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State of the Market Part I: The Hard Facts.

A commercial lines hard market looms like a ghost from a decade past. Classic signs, like specters from the '80s, are reappearing. Double-digit price increases, tougher underwriting, availability issues, surplus lines premium growth, requests to form captives and new niche markets are appearing across the industry. What otherwise could be as harsh as the mid-1980s market will, however, be softened by a strong industry surplus.

In our annual examination of market conditions, we review the results from Best's Aggregates & Averages--Property-Casualty to define the drivers forcing this hardening market and project the landscape for 2001 and beyond.

Driver 1

Combined loss and expense ratios for commercial lines reported in 1999 financial statements deteriorated substantially for workers' compensation and commercial auto, and property insurance continued to be unprofitable.

Yet, the 1999 calendar year results do not indicate the true magnitude of underwriting problems. Results for 2000 are expected to get worse. The price increases that began late in 1999 and accelerated in 2000 will have a positive, though limited, effect offsetting the combination of increasing loss costs and prior year adverse developments for 2000.


Driver 2

Operating results from 1999 have set the stage. For calendar year 1999, net underwriting losses for commercial lines property/casualty of $12.1 billion are offset by a $17.7 billion investment income to create a $5.2 billion operating income for commercial lines insurers. Adding $4.6 billion of realized capital gains (and subtracting taxes) results in net income of $8.5 billion. This is only an 8.6 percent return on earned premium. As underwriting losses worsen and investment income is level at best, these carriers are unlikely to achieve even these modest income results for 2000.

The results for the consolidated P/C industry are similar, with pretax operating income coming entirely from investment income, which offsets large underwriting losses. The $21.9 billion net income after capital gains and taxes in 1999 is a 7.7 percent return on earned premium.

Realized capital gains for the first six months of 2000 were $7.2 billion pretax for the P/C industry and unrealized capital losses were $8.5 billion--$7.2 billion shifted to realized gains and $1.3 billion other unrealized losses, as reported in Best's Viewpoint, September 25, 2000. Given investment market conditions, unrealized capital losses accelerated in the second half of 2000, but this may differ from company to company, depending on bond and stock investment choices.

Unrealized capital losses, along with capital and surplus paid out (mainly stockholder dividends), offset net income and reduce policyholder surplus for 1999. For commercial lines carriers, policyholder surplus decreased $1.7 billion during 1999, while for the consolidated P/C industry, it rose $1.1 billion. Analysts indicate a further reduction of approximately $8 billion during the first six months of 2000 for the total P/C industry. (We may assume that the majority of this is assignable to commercial lines carriers, although personal auto results have also been a problem for many.)

Commercial lines carriers will have a reduced 2000 pretax operating income and a reduced net income, unless propped up by realized capital gains. Policyholder surplus will drop as much as $10 billion for 2000. For the total P/C industry, this may drop more than $15 billion.

Table 2 Commercial Casualty Insurance Carriers and Consolidated P&C Industry Totals
Summary of 1999 Operations

 Commercial Industry
 Carriers(*) Totals(**)

Statement of Income (in Millions)

Premiums Earned $98,670 $282,791
 Losses & LAE Incurred 79,370 222,270
 Underwriting Exp. & Other Deductions 29,447 80,250
 Dividend to Policyholders 1,959 3,347

Net Underwriting Income -12,106 -23,076
Net Investment Income 17,698 38,855
Other Income (Exp.) -374 -1,353

Pretax Operating Income 5,217 14,425

Realized Capital Gains 4,585 13,016
Income Taxes Incurred 1,308 5,576

Net Income 8,494 21,865

Change in Policyholders Surplus

Net Income $8,494 $21,865
Unrealized Capital Gains 273 1,856
Capital and Surplus Paid In -1,269 578
Capital & Surplus Paid Out -7,396 -16,713
Other Changes -1,856 -6,462
Change in Policyholders Surplus -1,754 1,124

1999 Beginning Policyholder's Surplus $112,972 $333,224
1999 Ending Policyholder's Surplus 111,218 334,348

Source: Best's Aggregates & Averages - Property-Casualty, 2000 ed., pp. 34-35 and pp. 4-5.

(*) 403 Organizations excluding State Funds

(**) 1,028 Property-Casualty Organizations (2,480 companies)

Driver 3

Workers' compensation and commercial auto liability are the two commercial casualty lines with the greatest problems. Last January, we predicted a one-year, $1 billion increase in incurred losses and defense and cost containment expenses for 1999 workers' comp, largely from accident years (the years in which the losses were incurred) 1997 and 1998, and a $500 million increase for all prior years for commercial auto. In fact, workers' comp for 1997 and 1998 accident years rose $906 million and commercial auto for accident years 1996, 1997 and 1998 increased $595 million.

