Insurer Financial Results: 2006

Executive Summary

The U.S. property/casualty insurance industry’s net income after taxes rose $19.5 billion, or 44.3%, to $63.7 billion in 2006 from $44.2 billion in 2005.[1]1. This study defines the U.S. property/casualty insurance industry as all private property/casualty insurers 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 April 17, 2007 and excludes foreign subsidiaries of U.S. insurance groups. All figures are represented net of reinsurance, unless otherwise noted. As a result of the industry’s income, its consolidated surplus (statutory net worth) increased $61.4 billion, or 14.4%, to $487.1 billion at year-end 2006 from $425.8 billion at year-end 2005.

The property/casualty industry’s GAAP rate of return on average net worth (RONW) — a key measure of overall profitability — increased to 12.2% in 2006 from 9.6% in 2005. At 12.2%, the industry’s RONW had risen to its highest level since 1988, when it was 14.1%. But even at 12.2%, insurers’ GAAP RONW remained low compared with the rates of return earned by firms in other

industries.[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 70 for a discussion of the major differences between GAAP and SAP.

Much of the increase in the industry’s net income, surplus, and overall profitability in 2006 is attributable to a sharp decline in catastrophe losses from hurricanes and other natural disasters. According to ISO’s Property Claim Services® (PCS®) unit, direct insured property losses (before reinsurance recoveries) from catastrophes dropped to $9.2 billion in 2006 from a record $62.3 billion in 2005.[3]3. The PCS data for direct insured property losses from catastrophes cited in this study is on an accident-year basis, excludes loss adjustment expenses, and is for all insurers, including residual market insurers, as well as foreign insurers and reinsurers. The data about direct catastrophe losses is based on information available through June 20, 2007, and is subject to change as more information about the cost of settling claims from the 2005 hurricanes becomes available. ISO estimates that the net catastrophe loss and loss adjustment expenses (LLAE) after reinsurance recoveries included in private insurers’ financial results fell to $12.3 billion in 2006 from $34.8 billion in 2005.[4]4. ISO’s estimates for the net catastrophe LLAE included in private U.S. insurers’ calendar-year 2006 results include revisions to U.S. insurers’ estimates of their net LLAE at ultimate from the hurricanes of 2005 and the terrorist attack on September 11, 2001. ISO’s analysis indicates that insurers increased their estimates of net LLAE at ultimate from the 2005 hurricanes by $2.7 billion in 2006, as they reduced their estimates of net LLAE at ultimate from the terrorist attack by $0.1 billion.

Though catastrophe losses declined substantially, they remained high compared with long-term norms. The $9.2 billion in direct catastrophe losses in 2006 compares with an inflation-adjusted average of $6.3 billion per year since 1950. And estimated net catastrophe losses amounted to 4.3% of total net LLAE excluding catastrophe losses in 2006. From 1960 to 2006, net catastrophe losses averaged 2.6% of total net LLAE excluding catastrophe losses.

Nonetheless, analysis of insurers’ results for 2006 and other data indicate that the improvement in insurers’ results last year has already led to an escalation of competitive pressures and lower prices in many insurance markets, though conditions remain difficult in some coastal insurance markets exposed to hurricanes.

Net Income and Return on Net Worth

The industry’s $63.7 billion in net income in 2006 consisted of $31.2 billion in net gains on underwriting, $52.3 billion in net investment income, $3.4 billion in realized capital gains on investments, and $1.0 billion in miscellaneous other income, less $24.2 billion in income taxes.[5]5. Throughout this report, figures may not balance because of rounding. Unless stated otherwise, the phrase “income taxes” and the phrase “federal income taxes” both refer to federal and foreign income taxes as shown in insurers’ statutory Annual Statements. (See Table 1.)

Summary of Financial Results - Property/Casualty Insurance Industry,2005 - 2006

The $31.2 billion in net gains on underwriting in 2006 constitutes a $36.8 billion positive swing from the $5.6 billion in net losses on underwriting in 2005. Of the $36.8 billion improvement in underwriting results, an estimated $22.6 billion is attributable to a decline in the net catastrophe loss and loss adjustment expenses included in insurers’ financial results.

