Did you hear the one about the fellow who lost money on every widget he sold for 25 years but was able to make it up on volume?
Substitute the words "widget" and "volume" with "insurance policy" and "investment income" and you replace the old joke with some idea of the complex property/casualty industry profit and loss picture that up until the very recent past, saw the industry lose money on its basic product every year for more than two decades.
Insurers celebrated their first recent underwriting profit in 2006 with an impressive $31.2 billion net gain compared to a loss of $5.2 billion the previous year.
Celebrate may seem an insensitive description since the welcome turn of events resulted from the decimation of an iconic American city, followed by a year whose theme song could have been "Blue Skies," as opposed to "Stormy Weather."
But other factors may have also led to a minimum of champagne corks popping off by industry leaders.
Perhaps they feared some federal lawmaker devising a new windfall underwriting profits tax along the lines of the one Big Oil faces periodically. Insurance industry profits--especially after a year when many a policyholder was left holding the bag upon discovery the water that destroyed their home had the temerity not to be wind-driven--do not sit well in certain quarters.
Even the man Forbes magazine calls the richest in the world, Warren Buffett, says all property/casualty insurers have to do is break even on underwriting to assure an overall profitable enterprise by taking advantage of the funds temporarily held by the industry.
"This float is 'free' as long as insurance underwriting breaks even, meaning that the premium we receive equal the losses and expenses we incur," he wrote in his eagerly awaited letter to shareholders this year.
Of course, breaking even means savoring some winning years after dozens of losers. In fact, the Jersey City, N.J-based insurance information clearing house the Insurance Services Office Inc. estimated that while insurers made more than $30 billion in underwriting profits in 2006, since 1959 they have lost $434.3 billion. That's a lot of catching up to do.
That being said, it is important to remember that even in 2005, while suffering a $5.6 billion underwriting loss, the industry enjoyed net income after taxes of $44.2 billion.
And with the nearly $37 billion positive swing in underwriting results, net income rose to $63.7 billion the following year. So every little bit helps.
Analysts expect the same underwriting black ink for 2007: although they don't expect profits to be quite as free-flowing as 2006. But even back to back years of profits gives credence to the notion that perhaps underwriting profits will no longer be Haley's Comet-like events, but instead part of the natural order of things.
(Industrywide 2007 results are set to be published in early April, before the publication of this article but well past its press deadline. You can find it now on our Web site. Highline Data reported early last month that the industry's combined ratio rose two points to 94 for 2007.)
HOW LONG CAN THIS GO ON?
So the question remains, has the property/casualty industry found a way to make a profit from its main business on a year-by-year basis so it does not have to rely on investments solely?Or will the fierce cyclical nature of the business forever doom it to a boom-bust scenario and sea of red underwriting ink?
You can't look at this question without examining insurance's unique characteristics that can, depending on who you talk to, present roadblocks to consistent underlying profitability. The first and foremost is state price regulation.
Since the government and mortgage bankers force you to purchase auto and home policies, carriers should not have carte blanche to charge what traffic will bear since the traffic is not voluntary, so the theory goes.
The insurance industry counters that such regulation stifles competition and ends up costing the consumer it aims to protect more money than a free market system would.
But in the end, the timeless laws of supply and demand, or fear and greed if you will, will govern just how consistently the property/casualty industry in the future will turn a profit on the policies its sells and services.
Don Griffin, director of personal lines for the Property Casualty Insurers Association of America, sees rising combined ratios in the cards, but perhaps not repeatedly crossing the break-even 100 mark as regularly as in the past.
"I think companies have gotten a lot more sophisticated about using the tools that are out there such as insurance scoring that enables them to write business at the appropriate price so that they don't lose as much," he says.
As an example, the pool for those drivers who can't be placed in the standard market has dropped about 30 percent in recent years. "What that tells me is the standard markets are getting a lot more sophisticated in writing people they were not able to write with the right results in previous years," he says.
Birny Birnbaum, director of the Austin, Texas-based Center for Economic Justice and a prominent insurance industry critic, says the shift away from price competition to such sophisticated pricing models has resulted in a new era of underwriting profits, which he does not view as all that necessary to the health of the industry, citing Buffett as his comrade in arms on the issue.
"So while the industry whines about low returns on capital, the fact is that over-capitalized insurers routinely buy back large amounts of stock because they cannot deploy that excess capital," he says.
While such measures may not serve the public weal as much as industry critics and regulators may like, they do tend to bolster stock prices and return on equity figures, thus increasing the allure of the industry to investors and their capital, industry advocates assert.
