This is the sixth year of the soft market and pricing remains favorable for insurance buyers. But there is an underlying weakness beneath the surface that provides an early harbinger of the change to come. How long the soft cycle will last is, as always, unclear. Nevertheless, the chance of a soft landing, or some other benign end to the cycle, is highly unlikely. Instead, the cycle will end in tears-as it always does. Those who begin preparing now will be well served. Those who do not will be expecting different results from a market that has done the same thing over and over again. And as Einstein famously said, that is the very definition of insanity.In 2009, the U.S. property/casualty industry rebounded. All measures showed improvement against 2008, during which the industry was hammered by catastrophes and the financial crisis. Overall, the U.S. P/C industry generated a net income of $31.1 billion, up substantially from the meager $8.6 billion reported in 2008.
The industry also posted a better combined ratio, and the improvement to 101.2%, compared to the 104% of 2008, was due to several factors. First was a benign Atlantic hurricane season. Total U.S. catastrophe losses for the year were only $14.6 billion compared to $28.2 billion the year before, making 2009 one of the lightest catastrophe years in the past decade. The industry also continued to release loss reserves. The $12 billion in reserves released marked the fourth consecutive year of releases. Finally, the industry recorded $43.5 billion in net investment gains as the stock market recovered, up more than 30% over 2008's total. The combination of these three factors allowed the industry to improve its capital position, and industry surplus increased more than 9% to $519 billion.
Even with these positive results, however, the P/C industry's return on equity was only 5.8% in 2009-significantly below the historic average of 9.1%, according to ISO. Furthermore, 2009 was the third consecutive year in which net written premium for the U.S. industry was down-insurers reported $419 billion in net written premium, down 6% from the prior year. While some of this premium reduction can be attributed to the recession, which impacts exposure levels and customer buying patterns, a 6% reduction certainly implies a real reduction in premium even on a recession-adjusted basis. The drop was most pronounced in the commercial segment, which fell 9% for the year. And while final figures have not yet been reported, the surplus lines industry undoubtedly experienced an even larger decrease in premium. Based on prior-year trends and anecdotal reporting from carriers and brokers, industry premium was most likely down in excess of 10%.
What this tells us as we enter the second half of 2010 is that it will be difficult for the industry to generate even the same modest results as it did in 2009-particularly when you factor in the number of disasters that have occurred. In the first quarter, Chile was hit by the devastating 8.8 magnitude earthquake. While insured loss estimates still vary, the insured loss seems to be settling into the $8 to $10 billion range. A week after the Chile quake, Europe suffered winter storm Xynthia, which is estimated to have caused an insured loss of up to $2 billion. Several storms in Australia soon after led to insured losses estimated to be in excess of $750 million. And of course, in late April, the Deepwater Horizon oil rig exploded and sank in the Gulf of Mexico. While much of the ensuing environmental disaster is not covered, the insured loss should still exceed $2 billion. Between these four events, less than five months into the year, the global insurance industry had already suffered $14 billion in catastrophe losses in 2010-before hurricane season even started.
The bulk of the losses for these catastrophes is being borne by large, global reinsurers and insurers outside of the United States. As a result, for the first quarter of 2010, the Reinsurance Association of America reported a combined ratio for the 19 companies it surveyed of 102.2% up from 95.5% for the same period last year. While these losses will not directly impact U.S. insurers, they will certainly have a ripple effect over time should these loss levels persist. Fortunately, this has not yet occurred, and first quarter results for 2010 for U.S. insurers were generally strong.
The 2009-2010 Rate Environment
At this time last year there was a feeling that rates were beginning to stabilize-and even firm. This was particularly true for catastrophe property rates and for D&O coverage for financial institutions. Such thinking was based on the poor results of 2008 and the uncertainty regarding the fate of several industry leaders, notably XL, Hartford and Chartis.
Nevertheless, things returned to normal, and rates again began to fall in all segments as the year progressed. Rate decreases were the most significant in the first and fourth quarter of 2009 with a moderating trend mid-year. In general, prices were softest in the liability lines, and the larger accounts generated more substantial reductions on a percentage basis as markets chased premium. On average, rates decreased between 5% and 10%.
So far in 2010, we have seen a continuation of the same soft market pricing and rates have again declined in the 5% to 10% range. While aggressive pricing drops persist on specific risks, it is clear that the rate of decrease is moderating overall. And insurers are looking to slow the pace of decline.
We have not yet seen many carriers walking away from renewals and, to the contrary, there is an acknowledgement that insurers have been looking to aggressively protect renewals when facing competition. So to secure a new customer, an insurer will generally have to reduce rates from the expiring level well in excess of 10%.
