Profitability in the property/casualty insurance industry rebounded sharply in the first quarter of 2013. The improvement was propelled chiefly by growth in premiums, a reduction in catastrophe losses and favorable prior year reserve development. The effect: the industry combined ratio fell to 94.8 in the first quarter from 99.0 in the first quarter of 2012.
The industry's bottom line benefited commensurately as overall net income after taxes (profits) surged by 40.9 percent during the quarter to $14.4 billion from $10.2 billion in the year earlier period, pushing the industry's return on average surplus up to 9.6 percent, up from 7.2 percent in the first quarter of 2012 and well above the 5.9 percent and 3.5 percent returns recorded for full-year 2012 and 2011, respectively.
Top line growth is also a consistent and meaningful contributor to improved profitability. Net written premiums were up 4.1 percent during the quarter, more than a full point above the 3.0 percent gain recorded in first quarter of 2012, marking the twelfth consecutive quarter of growth and the longest continuous period of growth in nearly a decade.
Persistently low interest rates, of course, remain a challenge for the industry, with net investment income during the quarter slipping by $0.3 billion or 2.3 percent compared to the first quarter of 2012. Overall industry capacity rose to a record $607.7 billion as of March 31, 2013-up $28.5 billion or 4.9 percent from $579.3 billion as of year-end 2012. The industry results were released by ISO, a Verisk Analytics company, and the Property Casualty Insurers Association of America (PCI).
Profitability Improves: Catastrophe Losses Less of Drag on Earnings
The strong first quarter of 2013 marks a pivoting away from the superstorm Sandy-related discussions that dominated headlines in the final few months of 2012. As noted earlier, the P/C insurance industry reported an annualized statutory rate of return on average surplus of 9.6 percent during the first quarter of 2013 (9.7 percent after excluding mortgage and financial guaranty insurers), up from 7.2 percent in the year earlier quarter (8.2 percent after excluding mortgage and financial guaranty insurers). The first quarter of 2013 marks the first in years that the mortgage and financial guaranty segment did not exert a significant (adverse) distortionary impact on the industry's overall financial performance. Over the past several years, the combined ratio in the segment had at times exceeded 200. Thus, even though these lines account for only about 2 percent of industry premiums, they had a disproportionate impact on underwriting performance and profitability. With mortgage and financial guaranty insurers at long last returning to profitability during the quarter (turning in an annualized return of 8.5 percent compared to negative 37 percent in the year earlier period)-due in large part to improving real estate and credit market conditions-the drag on overall industry performance has been removed (at least in the most recent period). A discussion of the key drivers of the quarter's performance follows.
Catastrophe Losses and Underwriting Performance
While the past two years (2011 and 2012) ranked among the costliest on record for catastrophe losses, direct insured losses from catastrophes during the first quarter of 2013 fell by $1 billion to $2.6 billion from $3.6 in the year earlier period, providing a meaningful lift to the industry's bottom line. This year's first quarter catastrophe losses were close to the 10-year average for the first quarter of $2.4 billion, according to ISO's PCS unit. The second quarter, however, was witness to a number of significant events, including the May 19 tornado in Moore, Oklahoma, and June wildfires in Colorado. Altogether, catastrophe losses through the first half of 2013 are estimated at approximately $8.1 billion.
Favorable Reserve Development Strengthens
In addition to accelerating premium growth and lower catastrophe losses, favorable development of prior-year claims reserves totaled $5.6 billion in the first quarter of 2013, a material increase from $3.9 billion in the first quarter of 2012, according to ISO/PCI. Some of the reserve release is associated with lower than expected costs for Sandy claims, whereas much of the remaining sums released are associated with older events. Removing the effects of favorablereserve development results in a combined ratio of 96.3 for the quarter (versus 94.8 when included).
Combined Ratio Improves: Rare Underwriting Profit Recorded
The overall improvement in underwriting in the 2012's first quarter was material and notable, with the industry's combined falling to 94.8 compared with 99.0 a year earlier (excluding mortgage and financial guaranty insurers the combined ratios for the same periods were 94.8 and 97.5, respectively). According to ISO/PCI, the quarter's underwriting profit was just the seventeenth on record since the start of 1986 (a period spanning 109 quarters).
Premium Growth: Top Line Growth Continues Also contributing to improved underwriting performance was continued and steady premium growth, which rose 4.1 percent in the first quarter, more than a full percentage point above the 3.0 percent year earlier reading. Premium growth for full-year 2012 was up 4.3 percent.
There are two principal drivers of growth in the property/casualty insurance industry: exposure growth and rate. Exposure growth-basically an increase the number and/or value of insurable interests (such as property and liability risks)-is being fueled primarily by the rebounding economy. Nominal (current dollar) GDP in the first quarter increased by 3.4 percent relative to the first quarter in 2012, meaning that the property/casualty insurance industry saw growth better than that of the overall economy over the past year.
Not all economic growth, however, leads directly to the formation of insurable exposures. Indeed, historically, the most important determinant in industry growth is rate activity. With auto, home and major commercial lines all trending positively, overall industry growth could outpace overall economic growth in 2013, as was the case in 2012.
