Insurer Financial Results: 2004

Executive Summary
Analysis of property/casualty insurer financial results for 2004 reveals that insurers' surplus, or statutory net worth, rose to a record high, as their net income after taxes and rate of return on net worth both increased for the third consecutive year. But insurers' overall rate of return remained low compared with long-term historical norms and the rates of return of firms in other industries. And written premium growth continued to slow in 2004 as a result of changing conditions in insurance markets, raising questions about the sustainability of improvement in insurers' financial results going forward.

Net Income and Return on Net Worth
The property/casualty insurance industry's net income after taxes rose to $38.7 billion in 2004 from $30.0 billion in 2003 and a record-low -$7.0 billion in 2001. [1]1. This study defines the U.S. property/casualty industry as all private 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 is based mainly on insurers' statutory financial statements as supplied to ISO by March 29, 2005, and excludes foreign subsidiaries of U.S. insurance groups. All figures are represented net of reinsurance, unless otherwise noted. The industry's GAAP rate of return on average net worth (RONW) rose to 9.4% in 2004 from 8.9% the year before and -1.2% in 2001. [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 state regulators. See Appendix C on page 76 for a discussion of the major differences between GAAP and SAP. (See Table 1.)

Image

Improvement in underwriting results has driven the increases in the industry's net income and GAAP RONW since 2001, when the industry suffered its first-ever net loss after taxes. In 2004, the industry posted its first net gain on underwriting since 1978, with the $5.0 billion net gain on underwriting last year constituting a $9.9 billion positive swing from the $4.9 billion net loss on underwriting in 2003 and a $57.6 billion improvement from the record $52.6 billion net loss on underwriting in 2001.

Improvement in investment results also contributed to the increases in the industry's income and profitability in 2004. Net investment income rose 2.4% to $39.6 billion last year from $38.6 billion in 2003, as realized capital gains on investments increased to $9.3 billion from $6.6 billion. But the industry's miscellaneous other income slid to -$0.5 billion in 2004 from -$44 million the year before.

Combining insurers' net gains or losses on underwriting with their investment income, realized capital gains, and miscellaneous other income, the industry's net income before taxes increased to $53.4 billion in 2004 from $40.4 billion in 2003. [3]3. Throughout this report, figures may not balance because of rounding. Partially offsetting the increase in net income before taxes, the industry's federal income taxes rose to $14.7 billion last year from $10.3 billion a year earlier.

At $38.7 billion in 2004, net income after taxes had risen 5.2% above its previous peak of $36.8 billion in 1997. However, adjusted for inflation, the industry's net income last year was 10.6% less than it was in 1997.

Rising to 9.4% in 2004, GAAP RONW reached its highest level since 1997, when it was 11.6%. But the industry's GAAP RONW for 2004 was 0.5 percentage points less than its 9.9% average RONW from 1971 to 2003. [4]4. Data for insurers' GAAP rate of return on average net worth for years before 1971 is not available. Analysis of data by decade shows that, despite the improvement in insurers' GAAP RONW since 2001, the industry's profitability has been trending downward. The industry's average RONW fell from 11.8% during the ten years ending 1984 to 10.1% during the ten years ending 1994 and 6.9% during the ten years ending 2004.

Underwriting Results
The industry's statutory combined ratio — a key measure of losses and expenses per dollar of premium — improved to 98.1% in 2004 from 100.1% in 2003 and 115.9% in 2001, as the industry achieved its first net gain on underwriting in twenty-six years. At 98.1% last year, the combined ratio had declined to its lowest level since 1978, when it was 97.4%.

The improvement in underwriting results last year reflects the excess of growth in premiums over growth in losses and other expenses. In 2004, written premiums increased $18.8 billion to $423.3 billion, and earned premiums rose $26.3 billion to $412.6 billion. Loss and loss adjustment expenses (LLAE) grew $10.9 billion to $299.5 billion, other underwriting expenses increased $5.7 billion to $106.4 billion, and dividends to policyholders fell $0.2 billion to $1.6 billion.