But while insurers seek to protect their turf, the greatest movement appears to be coming from the surplus lines marketplace as admitted carriers continue to expand their appetite to win business from surplus lines carriers. The regulatory bias towards admitted markets gives standard market insurers a competitive advantage in these situations. Admitted insurers find it easier to win business by moving into traditional surplus lines areas.
It remains to be seen how this will impact results, but it is logical to assume that insurers aggressively writing coverage for tough classes in which they have limited expertise will end up with a problem. Because of the depressed rates and intense competition from admitted markets, some surplus lines carriers are pulling back and closing offices-or exiting lines of business altogether-until conditions improve. In late May, for example, Axis announced it was ostensibly exiting the primary casualty line because rate levels made it impossible for them to compete profitably in the current environment.
How Far from the Bottom Are We?
The $64,000 question that everyone asks is "how far from the bottom of the market are we?" Every indication is that things are deteriorating. These price decreases cannot continue indefinitely. The idea of a soft landing-while appealing-is completely inconsistent with historical market behavior and the way this cycle is playing out. On the contrary, it is clear that soft market pricing will continue to erode the financial strength of the industry and that a catastrophic event-or series of events-will turn the market, as has happened in each of the past market turns. We are not there yet, but we are clearly headed in that direction.
In an attempt to determine where the bottom is we analyzed several different measurements that provide a picture of where the industry is in respect to historical levels and previous market turns. One key measurement is the amount of policyholder surplus in the industry.
The U.S. industry had policyholder surplus of $519 billion at the end of 2009, according to A.M. Best. At that level, the industry is in one of the best capital positions it has been in during the last 20 years. To put this in perspective, the surplus of the U.S. P/C industry was 3.55% of gross domestic product (GDP) at the end of the first quarter of 2010, according to Advisen. In comparison, that same measure on June 30, 2001, was 2.8%. By analyzing previous market cycles, Advisen believes that industry equilibrium is 3.2%. If that number is correct then the industry currently has approximately $50 billion of excess capital.
Another measure of industry stability in terms of financial strength is the ratio of net premium written (NPW) to policyholder surplus (PHS). With NPW coming in at $419 billion for 2009, the ratio of NPW to PHS is 0.81:1. This ratio has steadily declined over time from close to 2:1 during the 1980s and is presently at the lowest level it has been in 30 years. Clearly, the industry can absorb substantial losses against its current premium level.
On the other hand, while the industry appears to be well capitalized, the premium and rate levels tell a different story. If you look at the ratio of NPW to GDP over time, industry premium levels are at the lowest point in the last 30 years. At the end of 2009, NPW was 2.89% of GDP. Over the last 30 years that percentage has gone from highs of 3.96% in 1987 and 3.79% in 2003 at the peak of the last two hard markets to lows of 2.94% in 1984 and 3.04% in 2000 at the troughs of the last two soft markets.
The current level of 2.89% is the lowest in the last 30 years. So while the industry may have excess capacity, premium levels would indicate that a market change is overdue.
Similarly, it is important to review rate levels. While tracking rate levels is an imperfect science, it is instructive to watch how they behave over time. The three groups that have tracked premium rate levels since 2001 are the Council of Insurance Agents & Brokers (CIAB), Advisen and MarketScout. According to CIAB, on a cumulative rate change basis, rate levels are still between approximately 5% and 20% above where they were at the beginning of 2000. While MarketScout does not specifically report rate movement over time, if you aggregate the rate changes they report by month over the last 10 years, it shows that rates are approximately 15% above the levels that they were at in 2001. Likewise, Advisen reports that the aggregate rates are 17% above where they were at the start of 2001. All three groups report rates in the area of 15% or more above bottom of the market levels. Not all lines of business move the same and, overall, umbrella and property rates seem to have held up the best while general liability and workers compensation rates are closest to previous lows. Regardless, given the current pace of rate reduction (5% to 10% per year), we would expect the rates to be back to historic lows in the not too distant future.
It is not yet clear when this soft market cycle will end. But what is clear is that results are deteriorating, and while a change is not imminent, it is probably not too far off. It is also clear that, as an industry, we are doomed to repeat the mistakes we have made in the past. While better analytic tools and more fluid movement of capital will most likely shorten the market cycle and reduce the severity on each end, they will not eliminate the cycle itself. That takes a level of discipline that has
heretofore eluded the U.S. P/C market.
As Albert Einstein famously said, the definition of insanity is "doing the same thing over and over again and expecting a different result."