News Analysis: Commentary on Full Year 2001

The property/casualty insurance industry reported a statutory rate of return of negative 2.7 percent in 2001, down from 6.5 percent return for the year 2000. The results were released by the Insurance Services Office, Inc. (ISO) and the National Association of Independent Insurers (NAII).

2001: The Insurance Odyssey Ends (Badly)
There was a time when insurance executives held out high hope for 2001. In late 2000, the much-feared Y2K bug had failed to materialize, a pro-business Republican had just been elected President, there were irrefutable signs that insurance markets were undergoing their first significant and sustained hardening in more than a dozen years and p/c stocks were up more than 40 percent. Happy days were here again, or so it seemed. Yet even then, the telltale breezes of what would become the “perfect storm” of 2001 were already beginning to stir. The key forces that came together to form the “perfect storm” of 2001 were recession, underpricing, catastrophe losses, medical cost inflation, Enron, abuse of the legal system and, of course, the September 11 terrorist attack. The role that each played in the context of the 2001 financial results is described below.

Recession
Early in 2001 it was clear that the economy was weakening rapidly and that the longest economic expansion in United States history was about to end. In a bid to soften the economic downturn, the Federal Reserve in January made the first of its 11 rate cuts in 2001. The aggressive action by the Fed, while beneficial, could not avert a recession, which began in March 2001.

The weak economy of 2001 negatively affected insurer investment returns and commercial lines exposure growth. The S&P 500 was down 13 percent for the year—that following a decline of 10.1 percent in 2000. This factor contributed heavily to the industry’s 58 percent drop in realized capital gains last year. At the same time, the sharp decline in interest rates took its toll on investment income, which fell 9 percent.

The recession of 2001 was concentrated on the business sector. Businesses cut back drastically on investment and payrolls, pushing the unemployment rate to 4.8 percent last year, up from 4.0 percent in 2000. The unemployment rate as of March 2002 stood at 5.7 percent. Exposure growth in commercial property lines and workers compensation has suffered as a result.

Fortunately, the Fed’s action kept the consumer sector relatively strong. With interest rates at or near generational lows, new home construction and sales of new cars approached record levels despite the recession. Strong car and home sales not only tempered the severity of the recession of 2001, but also benefited personal lines insurers who would otherwise have experienced slower growth in the number of cars and homes insured.

Chronic Underpricing During the 1990s
The cost of managing risk for U.S. corporations plummeted by 42 percent between 1992 and 2000. While some of the decrease in the cost of commercial insurance over this period was justified in light of improved fundamentals (e.g., falling medical inflation, decreasing claim frequencies and severities in some lines, etc.), at some point the pricing and underwriting cart got ahead of the horse. For a time, a bull market in both stocks and bonds kept the cart reasonably close, but when investments faltered and fundamentals once again began to deteriorate, the full impact of years worth of chronically underpriced business left the insurance horse with years of catching-up to do.

The industry’s statutory underwriting losses soared by $23.3 billion or 85.4 percent last year, in large part due to the chronic underpricing and lax underwriting of the 1990s. While the September 11 terrorist attack also contributed significantly to the increase, it is important to note that statutory underwriting losses were already up 55.4 percent through the first half of 2001—well before the attacks occurred.

The industry is still coming to terms with the sins of the past and the cost drivers of the future, as the deteriorating fundamentals vividly reveal. Restoring rate adequacy (which includes a reasonable profit provision) and underwriting discipline is a process that will take years. For this reason, significant underwriting losses can be expected for many insurers through 2002. As a result, there is every reason to believe that the current hard market will remain intact through 2003.

Catastrophes (excluding September 11)
Well before the September 11 terrorist attack, 2001 was shaping up to be a bad year for catastrophic losses. Tropical Storm Allison, which struck Texas in June, was the most expensive natural disaster of 2001, costing insurers $2.5 billion. An additional $5 billion in catastrophe losses occurred throughout the year without attracting much in the way of media attention. Non-9/11 catastrophe losses totaled $7.5 billion last year, putting 2001 well above the $4.3 billion recorded in 2000. As noted in the ISO release, total catastrophe losses for 2001 (including $16.6 billion in 9/11 property and business interruption losses) came to a record $24.1 billion.