Also contributing to the increase in net income in 2006, net investment income rose $2.6 billion, or 5.2%, to $52.3 billion last year from $49.7 billion in 2005. With miscellaneous other income unchanged at $1.0 billion in both 2006 and 2005, operating income — the sum of net gains (losses) on underwriting, net investment income, and miscellaneous other income — increased $39.4 billion, or 87.3%, to $84.6 billion in 2006 from $45.1 billion in 2005.

But two items partially offset the increase in operating income. Realized capital gains dropped $6.3 billion, or 65.4%, to $3.4 billion in 2006 from $9.7 billion the year before. And income taxes more than doubled, rising to $24.2 billion last year from $10.7 billion in 2005.

The $19.5 billion increase in net income after taxes in 2006 powered a 2.6-percentage-point increase in the property/casualty industry’s GAAP RONW to 12.2%.

Using averages to smooth the effects of cycles and random shocks, a downward trend in insurers’ overall profitability becomes apparent. The industry’s average GAAP RONW fell to 7.3% in the decade ending 2006 from 9.9% in the decade ending 1996 and 12.3% in the decade ending 1986.

Underwriting Results

The industry’s statutory combined ratio — a key measure of losses and expenses per dollar of premium — improved to 92.4% in 2006 from 100.9% in 2005. At 92.4%, the combined ratio had improved to its best level since at least 1959, when ISO’s records begin. But lower investment yields and financial leverage mean that combined ratios must now be better than they were in the past for insurers to achieve the same level of overall profitability they once did. For example, the industry’s 12.2% GAAP RONW for 2006 was 5.0 percentage points less than the 17.3% GAAP RONW for 1987, even though the 92.4% combined ratio for 2006 was 12.3 percentage points better than the 104.6% combined ratio for 1987.

The improvement in underwriting results last year reflects an increase in premiums and a decline in overall LLAE as catastrophe losses receded from their record high in 2005.

Net written premiums climbed $18.3 billion to $443.8 billion in 2006 from $425.5 billion in 2005, with written premium growth accelerating to 4.3% in 2006 from a record-low 0.3% in 2005. Net earned premiums rose $18.2 billion to $435.8 billion last year from $417.6 billion the year before, with earned premium growth increasing to 4.4% in 2006 from 0.9% in 2005.

Overall LLAE decreased to $283.7 billion in 2006 from $311.6 billion the year before. Much of the $27.9 billion, or 9.0%, decrease in overall LLAE is attributable to the estimated $22.6 billion decline in the net catastrophe LLAE included in insurers’ financial results. But noncatastrophe LLAE also declined in 2006 — falling $5.3 billion, or 1.9%, to $271.4 billion last year from $276.8 billion the year before.

Other underwriting expenses — primarily acquisition expenses; other expenses associated with underwriting, pricing, and servicing insurance policies; and premium taxes — increased $7.7 billion, or 7.0%, to $117.5 billion in 2006 from $109.8 billion the year before.

Dividends to policyholders rose $1.6 billion, or 85.1%, to $3.4 billion last year from $1.9 billion in 2005.

Growth in premiums fell far short of inflation and increases in economic activity last year. In 2006, the gross domestic product (GDP) of the U.S. — the dollar value of economic output — rose 6.3% or nearly one and a half times the increase in net written premiums. And the gap between GDP growth and net written premium growth widened to 4.0 percentage points in fourth-quarter 2006, as GDP increased 5.7% and premiums rose 1.7%. The gap between overall growth in the economy and growth in premiums suggests that the improvement in insurers’ financial results in 2006 has spurred increasing competition in many insurance markets, despite ongoing affordability and availability problems in some coastal insurance markets exposed to hurricane losses.

U.S. government Consumer Price Indexes (CPIs) for personal lines insurance and ISO MarketWatch® data about rates on renewals for commercial insurance policies also indicate that the improvement in underwriting and overall financial results in 2006 has contributed to increased competition and lower prices in many insurance markets. Countrywide, the CPI for tenants’ and household insurance dropped 0.9% in 2006. Though the CPI for motor vehicle insurance rose in 2006, it increased only 0.6% — far less than the 4.7% increase in the CPI for motor vehicle repairs and the 3.2% increase in the CPI for all items. Moreover, ISO MarketWatch data shows that rates on commercial renewals in December 2006 were 2.4% below year-ago levels.[6]6. ISO MarketWatch® tracks rates 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.