Nonetheless, written premium growth slowed to 4.7% last year from 9.4% in 2003 and 14.3% in 2002. U.S. government Consumer Price Indexes for personal insurance and ISO MarketWatch® data about rates on renewals for commercial insurance policies indicate that changing conditions in insurance markets contributed to the slowing in premium growth. For example, countrywide data for the ISO MarketWatch lines [5]5. ISO MarketWatch® 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 statistical territory. shows that rate changes on renewals for commercial lines policies peaked in July 2002 at 12.9% but then dwindled to 1.0% in December 2004. The slowing in rate increases is consistent with the cyclical pattern that would emerge before the onset of softening in insurance markets, raising questions about the sustainability of recent improvement in insurers' financial results.

As premium growth slowed in 2004, growth in LLAE accelerated to 3.8% from 1.8% in 2003. Some of the growth in LLAE is attributable to an increase in catastrophe losses. In 2004, catastrophes caused $27.5 billion in direct insured losses to property — up from $12.9 billion in 2003, according to ISO's Property Claim Services® unit. Adjusting direct insured losses in 2004 for losses covered by residual market mechanisms, the Florida Hurricane Catastrophe Fund, and foreign reinsurers, ISO estimates that U.S. insurers' net underwriting results for 2004 included about $15.2 billion in catastrophe losses — roughly $2.5 billion more than their underwriting results for 2003. [6]6. ISO's estimates for the net catastrophe losses included in insurers' calendar-year results for 2004 and 2003 also reflect downward revisions to U.S. insurers' estimates of their net losses from the terrorist attack on September 11, 2001. ISO's analysis indicates U.S. insurers reduced those estimates by $1.1 billion in 2004 and $0.2 billion in 2003.

Catastrophe-adjusted LLAE rose 3.0% in 2004 to $291.2 billion from $282.6 billion in 2003. [7]7. ISO used the long-term average relationship between the catastrophe losses included in insurers' financial results and other LLAE to determine "normal" catastrophe losses for each year and then adjusted reported LLAE by substituting normal catastrophe losses for the actual catastrophe losses included in insurers' financial results. Catastrophe-adjusted losses would have risen more quickly last year if not for a decline in newly recognized environmental and asbestos (E&A) losses on policies written long ago and a slowing in the rate at which insurers strengthened LLAE reserves for other losses. ISO estimates that insurers' overall LLAE last year included $4.9 billion in E&A losses on old policies — down from $6.4 billion in 2003 .[8]8. Based on the data included in the Notes to Financial Statements in statutory Annual Statements, ISO estimates that insurers incurred $7.3 billion in E&A LLAE in 2003, but only $6.4 billion was included in the overall LLAE that flowed through insurers' income statements. The data about E&A experience in the Notes to Financial Statements excludes LLAE associated with policies explicitly covering environmental or asbestos losses. Because pollution exclusions adopted by many insurers in the mid- to late-1980s have generally held up against legal challenges, the data in the Notes pertains primarily to experience for policies written before the adoption of such exclusions. And ISO's preliminary analysis of LLAE reserves as of year-end 2004 suggests that insurers strengthened reserves for losses not associated with catastrophes or E&A claims by between $8 billion and $14 billion in 2004, after strengthening such reserves by between $10 billion and $16 billion in 2003. [9]9. ISO's estimates for reserve strengthening include both additions to loss reserves for prior accident years and an assessment of the adequacy of reserves for losses occurring in the current accident year. Despite the reserve strengthening in recent years, a preliminary ISO analysis of the available data indicates insurers' reserves for LLAE other than those associated with catastrophe and E&A claims were deficient by between $11 billion and $35 billion at year-end 2004.

In recent years, swings in catastrophe losses, E&A losses, and changes in the adequacy of reserves for other claims have all had a significant effect on insurers' reported financial results. Adjusted for catastrophes, E&A losses, and changes in reserve adequacy, the combined ratio for 2004 was 92.3%, and the industry's GAAP RONW was 13.2%.