ISO assistant vice president Michael Murray says it was too soon tell if the property/casualty industry will see a new era of regular underwriting profitability.
Technological advances will enable insurers to adjust pricing more quickly to changing conditions, which could augur a new era of profitability.
"But in the final analysis, people still make all the critical decisions, such as how to set the parameters in decision-making tools," he says.
Thus, experts like Griffin and Murray are wary of predicting profitable underwriting years as the rule rather than the exception, even if they do appear more often than in decades past.
Reading the tea leaves to determine the severity of any pricing climate is as much of an art as a science.
The Council of Insurance Agents and Brokers reported that prices for commercial insurance dropped 12 percent for all size of accounts in the last quarter of 2007.
A poll conducted earlier this year of Wall Street stock analysts and industry professionals by the New York City-based Insurance Information Institute says expectations were for moderately decreasing underwriting profits for both 2007 and this year. At the same time, premium growth is expected to slow to a crawl for 2007 and dip into the negative realm in 2008.
"The apparent paradox of strong profits but stagnant premium growth is a reminder of the highly cyclical nature of the property/casualty business and the fact that the industry's financial fortunes are determined by a myriad of factors," says institute president Robert Hartwig.
The most unpredictable factors of course remain the catastrophes, whether of the 2001 man-made kind, or the ones four years later of the natural variety.
As an example, the 2001 World Trade Center attacks took much of the steam out of efforts to deregulate both the commercial and personal lines pricing, while the 2005 Katrina-Rita-Wilma losses prompted more state intervention into the reinsurance market with mixed results.
Several new wrinkles now appear including the general dismal economic figures announced last month indicating a deeper and longer recession than many have predicted, and the subprime credit market crisis which has taken its toll on a number of companies.
Hartwig cited the economy and the sharpened interest in reinsurance alternatives such as catastrophe bonds and captives as factors leading to a softening pricing environment. "The major exception to this trend is hurricane-exposed coastal property insurance coverages, where insurers are seeking to charge premiums that are commensurate with the substantial risks they assume," he says.
In addition to whether underwriting profits are here to stay, the question also remains as to how necessary they are.
"The answer depends on who you talk to," says Griffin.
Companies and stockholders will clamor for any source of profit for a return beyond the historical 10 percent. "But the competition is such that I don't think that will be allowed in the marketplace," he says.
2008: A WATERSHED YEAR?
Excess capital, estimated by some at around $100 billion, has helped spur this competition and resulting price softening. In the past, insurers have taken this loose change and sold more insurance as the means of deploying it to their best possible advantage.
But that could be changing.
Hartwig noted that increased dividends and record share buybacks are among the aggressive capital management tools that insurers are now using.Those could lead to shallower market cycles and profitability troughs, much to the dismay of those industry critics.
And then there are the regulatory and ultimately, political, factors.
"Most people don't begrudge most industries from making a profit but they don't particularly care for it when insurance does," Griffin says. "People think we are making profits off the misfortune of others, but that is not the way the program works."
Griffin says the industry won virtually all court tests on the wind vs. flood issue and has an exemplary record in paying the claims from the 2005 KRW disaster.
But despite that, the insurers face possible federal and state tinkering with the nearly 40-year-old flood exemption. Any such effort would involve a rethinking of the federal flood insurance program and new multiperil policies to cure the ills of so many homeowners who ended up without coverage in 2005 when disaster struck.
The initials WTC and KRW signify events that will forever alter the profit structure of the property/casualty industry, which as one piece of the global financial service sector puzzle is undergoing seismic changes in any number of ways.
Last month's auto-da-fé by a parade of fallen financial services top executives before Congress will only heighten the tensions that must be felt in all executive suites, while a seriously nose-diving economy will not lighten the load.
For the insurance industry, the float that it has always relied on may not be as plentiful as in the past and could force its executives to look more toward creating profits from disciplined underwriting as a way to bolster their bottom lines.
"The current volatile investment environment and the concern voiced by the Federal Reserve, the Treasury and foreign central banks are reminders of the uncertainty and fragility of investment returns, even in the insurance industry's very conservatively managed investment portfolio," Hartwig says. He will certainly not lack for company in watching to see if the new century finally brings a new paradigm.
"Insurance CEO's continue to vow that it will be different this time around, and 2008 is quickly shaping up as the year when the industry's fortunes will be cast," he says.
STEVE TUCKEY has written on insurance issues for a decade for several national media outlets.
April 15, 2008
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