Slip-sliding away

S&P takes a look at the insurance industry's financial status

By Phil Zinkewicz

Last year, banks, investment firms and other financial institutions—not to mention the U.S. auto industry—sat on a financial fault line perilously close to total annihilation until the federal government stepped in. How government loans and bailouts will work to steady a faltering economy is anyone’s guess.

To date, the property and casualty insurance industry has not experienced the bloodletting that has hit other parts of the financial world. You can’t count AIG because that was a holding company failure, not a failure of its myriad insurance companies, which are still operating successfully. Nevertheless, the property and casualty insurance industry has been negatively affected by the economic downturn as well as the normal soft market cyclicality that has dominated the industry over the last few years. Standard & Poor’s has taken a look at where the industry stands and communicates those findings to the public via articles, press releases and teleconferences.

First, let’s look at how the industry fared during the first nine months of 2008 as reported by the Insurance Services Office (ISO) and the Property Casualty Insurers Association of America (PCI).

The U.S. property and casualty insurance industry’s net income after taxes through nine-months 2008 amounted to $4.1 billion, down 91.8% from $50 billion through nine-months 2007. The insurance industry’s overall profitability as measured by its annualized rate of return on average policyholders’ surplus dropped to 1.1% for nine-months 2008 from 13.1% for the same period a year earlier.

Both underwriting results and investment results also deteriorated, according to ISO and PCI.

Insurers suffered $19.9 billion in net losses on underwriting through the first nine months of last year, a $38.3 billion adverse swing from insurers’ $18.4 billion in net gains on underwriting through nine months 2007. The combined ratio worsened to 105.6 in the first nine months of 2008 from 93.8 in the first nine months of 2007.

Insurers’ net investment gains declined 40.7% to $28.3 billion for the first nine months of 2008 from $47.8 billion for the same period a year earlier.

“Insurers’ results through the first nine months of 2008 fell victim to a ‘perfect storm,’ as the downturn in the economy, the crisis roiling the financial system, softening in insurance markets and weather-related catastrophe losses combined to take a toll on underwriting and investment results,” said Michael R. Murray, ISO’s assistant vice president for financial analysis. “Insurers’ 1.1% annualized rate of return for the first nine months of 2008 was the second-lowest nine-month annualized rate return since the start of ISO’s quarterly data in 1986,” he said.

Standard & Poor’s has taken a strong look at the current property and casualty insurance industry situation. In an article published by S&P late last year and in a subsequent teleconference, S&P executives said it had revised its ratings outlook on the U.S. personal lines insurance sector from stable to negative. The article said that the negative outlook is based on “the likelihood of sector-wide weaker operating performance” stemming from: the significant catastrophe losses of 2008; lower investment income; sizeable asset and investment losses triggered by general credit and equity market deterioration; reduced financial flexibility resulting from limited access to the capital markets.

Said the authors of the S&P article: “The revised outlook reflects our belief that, in the next 12 to 18 months, the number of personal lines companies with negative outlooks should increase, and downgrades should exceed upgrades in 2009.”

In a second article also published by S&P at the end of 2008, the authors remarked: “The U.S. commercial lines property/casualty insurance sector might be glad to see 2008 wind down—if only the prospects for 2009 were any better.”

S&P didn’t announce that the commercial lines industry was moving from stable to negative, as it did with the personal lines industry. However, that was because S&P has had the commercial lines arena in its “negative” outlook since August 2008. In this article, S&P simply repeated its former arguments. “Ongoing price declines for commercial lines, substantial second-half catastrophe losses incurred as a result of such events as Hurricanes Gustav and Ike and the wildfires in California, decreased investment income, and very substantial increases in unrealized capital losses added to make up for tough going in 2008. Unfortunately, it doesn’t look like things are going to get much better anytime soon.”

Continued the S&P article: “Our primary concern is the rapid deterioration in underwriting profitability that we have seen in 2008. The pricing cycle for commercial P-C insurance has been unfavorable to insurers for the past three years, especially in casualty lines. By August, prices had fallen to the point at which we believed that the sector’s favorable underwriting results of the past three years would turn into underwriting losses by 2009. The substantial hurricane-related catastrophe losses experienced in the third quarter have accelerated this timetable, and it now appears likely that the industry will record an underwriting loss for 2008.”

Finally, S&P offered its own advice to the insurance industry. “The deteriorating U.S. economy—with its waves of layoffs, dislocations in the credit and equity markets, and falling home prices—will present a challenge in 2009 for almost every domestic business sector, and insurance is no exception. Insurers have always needed to be mindful of their capital management strategies, the pricing of their products and risks in the credit and equity markets that can affect their business profiles, portfolios, profits and, ultimately, ratings. But this is even truer in a recession, when missteps that might have only minor repercussions in sunnier times could now have harsher consequences.

“The recession has clearly taken its toll on North American insurers,” S&P continued.

S&P said its analysts firmly believe that strong enterprise risk management (ERM) is increasingly critical to assessing the credit quality of North American insurance companies. “The insurers that can best identify, aggregate and control their liquidity, credit and market risks during this economic downturn will be most able to manage their capital needs efficiently and incur the least erosion to their creditworthiness, S&P reported.

“We will also buttress our analysis of risk management by assessing an insurer’s economic capital model (ECM) beginning in 2009. These models constitute a further refinement by each insurer to assess risk and help determine its capital needs. As such, the insurer’s ECM and its risk management policies are closely related, both to each other and to the rating process.”