By Aaron Brandenburg, CPCU, ARM, NAIC Economist and Statistical Information Manager
The overall economy has an effect on the property/casualty (P/C) insurance markets because underlying insured exposures—whether they are homes, cars, businesses or commercial liability exposures—are affected by economic changes. The recent economic downturn has tempered underlying exposures and led to stagnant premium growth in the P/C market. This article will examine the state of the P/C insurance market in terms of the effect of the overall economy and catastrophic events on the industry, as well as resulting premium growth, losses and profitability in recent years.
• State of the P/C Market
In 2011, premium among P/C lines of business increased 3% (Figure 1). This was the largest increase in premium since 2006. However, even with last year’s gains, overall premium remains about where it was in 2005, even in nominal terms. Taking inflation into account, premium has fallen nearly 13% from 2005 to 2011 in real terms.
As seen in Figure 2, gross domestic product (GDP) decreased dramatically in 2008 and 2009, including a 3.5% decline in 2009. Although the “Great Recession” officially ended in June 2009, 18 months after it began in December 2007, the economy has not returned to full health. Only moderate growth was seen in 2011. As long as GDP remains sluggish, insurers will struggle to increase the exposure base and increase overall aggregate premiums.
Figure 2: Percentage Change in Real GDP
(Chained 2005 Dollars)
Source: The Bureau of Economic Analysis (BEA).
Unemployment in the United States remains high. The U-6 unemployment rate—a broader measure of employment that includes those individuals who have stopped looking for work or work part-time because they cannot find full-time jobs—currently stands at nearly 15%. This measure provides a deeper look into the relative weakness of the jobs market than the official unemployment rate because, while these people are employed, they are not as productive as they could, and would like to, be.
The U-6 rate is down from 17% in 2010 and 2011, but remains well above the 8% range seen in 2006 and 2007 (Figure 3). Declines in employment affect lines of business like workers’ compensation, but also personal lines such as auto or homeowners, as consumer spending declines or stagnates.
Figure 3: U-6 Unemployment Rate
Source: The Bureau of Labor Statistics (BLS). Data as of June 2012.
The S&P/Case-Shiller Index is a leading measure of the U.S. residential housing market. The index tracks changes in the value of residential real estate nationally, as well as in 20 individual cities. Currently, the index shows home prices to be at about where they were in 2002. Prices have fallen more than 30% since their peak in 2006. New single-family homes sold are at an all-time low and have been for the past two years.
Moreover, an increasingly large percentage of homeowner mortgages (more than 30% in most metropolitan areas) are “underwater,” meaning the homeowner owes more on the mortgage than the house is worth. The time required for foreclosures to sell has lengthened as less expensive houses for sale languish on the market. Negative equity could be the biggest problem in the housing market today because it causes foreclosures, stymies consumer spending and traps potential home buyers and sellers in place.
In addition to the economic exposure base, the P/C insurance market has been further stressed by tepid investment results. The benchmark 10-year Treasury note, an especially critical element to the investment portion of insurance companies, is at record lows, yielding well under 2% (Figure 4). This is down from the 3.2% average over the period of 2008–2011 and way down from 6% in the early 2000s. In June 2012, the yield fell below 1.5% for the first time ever.
Figure 4: 10-Year Treasury Yield
Source: U.S. Department of the Treasury. Data as of June 30, 2012.
The Federal Open Market Committee (FOMC) of the Federal Reserve has kept interest rates near zero since December 2008 and has signaled it will continue to keep rates there until at least late 2014. On June 20, 2012, the Fed announced its intention to extend a bond maturity-extension program called “Operation Twist” through the end of the year. The continuation of the maturity extension program will continue to put downward pressure on longer-term interest rates.
In the current prolonged low-interest-rate environment, the P/C insurance market will likely continue to be strained in terms of generating new premium from the exposure base. Some companies might elect to raise rates in an attempt to increase premiums and to make up for a lag in investments. However, rate increases need to receive rate approval from state insurance regulators and there are limits on the size of the increases that regulators will approve and that consumers will bear.
The overall stock market has recovered from the losses of 2008, but it remains in that same general price level. Any increase in inflation would also eat into these investment gains. Higher prices increase insurers’ risks of mispricing by adding to unexpected claims costs related to items like building materials and medical expenses. Some insurers have reported that they are protecting themselves from inflation by moving into real assets, infrastructure, assets with more global content, and real estate.