Investment Income and Capital Gains
Growth in net investment income slowed to 2.4% in 2004 from 3.8% in 2003. Over the long term, growth in investment income has slowed from 18.7% per year in the 1970s to 12.8% per year in the 1980s, 2.2% per year in the 1990s, and 0.6% per year so far this decade.

Though investment income grew in each of the past two years, it did not grow enough to offset the cumulative effects of the 1.4% decline in 2002 and the record 7.3% decline in 2001. The industry's $39.6 billion in investment income in 2004 was 2.7% below its $40.7 billion in investment income in 2000.

Declines in investment income are a relatively new phenomenon. Investment income grew every year from the start of ISO's records in 1959 through 1991. But investment income declined in six of the past thirteen years and in two of the past four. These declines mean that insurers can no longer count on having ever-increasing amounts of investment income to offset losses on underwriting.

The growth in investment income last year is the net result of increases in insurers' average holdings of cash and invested assets and a decline in the yield on cash and invested assets. Insurers' average holdings of cash and invested assets grew 11.7% in 2004 to $984.5 billion. But the yield on cash and invested assets fell to 4.0% in 2004 from 4.4% the year before.

The long-term slowing in the growth of investment income reflects trends in interest rates and the yield insurers earn on their cash and invested assets. The average yield on ten-year Treasury notes fell from 10.6% in the 1980s to 6.7% in the 1990s and 4.8% so far this decade. Reflecting the trends in interest rates, the average yield on insurers' cash and invested assets dropped from 7.6% in the 1980s to 5.9% in the 1990s and to 4.6% during the past five years.

The long-term slowing in the growth of investment income also reflects trends in insurers' holdings of cash and invested assets. Growth in insurers' average holdings of cash and invested assets receded from 11.9% per year in the 1970s to 11.7% per year in the 1980s, 6.5% per year in the 1990s, and 4.3% per year so far this decade.

The declines in insurers' yield on cash and invested assets and the slowing in the growth of cash and invested assets mean that combined ratios must now be lower than they were in the past for insurers to achieve the same level of overall profitability. Insurers' GAAP RONW last surpassed 15.0% in 1987, when it was 17.3% and the combined ratio was 104.6%. ISO estimates that achieving the same rate of return with investment results, an effective tax rate, and financial leverage like those in 2004 would require that the combined ratio improve to about 88%.

Combining insurers' $9.3 billion in realized capital gains in 2004 with their $9.9 billion in unrealized capital gains, insurers posted $19.2 billion in total capital gains for the year — down from $31.6 billion in 2003. Nonetheless, the $50.8 billion in capital gains during the past two years more than offsets the $35.7 billion in capital losses that insurers suffered from 2000 to 2002.

Insurers' capital gains during the past two years and insurers' capital losses during the preceding three years both reflect developments in financial markets. In particular, the S&P 500 index of common stock prices rose 9.0% in 2004 after rising 26.4% in 2003. That index declined each year from 2000 to 2002, falling 15.7% per year on average from year-end 1999 to year-end 2002.

Surplus and Leverage
The property/casualty industry's surplus increased 13.4% to $393.5 billion at year-end 2004 from $347.0 billion at year-end 2003. The industry's surplus at year-end 2004 was a record high, both before and after adjusting for inflation. On an inflation-adjusted basis, surplus at year-end 2004 was 1.9% above surplus at year-end 1998, the previous record.

The $46.5 billion increase in surplus in 2004 is the third-largest dollar increase in surplus on record before adjusting for inflation and the fourth largest after adjusting for inflation. Additions to surplus last year included $38.7 billion in net income after taxes, $9.9 billion in unrealized capital gains on investments, $8.3 billion in new funds paid in, and $2.8 billion in miscellaneous other additions to surplus. These additions were partially offset by $13.3 billion in dividends to stockholders. (See Table 2.)