The 1.9% decline in noncatastrophe LLAE in 2006 reflects two developments — a drop 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 E&A LLAE on old policies dropped to $2.0 billion in 2006 from $4.2 billion in 2005.[7]7. Newly recognized E&A LLAE in 2005 would have totaled $5.3 billion if one insurer had not transferred an estimated $1.1 billion in E&A LLAE to its foreign parent as part of a transaction in which it ceded $6.0 billion in overall LLAE. And ISO’s preliminary analysis of LLAE reserves as of year-end 2006 suggests that insurers strengthened reserves for losses not associated with catastrophes or E&A claims by between $4 billion and $10 billion in 2006, after strengthening such reserves by between $16 billion and $22 billion in 2005.[8]8. 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. As a result of recent reserve strengthening, ISO’s preliminary analysis of the available data indicates insurers’ reserves for LLAE other than those associated with catastrophe and E&A claims may have been redundant by between $5 billion and $27 billion at year-end 2006.

In recent years, 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. ISO’s analysis indicates that, if not for abnormally high catastrophe losses, E&A losses, and changes in reserve adequacy, the industry’s combined ratio would have risen to 89.2% in 2006 from 88.8% in 2005, instead of declining to 92.4% from 100.9%. Similarly, the industry’s GAAP RONW would have declined to 13.9% in 2006 from 17.0% in 2005, instead of rising to 12.2% from 9.6%.[9]9. When calculating adjusted combined ratios and GAAP rates of return, ISO smoothed catastrophe losses, excluded E&A LLAE as defined for purposes of the Notes to Financial Statements included in the statutory Annual Statements insurers file with state regulators, and restated other losses to eliminate changes in reserve adequacy.

The combined net effect of abnormally high catastrophe losses, E&A losses, and changes in reserve adequacy during the eleven years ending 2006 was to raise the industry’s combined ratio by an average of 1.8 percentage points and cut its rate of return by an average of 1.2 percentage points.

Investment Income

Growth in reported net investment income slowed to 5.2% in 2006 from 24.4% in 2005. But adjusted for nonrecurring special developments affecting reported investment income, investment income grew 12.4% in 2006, as insurers’ average holdings of cash and invested assets increased 8.2% and the yield on cash and invested assets increased to 4.5% from 4.3% in 2005.[10]10. See page 16 for further information about nonrecurring special developments affecting insurers’ financial results for 2006 and 2005.

The average rate of growth in investment income slowed to 3.3% per year in the decade ending 2006 from 5.6% per year in the decade ending 1996 and 16.9% per year in the decade ending 1986. The long-term slowing in the growth of investment income reflects trends in interest rates and associated declines in the yield on insurers’ cash and invested assets. The average yield on ten-year Treasury notes fell to 5.0% in the ten years ending 2006 from 7.5% in the ten years ending1996 and 10.5% in the ten years ending 1986, as the average yield on insurers’ cash and invested assets dropped to 4.8% from 6.5% and 7.3%.

The long-term slowing in the growth of investment income also reflects trends in insurers’ holdings of cash and invested assets. The rate of growth in insurers’ average holdings of cash and invested assets slowed to 5.5% per year in the decade ending 2006 from 9.1% per year in the decade ending 1996 and 12.5% per year in the decade ending 1986.

Capital Gains

Combining insurers’ $3.4 billion in realized capital gains in 2006 with their $20.8 billion in unrealized capital gains, insurers posted $24.1 billion in overall capital gains last year — up from $6.3 billion in 2005. The near quadrupling of overall capital gains reflects developments in financial markets. In 2006, the S&P 500 index of common stock prices rose 13.6% — more than four times the 3.0% increase in the S&P 500 in 2005.

The S&P 500 rose during each of the four years from 2003 to 2006 — climbing an average of 12.7% per year — and insurers posted overall capital gains during each of those four years. Conversely, the S&P 500 declined during each of the three years from 2000 to 2002 — falling an average of 15.7% per year — and insurers posted overall capital losses during each of those three years.