Improving labor market conditions in 2012 are also critical to top line growth in the P/C insurance industry. Job growth benefits the entire economy, of course, but the associated expansion of payrolls benefits workers compensation insurers in particular. The United States economy added 637,000 private sector jobs during the first quarter of 2013 (and 972,000 through May). Combined with modest increases in the hourly earnings of employees, payrolls expanded at an average annual pace of $188 billion during the quarter, which will contribute to billions of dollars in new premiums written being earned by workers compensation insurers in 2013. Indeed, workers compensation, hit hard during the recession by a soft market and a precipitous drop in payrolls, has within the span of just a few years transformed itself from the fastest contracting major property/casualty line to the fastest growing, with direct premium growth in 2013 up by approximately 10 percent.
Strong growth in the workers compensation line, recovery in the residential construction sector and stronger car sales are just a few of the reasons why moderate growth is likely to continue through the remainder of 2013. Among carriers writing predominantly commercial lines, premiums written rose by 3.2 percent in the first quarter of 2013 (actually down from 4.2 percent in a year earlier) compared to 5.0 percent for insurers writing predominantly personal lines (up from 2.5 percent a year earlier) and 3.7 percent for those with a more balanced mix of business (up from 3.2 percent a year earlier).
Investment Performance: Low Interest Rates Had Expected Effect
Total investment gains (which consist of net investment income plus realized capital gains net of realized capital losses) rose by $0.42 billion, or 3.4 percent, to $12.77 billion in 2013:Q1 vs. $12.35 billion in 2012:Q1. It is instructive to compare the components of the quarter's total investment gains with the first quarter of 2012.
Net investment income (primarily interest earned on the industry's bond portfolio plus stock dividends) fell by $0.27 billion (-2.3 percent) to $11.39 billion during the first quarter. Realized capital gains, which totaled $1.38 billion during the quarter, rose by $0.69 billion, doubling the realized capital gains in 2012:Q1.
Slightly over 70 percent of the property/casualty insurance industry's investment portfolio is invested in bonds. Bond market yields (and prices) in the first quarter of 2013 were fairly steady; Moody's AAA-rated seasoned corporate yields ranged between 3.80 percent and 3.93 percent. The yields that P/C carriers have achieved reflects not only the downward slide in prevailing interest rates but also the result of adjusting the mix of bond maturities in their portfolios, moving toward shorter terms. This shift began roughly when the "Great Recession" started. At year-end 2007, bonds with maturities of 1-to-5 years constituted 30 percent of bond investments; that percentage rose to roughly 40 percent at year-end 2010 and has held there through the end of 2012. In contrast, during the same periods, the percentage of bonds with maturities of 5-to-10 years dropped from 34 percent at year-end 2007 to 27 percent at year-end 2010. Similar shrinkage occurred for bonds with longer maturities. This shortening of maturities of invested bonds contributed to the drop in 2013:Q1 net investment income. Importantly, the shortening of maturities leads to a reduction in the duration of industry's bond portfolio which, in turn, reduces the vulnerability of the portfolio to interest rate risk, currently an acute concern given the likelihood of higher interest rates as the Federal Reserve contemplates unwinding its longstanding quantitative easing (QE) program.
The conventional wisdom is that interest rates will remain low for a little while longer. The Federal Reserve continues to hold its key federal funds rate between zero and 0.25 percent and has signaled multiple times that it expects to keep it there until the economy strengthens. The Fed has said that it plans to keep interest rates low until the unemployment rate falls to 6.5 percent. However, with the unemployment rate now sliding towards the Fed's target, speculation began in the 2013:Q2 that the Fed would soon start to taper its QE III program and let long-term bond yields rise.
In contrast, the broad stock market did quite well throughout 2013:Q1: the S&P 500 rose 5.04 percent in January, 1.11 percent in February and 3.60 percent in March. The market values of common and preferred stocks generally constitute about 16 percent of the investments of P/C insurers.
The outlook for inflation remains quite tame, with the consumer price index expected to rise by roughly 2 percent in 2013 and 2014. Low inflation gives the Fed the latitude to pursue an aggressive monetary policy.
Policyholders' Surplus (Capital/Capacity): New Record High Demonstrates Industry Strength and Resilience
Policyholders' surplus as of March 31, 2013 stood at $607.7 billion, up 3.6 percent or $20.8 billion from year-end 2012 and up 5.9 percent ($33.8 billion) from the first quarter of 2012. Policyholders' surplus has generally continued to increase despite high catastrophe losses over the past few years. The fact that the industry was able to rapidly and fully recoup its losses to surplus even in the event of disasters like Sandy (which produced $18.8 billion in insured losses) is continued evidence of the P/C insurance industry's remarkable resilience in the face of extreme adversity.
The bottom line is that the industry is, and will remain, extremely well capitalized and financially prepared to pay very large scale losses in 2013 and beyond despite the fact that insurers have paid catastrophe losses in each of the past two years that are more than 40 percent higher than the $23.9 billion average over the past decade. One commonly used measure of capital adequacy, the ratio of net premiums written to surplus, currently stands at 0.77, close to its strongest level in modern history.
The property/casualty insurance industry turned in a sharply improved performance in the first quarter of 2013 in terms of underwriting performance and overall return on average surplus (profitability). In addition, policyholders' surplus reached a new all-time record high. Although profitability surged amid lower catastrophe losses and strong prior-year reserve releases, overall investment gains were flat despite bullish stock market conditions, in large part due to historically low yields on fixed income securities pushing down investment income. Premium growth, while still modest, is now experiencing its longest sustained period of gains in a decade.
Fundamentally, the P/C insurance industry remains quite strong financially, with capital adequacy ratios remaining high relative to long-term historical averages.