Capital Punishment: Why Earning a Fair Rate of Return is Tougher than Ever in the P/C Insurance Business International Union of Marine Insurers New York, NY September 16, 2002 Robert P. Hartwig, Ph.D., CPCU, Senior Vice President & Chief Economist Insurance Information Institute 110 William Street New York, NY 10038 Tel: (212) 346-5520 Fax: (212) 732-1916 bobh@iii.org www.iii.org
Presentation Outline Profitability in the P/C insurance industry Insurer Cost of Capital: A Global Perspective Supply of Capital in P/C Insurance Industry Cost of Capital: How is it Computed? Factors Influencing Cost of Capital Special factors affecting p/c insurance Summary
Profitability in the P/C Insurance Industry
P/C Net Income After Taxes 1991-2002 ($ Millions) $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 -$5,000 -$10,000 $14,178 2001 was the first year ever with a full year net loss 2002 Q1 ROE = 1.7% $5,840 $19,316 $10,870 $20,598 $24,404 $36,819 $30,773 $21,865 $20,223 $20,420 -$7,921 91 92 93 94 95 96 97 98 99 00 01 02* *I.I.I. estimate based on first quarter 2002 data. Sources: A.M. Best, ISO, Insurance Information Institute.
P/C Industry Combined Ratio 120 115 110 2001 = 115.7 2002 Forecast* = 108.0 2002 Q1: 102.3 Combined Ratios 1970s: 100.3 1980s: 109.2 1990s: 107.7 2000s: 112.9 105 100 95 70 72 74 76 Sources: A.M. Best; III 78 80 82 84 86 88 90 92 94 96 98 00 02** * Based on III 2002 Groundhog Forecast
Combined Ratio: Reinsurance vs. P/C Industry Reinsurance All Lines Combined Ratio 110.5 108.8 126.5 115.8 105.0 106.9 113.6 108.5 119.2 106.5 104.8 105.8 100.8 101.6 100.5 105.6 114.3 107.7 107.2 110.1 116.0 117.4 101.6 142.9 150 140 2001 s combined ratio was the worst-ever for reinsurers 130 120 110 100 90 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002* *First Quarter 2002 for all p/c; first half for reinsurance. Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute
Underwriting Gain (Loss) 1975-2002* $10 $0 ($10) $ Billions ($20) ($30) ($40) ($50) ($60) P-C insurers paid $53 billion more in claims & expenses than they collected in premiums in 2001 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 *Annualized estimate based on first quarter 2002 data. Source: A.M. Best, Insurance Information Institute
*First Quarter Source: Insurance Information Institute; Fortune ROE: P/C vs. All Industries 1987 2002* 20% 15% 10% 5% 0% -5% 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002* US P/C Insurers All US Industries
ROE: Financial Services Industry Segments, 1987 2001 25% 20% 15% 10% 5% 0% -5% 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 US P/C Insurers All US Industries Life Diversified Finl. Comm. Banks Source: Insurance Information Institute; Fortune
ROE: Inland Marine vs. Overall P/C & Fortune 500, 1991 2000 30% 25% Inland marine profitability consistently above P/C & Fortune 500 25.9% 25.1% 23.5% 20% 15% 10% 20.5% 13.2% 12.8% 10.5% 17.5% 11.8% 22.0% 5% 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 US P/C Insurers All US Industries Inland Marine Source: NAIC, Insurance Information Institute; Fortune
12% After Tax ROE Requires Underwriting Profit Accident Year Combined Ratio P : S 90.0% 92.5 % 95.0 % 97.5 % 100.0 % 102.5 % 105.0 % 107.5 % 110.0 % 112.5 % 100 % 13.0 % 11.5 % 10.1 % 8.6 % 7.1 % 5.6 % 4.1 % 2.6 % 1.1 % -0.4 % 110 % 14.0 % 12.4 % 10.7 % 9.1 % 7.5 % 5.8 % 4.2 % 2..5 % 0.9 % -0.7 % 120 % 15.0 % 13.2 % 11.4 % 9.6 % 7.8 % 6.1 % 4.3 % 2.5 % 0.7 % -1.1 % 130 % 16.0% 14.0 % 12.1 % 10.2 % 8.2 % 6.3 % 4.4 % 2..4 % 0.5 % -1.5 % 140 % 16.9 % 14.9 % 12.8 % 10.7 % 8.6 % 6.5 % 4.4 % 2.4 % 0.3 % -1.8 % 150 % 17.9 % 15.7 % 13.5 % 11.2 % 9.0 % 6.8 % 4.5 % 2.3 % 0.1 % -2.2 % 160 % 18.9 % 16.5 % 14.1 % 11.8 % 9.4 % 7.0 % 4.6 % 2.2 % -0.2 % -2.5 % 170 % 19.9 % 17.3 % 14.8 % 12.3 % 9.8 % 7.2 % 4.7 % 2.2 % -0.4 % -2.9 % 180 % 20.9 % 18.2 % 15.5 % 12.8 % 10.1 % 7.5 % 4.8 % 2.1 % -0.6 % -3.3 % 190 % 21.8 % 19.0 % 16.2 % 13.3 % 10.5 % 7.7 % 4.9 % 2.0 % -0.8 % -3.6 % 200 % 22.8 % 19.8 % 16.9 % 13.9 % 10.9 % 7.9 % 4.9 % 2.0 % -1.0 % -4.0 % 225 % 25.3 % 21.9 % 18.6 % 15.2 % 11.9 % 8.5 % 5.2 % 1.8 % -1.5 % -4.9 % 250 % 27.7 % 24.0 % 20.3 % 16.5 % 12.8 % 9.1 % 5.4 % 1.7 % -2.1 % -5.8 % Source: Dowling & Partners
Insurer Cost of Capital A Global Perspective
Cost of Capital: A Definition Cost of Capital: Rate of return that can be earned by investors in industries offering comparable degree of risk Must be sufficient to maintain & attract capital Insurance Cost of Capital: Will vary substantially by line
ROE vs. Cost of Capital: US Non-Life 1991 2002* 20% 15% There is an enormous gap between the industry s cost of capital and its rate of return 10% 5% 0% US P/C insurers have missed their cost of capital by an average 6.7 points since 1991 14.6 pts 9.5. pts -5% 1991 1992 1993 1994 Source: The Geneva Association, Insurance Information Institute. 1995 1996 1997 1998 1999 2000 2001 2002
Cost of Capital: Non-Life Insurers:1978 1998 30% 25% 20% 15% 10% 5% 0% 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 * 1998 UK Switzerland France Germany Source: Kielholz, Walter, The Cost of Capital for Insurance Companies, The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.