Nearly a decade has passed since the trauma of Hurricane Andrew and many lessons have been learned, but natural disasters continue to take a heavy toll on insurers’ bottom lines. Long-term pricing and underwriting strategies in catastrophe-prone areas—even those not traditionally thought of as such (e.g., the “Hail Belt” and the “Ice Belt” states)—must continue to evolve to reflect the need to achieve and sustain profitability.

Medical Cost Inflation
The cost of providing medical care is a key cost driver in many lines of insurance, including auto, workers compensation, medical malpractice and numerous commercial liability lines. The cost of reinsurance and various excess and surplus lines markets is likewise affected.

After peaking at 9.0 percent in 1990, medical cost inflation fell until reaching just 2.8 percent in 1997. By 2001, the cost of providing health care rose 4.6 percent, according to the U.S. Bureau of Labor Statistics. The cost of employer-sponsored health care plans, however, rose 15-20 percent during the most recent renewal season. Clearly the cost of delivering health care through insurance schemes has diverged considerably from the official federal estimates, which merely compare the change in price of a fixed “basket” of goods and services through time. In reality, consumers of health care—whether through an employer-sponsored health care plan or through the workers’ compensation system—are becoming more sophisticated and more demanding.

Pharmaceutical manufacturers, medical device makers and medical service providers have also become unmistakably more aggressive and sophisticated marketers in recent years. Patients now routinely resist the shackles of managed care, demanding choice and input into the selection of service providers, care facilities and treatment protocols.

Federal statistics also do not capture the full impact of the legal system on the cost of providing health care. In several states, the medical malpractice market has essentially collapsed, in large part due to excessive litigiousness. The average jury award in medical malpractice cases more than tripled from $1.1 million in 1994 to $3.5 million in 2000, according to Jury Verdict Research. Likewise, the average jury award in a vehicular liability case rose from $187,000 to $269,000 over the same period.

Enron and the Issue of Corporate Governance
The spectacular collapse of the Enron Corporation—once the seventh largest corporation in the United States—blindsided the company’s investors and employees, not to mention its business partners and regulators. Unfortunately, the fallout from Enron has now engulfed numerous other corporations with questionable accounting practices as well their auditors and advisors.

While millions of investors lost money on Enron, insurers had a wider spectrum of exposures to the company than most. As large institutional investors, insurers, like many others, lost billions as Enron’s share price collapsed and its debt became nearly worthless. In addition, insurers guaranteed various Enron contracts through the sale of surety bonds and promised to indemnify the directors and officers of the company against legal action. While some insurers are challenging Enron’s surety and D&O claims based on its apparent misrepresentation of itself, the legal floodgates have been opened.

In 2001, trial lawyers declared open season on corporations with complex organizational structures. Last year, the number of shareholder federal class action lawsuits surged by 125 percent. In 2002, a large number of high-profile lapses in corporate governance have come to light and will no doubt spark additional litigation and create additional pressure on D&O and errors and omissions markets.

Revelations concerning Enron, dozens of other companies and their auditors has also spawned a crisis of confidence among investors regarding the quality of financial reporting. The crisis is contributing to the current poor performance of equity markets despite the recovering economy. According to a recent Wall Street Journal survey, one-third of investors no longer trust the quarterly numbers released by big Blue Chip companies.

Abuse of the Legal System
Though a perennial issue with insurers, abuse of the nation’s legal system produced very tangible impacts on insurer operations in 2001. The average jury award reached $1.2 million in 2000 (the latest year for which data are available), up 179 percent from $419,000 in 1994.

The extraordinary surge in new asbestos cases is perhaps the most spectacular and best-known example of tort system abuse. Despite having paid or reserved nearly $32 billion in claims, new analyses revealed that insurers’ ultimate liability could reach a staggering $65 billion.