Image

Leverage ratios, such as the premium-to-surplus ratio and the LLAE-reserves-to-surplus ratio, provide simple measures of how much risk each dollar of surplus supports. The industry's premium-to-surplus ratio fell to 1.08 last year from 1.17 in 2003 and 1.30 in 2002, after rising for four consecutive years from a record-low 0.84 in 1998. The industry's LLAE-reserves-to-surplus ratio also fell in 2004, dropping to 1.17 from 1.22 in 2003 and 1.38 in 2002, after rising for three consecutive years from a record-low 1.08 in 1999.

Despite year-to-year changes in premium-to-surplus and LLAE-reserves-to-surplus ratios, both have been trending downward. The average premium-to-surplus ratio fell from 2.22 in the 1970s to 1.78 in the 1980s, 1.18 in the 1990s, and 1.12 during the first five years of this decade. The average LLAE-reserves-to-surplus ratio increased from 1.69 in the 1970s to 1.97 in the 1980s but then declined to 1.60 in the 1990s and 1.24 so far this decade. The declines in leverage ratios suggest that the industry's financial condition has improved over the years.

Operating Cash Flow
Operating cash flow [10]10. Operating cash flow is the sum of underwriting cash flow, net investment income received, and other income received, minus taxes paid. (OCF) indicates the rate at which basic underwriting and investment operations generate cash to fund new investments, dividend payments to stockholders, or other activities.

OCF increased to an estimated $82.5 billion in 2004 from $68.9 billion in 2003 and a record-low $7.8 billion in 1999. [11]11. ISO's OCF data extends back to 1979. Improvement in underwriting cash flow led to the improvement in overall cash flow. Net underwriting cash flow increased to an estimated $54.2 billion in 2004 from $37.8 billion in 2003 and -$25.0 billion in 1999.

OCF ratios measure operating cash flow relative to net written premiums. The industry's operating cash flow increased to an estimated 19.5% of premium in 2004 from 17.0% in 2003 and a low of 2.7% in 1999.

Reflecting the improvement in cash flow for the industry as a whole, the market share of insurers with negative or low operating cash flow ratios dropped from 62.7% in 1999 to 9.7% in 2003, the latest year for which complete data is available. [12]12. ISO defined low operating cash flow ratios as being between 0.0% and 5.0% of net premiums written.

Data through 2003 shows that the OCF ratio for commercial lines insurers rose to 21.3% that year from 0.0% in 1999. During the same four years, the OCF ratio for balanced insurers increased to 18.2% from 3.0%, and the OCF ratio for personal lines insurers rose to 12.5% from 4.9%. [13]13. ISO classified an insurer as a personal lines insurer if the proportion of its total written premiums attributable to homeowners and personal automobile insurance exceeded the industry average by 20 percentage points or more. ISO classified an insurer as a commercial lines insurer if the proportion of its total written premiums attributable to homeowners and personal automobile insurance fell short of the industry average by 20 percentage points or more. ISO classified all other insurers as balanced. Though the OCF ratio for the industry overall fell to a record low in 1999, the OCF ratio for personal lines bottomed out at a record-low 1.5% in 2001.

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 2004 was 14.9% — 5.5 percentage points above the 9.4% GAAP RONW for the insurance industry as a whole and 4.8 percentage points above the 10.1% GAAP RONW for large insurers. [14]14. 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 2004, thirty-five large insurers each wrote more than $2.1 billion in premiums.

From 1983 to 2004, the estimated RONW for the Fortune 500 averaged 13.7% — 5.5 percentage points more than the 8.2% average RONW for the insurance industry and 5.1 percentage points more than the 8.6% average RONW for large insurers. And, in twenty of those twenty-two years, the rate of return for the Fortune 500 exceeded the rates of return earned by both the industry overall and large insurers.

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 1994 to 2003 (the latest year for which complete COMPUSTAT data was available), the RONW for 299 noninsurance industries averaged 10.3% — 3.7 percentage points more than the insurance industry's 6.5% average RONW for the period. In a ranking from most to least profitable during that ten-year period, insurance ranked 219 out of 300 industries. The results were similar when ISO lengthened the analysis to also include the ten years from 1984 to 1993.