What we did not anticipate was companies still finding amounts to release from prior years. As in previous cycles, insurance carriers have stored funds--conservative reserves from years of good operating results--that they release during difficult years to smooth earnings. Some carriers have drained these reserves as they continue the "cheating phase" of the underwriting cycle.

Workers' comp reserves for accident year 1996, which were marginal at best, are now deficient by at least the $392 million released during 1999 to prop up calendar year financial results. (This will be discussed further under Driver 6.) Any further reductions to prior year reserves initiated for either workers' comp or commercial auto will constitute additional underreserving which will exacerbate the problems ahead in commercial lines.


Driver 4

Calendar year loss and loss expense ratios are fixed and do not change, while accident year ratios are estimates of ultimate loss, and are adjusted each year. The difference between the calendar ratio and accident year ratio is caused by the total prior year development during that calendar year. By plotting workers' compensation loss and loss adjustment expense ratios against both calendar year and accident year, we can see that for 2000, the lines are expected to cross as the calendar year loss ratio exceeds the accident year loss ratio. This is caused by total 1999 development of approximately $1 billion upward, concentrated in accident years 1997 through 1999.

The National Council on Compensation Insurance (NCCI) has predicted that the accident year 1999 combined ratio after dividends will increase to 134 percent. Based on the 33.6 percent ratio for other expense and policyholder dividends, this implies the current 83.2 percent loss and LAE ratio will rise to 100.4 percent. The estimated 17.2 percent of earned premium translates into approximately $3.7 billion of underreserving and expected future increases for accident year 1999 beginning in 2000.


Driver 5

Paid to incurred ratios provide another quantification of problems building in workers' compensation. The ratios of paid losses and allocated expenses estimates of ultimate incurred losses (calculated December 31, 1999) for accident years 1992 through 1995 are quite stable for claims at 12, 24 and 36 months of age. The higher ratios for 1997, 1998 and 1999 accident years, however, are indications that December 31, 1999 estimates of ultimate losses are deficient.

Although slightly higher ratios could be caused by increased use of excess of loss reinsurance, these estimates can still be considered high. The 12-month average ratio of .217 from 1992 to 1995 and first-year payments of $4.124 billion imply ultimate incurred losses of $19 billion ($4.124 billion divided by .217) compared to the $16.6 billion of 1999 accident year incurred losses carried by the industry. This implied reserve deficiency estimate of $2.4 billion is not as severe as the $3.7 billion calculated by the NCCI. Large deficiencies are also evident for accident years 1997 and 1998.

The reduction in reserves for the 1996 accident year (documented in Table 3) results in a further increase in the paid to incurred ratio for 36 months, which already was out of line at 24 months. This implies that the reserve draws for 1996 may have gone too far, deepening reserve deficiencies in order to prop up 1999 calendar year financial results.

The combination of pricing competition (resulting in worsening accident year loss ratios), growing reserve deficiencies and flat or reduced investment income with growing unrealized capital losses has forced action in workers' compensation pricing and underwriting.

Table 5 Workers' Compensation Paid to Incurred Ratios (Based on 12/31/99 Estimates of Ultimate Incurred)
Age of Accident Year
Losses 1992 1993 1994 1995 1996 1997 1998 1999

12 months .211 .212 .217 .226 .232 .225 .260 .249
24 months .473 .475 .481 .480 .491 .509 .541
36 months .625 .622 .629 .620 .646 .661

 1992-95 Average 12 month paid to incurred ratio = .217.
 1992-95 Average 24 month paid to incurred ratio = .477.
 1992-95 Average 36 month paid to incurred ratio = .624.

Source: Best's Aggregate & Averages - Property-Casualty, 2000 ed. Paid losses from p. 229 divided by incurred losses valued 12/31/99 from p.224.

Driver 6

The financial strength of insurance companies will help to avoid harsh pricing reactions. Given the state of workers' compensation and commercial auto, the question might be why has there not been even stronger pricing and underwriting actions?

The last two years have the largest policyholder surplus in history and lowest written premium to surplus ratios. This financial strength has supported a measured response in most commercial lines markets to date. However, as indicated earlier, the surplus declined an estimated $8 billion in the first half of 2000, and the loss of surplus may have accelerated in the second half of the year. This reduction comes with little or no recognition of reserve deficiencies, which can be expected to be acknowledged and addressed partially, but grudgingly, in year-end 2000 statements.