Surplus and Leverage

The property/casualty industry’s surplus increased 14.4% to $487.1 billion at year-end 2006 from $425.8 billion at year-end 2005. The industry’s surplus at year-end 2006 was a record high, both before and after adjusting for inflation. On an inflation-adjusted basis, surplus at year-end 2006 was 10.8% more than surplus at year-end 2005, the previous record.

Additions to surplus last year included $63.7 billion in net income after taxes, $3.6 billion in new funds paid in, and $20.8 billion in unrealized capital gains on investments. These additions were partially offset by $24.5 billion in dividends to stockholders and $2.3 billion in miscellaneous charges against surplus. (See Table 2.)

Components of Surplus Change - Property/Casualty Insurance Industry,2005 - 2006

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 0.91 last year from 1.00 in 2005 and a cyclical peak of 1.30 in 2002. At 0.91 in 2006, the premium-to-surplus ratio had fallen to its lowest level since 1999, when it was 0.86, and was just 0.07 points above the record-low 0.84 in 1998. The LLAE-reserves-to-surplus ratio dropped to 1.06 in 2006 from 1.18 in 2005 and a cyclical peak of 1.38 in 2002.

The premium-to-surplus ratio rose to a record 2.75 in 1974 and has been trending downward since. The average premium-to-surplus ratio fell to 1.01 in the decade ending 2006 from 1.43 in the decade ending 1996 and 1.96 in the decade ending 1986.

The LLAE-reserves-to-surplus ratio changed little from 2.13 in 1974 to 2.09 in 1990 but then declined almost continuously to 1.08 in 1999 and, despite cyclical fluctuations, has not changed much since then.

With premium-to-surplus and LLAE-reserves-to-surplus ratios now significantly lower than they were in the past, the industry’s ability to meet its financial obligations may have improved with the passage of time. But these simple leverage ratios are often misleading. To the extent that they are affected by changing prices in insurance markets and changes in reserve adequacy, the trends in these leverage ratios are imperfect indicators of changes in insurers’ financial condition. In addition, increases in the number and value of properties in areas exposed to hurricanes and other natural catastrophes mean that insurers must now hold more capital just to be as financially secure as they were before the buildup. But to the extent that the long-term declines in premium-to-surplus and LLAE-reserves-to-surplus ratios mean that insurers are holding more capital relative to the risks they have underwritten, insurers may be using capital less efficiently than they used to.

The ratio of cash and invested assets to surplus provides a measure of financial leverage affecting the contribution of investment income to insurers’ overall rate of return. Because investment income equals the average amount of cash and invested assets times the yield on those assets and insurers’ overall rate of return equals their income divided by their average net worth, the lower the ratio, the lower the contribution of investment income to the overall rate of return. The ratio of cash and invested assets to surplus declined from a peak of 4.27 at year-end 1974 to 2.39 in both 1998 and 1999. It then rose as high as 2.89 in 2002 and fell as low as 2.48 in 2006.

Operating Cash Flow

Operating cash flow (OCF) indicates the rate at which basic underwriting and investment operations generate cash to fund new investments, dividend payments to stockholders, or other activities.[11]11. Operating cash flow is the sum of underwriting cash flow, net investment income received, and other income received, minus taxes paid.

OCF increased to an estimated $82.9 billion in 2006 from $76.7 billion in 2005 and a record-low $7.8 billion in 1999.[12]12. ISO’s OCF data extends back to 1979. The $6.2 billion increase in OCF last year reflects an increase in net underwriting cash flow, which rose $9.0 billion to an estimated $48.7 billion in 2006 from $39.7 billion in 2005. Net investment income received and other income received also rose in 2006, but by lesser amounts. Partially offsetting these developments, income taxes paid — a cash outflow — increased $5.8 billion to an estimated $21.5 billion last year from $15.8 billion in 2005.

OCF ratios measure operating cash flow as a percentage of net written premium, providing an indicator of free cash flow relative to net sales. The industry’s OCF ratio increased to an estimated 18.7% in 2006 from 18.0% in 2005.

From 1980 to 2006, the industry’s OCF ratio averaged 13.3%. But OCF as a percentage of written premiums varied from a high of 24.2% in 1986, the peak of a historic hard market, to a low of 2.7% in 1999, when net written premium growth was at a near record-low 1.9%.