The collapse of medical malpractice markets around the United States provide another vivid example of how abuse of the tort system is forcing insurers to change their operating practices. With few prospects for a turnaround—out-of-control jury awards forced one of the country’s leading writers of medical malpractice coverage to withdraw from the market entirely.

Abuse of the legal system can also be seen in the growth of novel types of claims, such as those alleging bodily injury and property damage from “toxic mold.” Such claims very often wind up in litigation. Costs associated with such claims in the Texas homeowners insurance market rose by an inexplicable 755 percent between early 2000 and mid-2001. Insurers have had to adopt much more stringent underwriting standards in the wake of the surge in mold suits and several multimillion dollar judgments.

Terrorist Attack of September 11
It is an understatement to say that the terrorist attack of September 11 was the most significant event of 2001. A consensus estimate puts total insured losses (including life insurance, reinsurance and foreign insurer exposure) at about $40 billion, though estimates have ranged as high as $70 billion. ISO estimates that U.S. property/casualty insurers face an estimated $25 billion in net underwriting losses from the attack. Because only about $10 billion of that amount appears to have been reported in the 2001 results (adding just 4.2 points to the industry’s 2001 combined ratio of 116.0), it is likely that September 11 charges will affect the balance sheet of insurers for years to come. [Note: A detailed PowerPoint presentation on the September 11 attack is available at http://www.iii.org/media/hottopics/insurance/sept11 ].

The effects of the September 11 terror attack extend well beyond the 2001 financial results. The event forced a top-to-bottom reevaluation of the underwriting and pricing risk associated with insuring against the peril of terrorism—a coverage that had been thrown in for free before the attack. Even lines not normally thought to be catastrophe prone, such as workers compensation, are being reevaluated.

September 11 also pressed insurers to lobby hard in Washington for a “backstop” that would establish the federal government as the reinsurer of last resort in the event of future attacks. While that effort continues, a market for terrorism insurance has emerged, with several major insurers and reinsurers now offering the coverage. This is a new risk for insurers, so at this point, coverage remains limited and relatively expensive. As a result, it is likely that trillions of dollars of exposure have been pushed back to business owners, their creditors and shareholders.

The Perfect Storm: Impact on Premium Growth
Widespread commercial insurance rate increases have gained headlines since September 11. Anecdotes detailing increases in the 100-plus percent range are common. As noted in the ISO release, however, net written premium growth for 2001 was just 8.1 percent. During the fourth quarter, premium growth was just 6.2 percent. Clearly, very little of the post-September 11 rate increases had been written by December 31. It is also likely that premium growth was adversely affected by the recession. Most of the increase in premiums written will be recorded in 2002 and earned in late 2002 and into 2003—and will be nowhere near the triple-digit figures so commonly cited in the media. The recovering economy will favorably impact growth as well. Analysts estimate 14.7 percent net written premium growth for 2002.

The Perfect Storm: Industry Capacity Continues to Shrink
The $27.8 billion decrease in surplus from $317.4 billion on December 31, 2000 to $289.6 billion as of December 31, 2001, represents a decline of 8.7 percent. Surplus is down 14.6 percent since peaking at $339.3 billion in June 1999. The decrease in the industry’s capacity (as measured by surplus), combined with heightened risk, strong demand and a return to more rational pricing will remain the major drivers of the current hard market. Capacity has now shrunk to less than what it was at year-end 1997.

The Perfect Storm: Impact on Stock Prices
By the end of 2001, property/casualty insurance stocks were down 1.2 percent, closing the year in far better shape than the S&P 500, which posted a decline of 13 percent. Considering the fact that 2001 was the worst year in the history of property/casualty insurance, it is clear that investors are expecting the hard market to deliver healthy profits in the years ahead.

Investors have kept the faith so far in 2002. Through mid-April, p/c stocks (on a market-cap weighted basis) were up 4.6 percent, compared to the S&P Index, which was down 2.9 percent.