Table 6 Financial Strength
 1995 1996 1997 1998 1999

Policyholder $230,000 $255,500 $308,500 $333,300 $334,300

Net Written 1.13 1.05 0.90 0.84 0.86

Loss & LAE 1.57 1.43 1.18 1.10 1.08

(*) Dollars stated in millions for all property and casualty lines combined.

Source Best's Aggregates & Averages - Property-Casualty, 2000 ed., p.252-253.

Driver 7

Declining investment income will not support increasing underwriting losses. Net investment income peaked in 1997 and has since slowed. This trend can be expected to continue as loss payments increase while loss reserves remain constant and surplus declines. Declining investment income will provide less and less operating income as underwriting losses increased for 2000 and rising medical costs along with funding reserve deficiencies offset premium increases in 2001 results.


Driver 8

As investment income declines slightly while underwriting losses grow substantially, industry pretax operating income shows a steep decline. The 1999 underwriting loss was the third worst in history. For 2000, results will surpass this mark, making it the worst year in history with the exception of 1992 results caused by Hurricane Andrew.


Driver 9

As the profit picture deteriorates, profitability measures demand a response. Total return on revenue will likely decline to less than 5.8 percent for 2000. The total return on equity ratio, however, should decrease less sharply due to surplus declines, but these ratios will be unsatisfactory to insurers and investors alike. There is a reason that Nationwide sold Wausau Insurance in 1999 to limit its involvement in commercial lines, and that Citigroup has chosen to emphasize personal lines and specialty lines rather than commercial lines initiatives.

Table 9 Industry Composite Profitability Measures 1,028 Property-Casualty Organizations (2,480 Companies excluding State Funds)
 Return on Total Total
Calendar Investment Invested Return on Return on
Year Yield Assets Revenue Equity

1995 5.8% 10.3% 15.9% 19.4%
1996 5.7 9.1 14.3 15.5
1997 5.8 11.6 24.3 23.3
1998 5.2 9.0 14.7 12.7
1999 5.0 6.9 8.4 7.1

Total Return = Net Income plus Unrealized Capital Gains.

Revenue = Net Earned Premium.

Equity = Average of Beginning and Ending Surplus.

Source: Best's Aggregates & Averages - Property-Casualty, 2000 ed., p. 117.


The worst is yet to come. Solvency will be a real issue for the next several years. Financially strong companies will talk tough, but sacrifice surplus in 2001 before giving up much market share. This will make weaker companies ever more vulnerable--limited price increases as costs increase and prior year reserve deficiencies eat away surplus. More insolvencies and consolidations should be expected as insurers work through results for 2000 and continually poor results in 2001.

The fact is, lower investment returns, deteriorating operating income and weakened reserves are forcing increased prices and stricter underwriting. This will only intensify this year.

Exposures with poor underwriting experience over the last three years will face sharper price increases and availability issues in 2001, joining the already ailing nursing home and commercial trucking sectors. This will continue in 2002 with prices not beginning to plateau until late in the year.

Some risks will be forced into the surplus lines markets for the first time. More companies with poor loss experience or high severity potential will be pushed into this alternative for the next two years. At the same time, fewer guaranteed cost programs will be offered, and at high prices. Loss sensitive programs may have a strong revival, including incurred and paid loss retro rating plans. These may be options for entities with strong loss control and claims management in segments facing severe price increases.

There will be new entrants into the field of commercial lines underwriting. Examples include two workers' compensation pools fronted by a carrier with new capital providing reinsurance. In times of rapidly rising prices it is tempting to avoid the sharp price increases in the traditional markets in favor of lower prices offered by these new markets. For longer tail lines like workers' comp and commercial auto, buyers beware! Some new markets may be quite good and prove stable; others may be based on naive capital (e.g., Unicover) and prone to create future insolvency problems for insureds and regulators alike.

Underwriters will continue to require more quantitative information and analysis. Risk managers should prepare clear, quality presentations of loss experience and exposures well in advance of renewal dates to meet the increased demands from underwriters and avoid crises at the time of renewal.

In sum, companies that have ignored safety improvements, loss control and claims management during the 1990s will pay a heavy price in the months ahead. Those that have emphasized and practiced these basics of risk management should be able to find relief in loss-sensitive rating plans.

Gregory Alff, FCAS, ("Hard Facts") is senior actuary with Willis, based in Nashville. He has contributed the market review since 1999. (
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Comment:State of the Market Part I: The Hard Facts.
Author:Alff, Gregory
Publication:Risk Management
Geographic Code:1USA
Date:Jan 1, 2001
Previous Article:Fending Off Employment Practices Liability.
Next Article:State of the Market Part II: A Survival Guide.

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