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 2006 was 16.7% — 4.4 percentage points more than the 12.2% GAAP RONW for the insurance industry as a whole and 3.9 percentage points more than the 12.8% GAAP RONW for large insurers.[13]13. 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 2006, thirty-five large insurers each wrote more than $2.2 billion in premiums.

From the start of ISO’s data for the Fortune 500 in 1983 to 2006, the estimated RONW for the Fortune 500 averaged 13.9% — 5.5 percentage points more than the 8.4% average RONW for the insurance industry and 5.1 percentage points more than the 8.8% average RONW for large insurers. And in twenty-two of those twenty-four years, the RONW for the Fortune 500 exceeded the RONW for both the industry overall and large insurers.

Analyses in this study 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 1996 to 2005 (the latest year for which complete COMPUSTAT data was available), the RONW for 304 noninsurance industries averaged 11.1% — 4.1 percentage points more than the insurance industry’s 7.0% average RONW for the period. In a ranking from most to least profitable during that ten-year period, insurance ranked 218 out of 305 industries. The results were similar when ISO lengthened the analysis to include the ten years from 1986 to 1995.

Special Developments

Nonrecurring special developments enumerated on page 16 affected results for 2006 and 2005. If not for those special developments, written premium growth would have accelerated to 3.5% in 2006 from 1.7% in 2005, and LLAE would have fallen 10.0% in 2006 after rising 5.5% in 2005. Net investment income would have risen 12.4% in 2006 instead of 5.2%, and net income after taxes would have increased 59.9% last year instead of 44.3%. The industry’s GAAP RONW would have increased 3.5 percentage points in 2006 to 12.5% instead of rising 2.6 percentage points to 12.2%.

Other Analyses

Additional analyses in this study report on:

  • the performance of insurance stocks;
  • reinsurers’ results and how they compare with those of the insurance industry overall; and
  • underwriting results by line of business.

1. This study defines the U.S. property/casualty insurance industry as all private property/casualty insurers 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 April 17, 2007 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 70 for a discussion of the major differences between GAAP and SAP.

3. The PCS data for direct insured property losses from catastrophes cited in this study is on an accident-year basis, excludes loss adjustment expenses, and is for all insurers, including residual market insurers, as well as foreign insurers and reinsurers. The data about direct catastrophe losses is based on information available through June 20, 2007, and is subject to change as more information about the cost of settling claims from the 2005 hurricanes becomes available.

4. ISO’s estimates for the net catastrophe LLAE included in private U.S. insurers’ calendar-year 2006 results include revisions to U.S. insurers’ estimates of their net LLAE at ultimate from the hurricanes of 2005 and the terrorist attack on September 11, 2001. ISO’s analysis indicates that insurers increased their estimates of net LLAE at ultimate from the 2005 hurricanes by $2.7 billion in 2006, as they reduced their estimates of net LLAE at ultimate from the terrorist attack by $0.1 billion.

5. Throughout this report, figures may not balance because of rounding. Unless stated otherwise, the phrase “income taxes” and the phrase “federal income taxes” both refer to federal and foreign income taxes as shown in insurers’ statutory Annual Statements.

6. ISO MarketWatch® tracks rates 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.

7. Newly recognized E&A LLAE in 2005 would have totaled $5.3 billion if one insurer had not transferred an estimated $1.1 billion in E&A LLAE to its foreign parent as part of a transaction in which it ceded $6.0 billion in overall LLAE.

8. 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. As a result of recent reserve strengthening, ISO’s preliminary analysis of the available data indicates insurers’ reserves for LLAE other than those associated with catastrophe and E&A claims may have been redundant by between $5 billion and $27 billion at year-end 2006.

9. When calculating adjusted combined ratios and GAAP rates of return, ISO smoothed catastrophe losses, excluded E&A LLAE as defined for purposes of the Notes to Financial Statements included in the statutory Annual Statements insurers file with state regulators, and restated other losses to eliminate changes in reserve adequacy.

10. See page 16 for further information about nonrecurring special developments affecting insurers’ financial results for 2006 and 2005.

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

12. ISO’s OCF data extends back to 1979.

13. 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 2006, thirty-five large insurers each wrote more than $2.2 billion in premiums.