If investments continue to stay at a moderate level, insurers might need to rely more on underwriting profits. The industry has rarely seen underwriting gains over the past 30 years. However, underwriting profits were common before the 1980s. In fact, in 40 of the 60 years before 1980 the P/C industry had a combined ratio below 100. Not a single underwriting profit was recorded in the 25 years from 1979 through 2003. A recent stretch of underwriting profits occurred from 2004 to 2007, but combined ratios have crept up since then. The combined ratio for the industry in 2011 was 108 (Figure 5).
Individual lines experienced even greater deterioration. The workers’ compensation line had a combined ratio around 119; the homeowners line was around 122; and liability and physical damage automobile coverage, for both private passenger and commercial, experienced combined ratios above 100. All of these combined ratios have seen significant increases since 2006.
The P/C insurance industry has typically been portrayed as being in a soft market in recent times. A soft market is characterized by low loss ratios, stable prices and adequate supply. In a hard market, supply is limited and, therefore, comes at a high cost. A hard market sees high loss ratios, tighter policy conditions, higher prices and, often, a movement to residual markets.
An increase in the combined ratio leads one to think there might be a hard market forming in P/C markets, either in the entire industry or certainly within certain lines. Several things can contribute to a hardening market. A decrease in surplus is often a precursor to a market turning. The industry has not experienced surplus declines recently. Surplus decreased by less than 1% in 2011. Large losses of a catastrophic nature can also put pressure on a market. The industry recently experienced large catastrophic losses. According to the Insurance Services Office (ISO) Property Claim Services (PCS) unit, $34 billion of catastrophic losses occurred in 2011, making it the third-largest catastrophic loss year in history (Figure 6). This is on the heels of the second-highest catastrophic loss year in 2010. Some perils have seen both frequency of events and severity of events increase, while other perils have only seen an increase in severity, often due to the increased value of exposures in harm’s way.
Figure 6: U.S. Insured Catastrophe Losses
Many researchers subscribe to the “capacity constraint” theory of insurance cycles, which asserts that negative net worth shocks caused by such events as large natural catastrophes lead to rapid price increases (a hard market), which then erode slowly as net worth adjusts (a soft market). In this way, the insurance pricing cycle can be viewed in terms of supply-and-demand economics.
Surplus is a measurement of underwriting capacity. When the supply of insurance capacity increases faster than the demand for that capacity, prices fall. Conversely, when supply constricts relative to demand, prices increase. In the recent soft phase of the cycle, prices fell due to an abundance of insurance capacity relative to wavering demand.
GDP can be used as a proxy for demand, because the need for more insurance is tied to economic growth. A ratio of surplus to GDP can be used to measure a market’s cycle. An increase in the ratio denotes that growth in supply (surplus) exceeds the growth in demand (GDP). This ultimately should lead to falling premiums. A look at Figure 7 shows that the ratio was trending upward throughout the recent soft market cycle. There has been an initial downturn in this ratio, which, if it continues, could provide a signal to a hard market.
Figure 7: Surplus / GDP
Sources: NAIC and Bureau of Economic Analysis.
Return on net worth for the overall P/C insurance market is shown in Figure 8. This data is taken from the NAIC’s Report on Profitability by Line by State and is only available through 2010. Profitability fell from 2006 to 2008 and then rose in 2009 and 2010. Generally, the P/C industry has followed a profitability pattern that follows that of all industries. Comparing return on net worth with the combined ratio, we see that they normally move inversely to each other (Figure 9). Knowing that 2011’s combined ratio was the highest of the past decade leads us to expect profitability to be relatively low for the industry in the near future.
Figure 8: Return on Net Worth
P/C Industry vs. All Industry Average
Source: NAIC Report on Profitability by Line by State.
Figure 9: P/C Industry — Combined Ratio and
Return on Net Worth
Source: NAIC Report on Profitability by Line by State.
Recent press reports indicate a rise in P/C insurance rates, especially in the commercial lines. This is not surprising, given the lagging exposure base and high combined ratios. The first half of 2012 has not improved over 2011, with weak jobs growth, continued stress in the housing market and a weakening economy further calling into question the possibility of an economic recovery. Based on the current economic and investment climate, it seems that insurers and reinsurers are likely to demonstrate an increased focus on underwriting profitability and risk selection, as well as opportunistic rate increases and book management.