U.S. P-C industry: "No pain, no gain"

Rough Notes, Jan 1999 by Stradtner, James B

The domestic property/casualty insurance industry has experienced a fair degree of prosperity over the past decade. This prosperity can be quantitatively measured by the industry's growth in surplus, reasonably high level of earnings and relatively satisfactory return on equity. The industry's combined ratio was 101.6 in 1997, the best ratio reported since 1979. As a direct result of these factors, publicly held property/casualty insurance stock prices rose to new, high levels through mid-year 1998.

What makes of all this most interesting is that this perceived prosperity occurred in a period in which the industry's fundamentals were not all that exciting. Intense price competition has seen premium growth slow to a low single-digit rate of 3.4% in 1996, 2.8% in 1997, and an estimated 2.4% in 1998. Underwriting has continued to be unprofitable, and declining interest rates have virtually slowed investment income to a no-- growth point.

Poor fundamentals that make the property/casualty industry look prosperous is truly one of the great enigmas of our time. The explanation of this enigma lies in certain external factors such as a prolonged period of economic stability, low inflation, low interest rates and one of the greatest "bull" markets in securities in many years. Never forget that realized and unrealized capital gains are a great panacea for a lack of underwriting profits.

Looking to the future, these external factors may not be so perfectly aligned with what has truly been happening in the industry, and it is possible to be more negative on the future outlook for the fundamentals. The single-digit industry premium growth expected for 1999 may barely exceed the rate of inflation, which is expected to rise from recent years. An economic recession is lurking somewhere in the future. Interest rates are still low and may be heading lower; and while this is a good thing for the valuation of fixed income security portfolios, it represents a real problem for the investment and reinvestment of cash flows.

The industry is still exposed to natural catastrophes. This fact was demonstrated in the third quarter of 1998 when such losses were more than enough to cause numerous companies to report a decline in earnings or even of operating losses. Commercial property/casualty premium rates continue at a very low competitive and unreasonable level. Y2K potential problems are an unknown in regard to insurance company internal operations and exposure to policyholder claims of a completely unexpected nature. The collapse in financial markets in the third quarter of 1998 also showed how fragile insurance company investment portfolios can be in terms of immunity from problems that expose the entire financial system to losses from investments in hedge funds, derivatives, option programs and investment pools.

Despite this, prices of property/casualty stocks have made a major recovery from their thirdquarter 1998 sell-off Is this false optimism or are investors willing to look through the current fundamental problems because the future outlook is much brighter? In our opinion, the latter is a more likely scenario.

By a more optimistic outlook for the industry, we mean a return to more sensible underwriting standards in all of its product pricing. This may well lead to a significant improvement in fundamentals, which goes beyond the false prosperity of the 1990s. Premium rates are still low; but perhaps they have bottomed out and, currently, are not going lower. Our estimate is that they will start to rise within the next year, and this will turn the underwriting cycle up after the longest down cycle in the industry's history. The industry pundits who have predicted that the underwriting cycle is dead will be proven wrong.

The long-awaited turn in the industry cycle will come, not because of some catastrophic event large enough to impact the industry's $300 billion surplus, but because a whole series of painful fundamentals will accumulate to demand a mandate for change. Add to this the demise, through mergers, acquisitions and failures, of a whole group of companies that contributed more than their share to product pricing problems.

Fewer and fewer insurance companies have a focus and a franchise that permits them to operate independently from the industry's problems for a long time. The annual $50 billion of mergers in the property/casualty industry is a good example of consolidation in any industry, especially an industry selling a generic product whose cost of goods sold may not be known for several years. Excess surplus, which used to give a management comfort, may now be a very good reason to acquire or be acquired.

We believe that there is still an industry cycle, and we hope the future upturn will last at least long enough to offset the pain of the down cycle that started in 1986. The gain for the industry will be a return to industry standards that provide a good economic use of the industry's surplus. Maybe the efficient stock market is saying that the property/casualty industry's long-term growth story is about to be told.