commercial fire, and commercial allied lines by class and geographic location.

8. For eleven commercial lines of insurance, ISO Market ProfilerTM provides market segmentation information, including insurance premium and loss statistics and business demographics for more than 900 industries at the county, state, and countrywide levels.

9. For purposes of this analysis, the long-tailed lines of insurance comprise commercial auto liability, general liability (including products liability), medical malpractice, personal auto liability, workers' compensation, and reinsurance. Because claims for those lines of business take a relatively long period of time to settle, insurers hold proportionately more reserves for those lines.

10. Operating cash flow is the sum of net premiums collected, net investment income received, other underwriting income received, and other income received, minus net loss and loss adjustment expenses paid, other underwriting expenses paid, policyholder dividends paid, and taxes paid.

11. ISO estimated the industry's operating cash flow for 2001 based on the historical relationships between items on insurers' income and cash flow statements.

12. This study classifies an insurer as "large" if the insurer accounts for more than 0.5% of the industry's net written premium in a given year. In 2001, thirty-seven large insurers each wrote more than $1.6 billion in premiums.

13. As of year-end 2001, the S&P property/casualty index was based on data for nine insurers that collectively accounted for 15.6% of total industry net written premium in 2001 and 22.2% of total stock company net written premium in 2000 (the latest year for which separate data on stock company premiums is available).

14. Investors in the S&P 500 index earned an average total rate of return of 15.2% per year from year-end 1981 to year-end 2001.

15. The number and value of the property/casualty mergers and acquisitions exclude the 1998 merger of Travelers Group, Inc. with Citicorp Inc., a noninsurer, and Citigroup Inc.'s acquisition of Associates First Capital Corporation in 2000.

16. In 2000, the S&P property/casualty index rose 52.6%, as the S&P 500 fell 10.1%.