Performance of Insurance Stocks
In 2004, investors in the S&P property/casualty index earned a total rate of return (capital gains plus dividends) of 10.4%. Investors in the S&P life/health index earned a total rate of return of 22.1% in 2004, and investors in the S&P financials index and the S&P 500 both earned total rates of return of 10.8%. Hence, investors in property/casualty stocks failed to do as well as investors in broader baskets of financial stocks or the S&P 500, while investors who focused on the life/health stocks did particularly well last year.

The performance of the S&P indexes during the past twenty years indicates that, over the long haul, investors in property/casualty stocks have earned total returns better than those earned by investors in life/health stocks, though not as robust as those enjoyed by investors in other stocks. From year-end 1984 to year-end 2004, investors in the S&P property/casualty index earned a compound average annual total rate of return of 12.2%. During the same period, investors in the S&P life/health index earned total rates of return averaging 10.8%. Investors in the S&P 500 earned total rates of return averaging 13.2%, and investors in the S&P financials index earned total rates of return averaging 14.8%.

Data from Goldman Sachs (GS) indicates personal lines property/casualty stocks outperformed commercial lines property/ casualty stocks and reinsurance stocks in 2004. Last year, the GS personal lines index rose 25.8%, as the GS commercial lines index rose 12.8% and the GS reinsurance index increased 1.8%.

1. This study defines the U.S. property/casualty industry as all private 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 is based mainly on insurers' statutory financial statements as supplied to ISO by March 29, 2005, and 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 state regulators. See Appendix C on page 76 for a discussion of the major differences between GAAP and SAP.

3. Throughout this report, figures may not balance because of rounding.

4. Data for insurers' GAAP rate of return on average net worth for years before 1971 is not available.

5. ISO MarketWatch® 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 statistical territory.

6. ISO's estimates for the net catastrophe losses included in insurers' calendar-year results for 2004 and 2003 also reflect downward revisions to U.S. insurers' estimates of their net losses from the terrorist attack on September 11, 2001. ISO's analysis indicates U.S. insurers reduced those estimates by $1.1 billion in 2004 and $0.2 billion in 2003.

7. ISO used the long-term average relationship between the catastrophe losses included in insurers' financial results and other LLAE to determine "normal" catastrophe losses for each year and then adjusted reported LLAE by substituting normal catastrophe losses for the actual catastrophe losses included in insurers' financial results.

8. Based on the data included in the Notes to Financial Statements in statutory Annual Statements, ISO estimates that insurers incurred $7.3 billion in E&A LLAE in 2003, but only $6.4 billion was included in the overall LLAE that flowed through insurers' income statements. The data about E&A experience in the Notes to Financial Statements excludes LLAE associated with policies explicitly covering environmental or asbestos losses. Because pollution exclusions adopted by many insurers in the mid- to late-1980s have generally held up against legal challenges, the data in the Notes pertains primarily to experience for policies written before the adoption of such exclusions.

9. ISO's estimates for reserve strengthening include both additions to loss reserves for prior accident years and an assessment of the adequacy of reserves for losses occurring in the current accident year. Despite the reserve strengthening in recent years, a preliminary ISO analysis of the available data indicates insurers' reserves for LLAE other than those associated with catastrophe and E&A claims were deficient by between $11 billion and $35 billion at year-end 2004.

10. Operating cash flow is the sum of underwriting cash flow, net investment income received, and other income received, minus taxes paid.

11. ISO's OCF data extends back to 1979.

12. ISO defined low operating cash flow ratios as being between 0.0% and 5.0% of net premiums written.

13. ISO classified an insurer as a personal lines insurer if the proportion of its total written premiums attributable to homeowners and personal automobile insurance exceeded the industry average by 20 percentage points or more. ISO classified an insurer as a commercial lines insurer if the proportion of its total written premiums attributable to homeowners and personal automobile insurance fell short of the industry average by 20 percentage points or more. ISO classified all other insurers as balanced. Though the OCF ratio for the industry overall fell to a record low in 1999, the OCF ratio for personal lines bottomed out at a record-low 1.5% in 2001.

14. 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 2004, thirty-five large insurers each wrote more than $2.1 billion in premiums.