Supply of Capital in the P/C Insurance Industry How Much is There?
Policyholder Surplus: 1975-2002* Billions (US$) $350 $300 $250 $200 $150 Surplus Peaked at $336.3 Billion in 1999 Surplus decreased 8.7% in 2001 to $289.6 Billion. Surplus rose 1.9% in the 1 st quarter of 2002 Surplus is now lower than at year-end 1997. $100 $50 $0 Surplus is a measure of underwriting capacity. It is analogous to Owners Equity or Net Worth in non-insurance organizations 75 77 79 81 83 85 87 89 91 93 95 97 99 01 *As of 1 st quarter 2002 Source: A.M. Best, Insurance Information Institute
Net Premiums Written to Policyholder Surplus Ratio 2.8 2.0 2000: 0.95 2001: 1.16 2002 (Forecast): 1.33 1.3 0.5 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Source: A.M. Best, Insurance Information Institute
Capital Raising by P/C Insurers Since September 11, 2001* ($ Millions) $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 Capital Raising by P/C Insurers Since 9/11 Totals $44.5B $27.9 Billion $25.4 Billion $4,872 14 Pending 38 Pending $16,437 $20,492 40 Completed 33 Completed $11,442 $0 2001 2002* Completed Pending *As of September 13, 2002. Source: Morgan Stanley, Insurance Information Institute.
* Target Commercial includes: Comm property, liability and workers comp; Surplus must also back-up on non-terrorist related property/liability and WC claims Source: Insurance Information Institute Capital Myth 3: P/C Insurers Have $300 Billion to Pay Terrorism Claims Total PHS = $298.2 B as of 6/30/01 "Target" Commercial* $100 billion 33% Only 33% of industry surplus backs up target lines Personal $150 billion 50% Other Commercial $50 billion 17%
Price Increases Needed to Second Quarter 2002 Achieve Cost of Capital Rate Increases By Line of Business No Change Up 1-10% 1 10% 10-20% 20-30% 30-50% 50%-100% >100% Comm. Auto 2% 6% 28% 39% 21% 1% 1% Workers Comp 5% 13% 19% 32% 15% 5% 2% General Liability 2% 9% 24% 45% 15% 2% 1% Comm. Umbrella 2% 4% 10% 20% 27% 17% 16% Comm. Property 3% 4% 16% 30% 31% 13% 1% Business Interr. 3% 8% 32% 33% 10% 1% 0% Surety Bonds 10% 13% 16% 14% 6% 0% 1% Source: Council of Insurance Agents and Brokers
Rate On Line Index (1989=100) 260 250 240 230 220 210 200 190 180 170 160 150 140 130 120 110 100 Prices rising, limits falling: ROL up significantly 89 90 91 92 93 94 95 96 97 98 99 00 01 02* Source: Guy Carpenter * III Estimate
Cost of Risk per $1,000 of Revenues: 1990-2002E $10 Cost of risk to corporations could rise sharply in 2002; About half of increase due to 9/11 $9 $8 $7 $6 $5 $6.40 $6.10 $8.30 $7.70 $7.30 $6.49 $5.70 $5.25 $5.71 $5.20 $4.83 $5.55 $7.22 $4 90 91 92 93 94 95 96 97 98 99 00 01E 02E Source: 2001 RIMS Benchmark Survey; Insurance Information Institute estimates.
Growth in Net Premiums Written (All P/C Lines) 25% 20% 15% 10% 2000: 5.1% 2001: 8.1% 2002: 10.3%* The underwriting cycle went AWOL in the 1990s. It s Back! 5% 0% 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 *Estimate based on first quarter 2002 Source: A.M. Best, Insurance Information Institute
Cost of Capital: How is it Computed?
Cost of Capital: Methods 2 Commonly Used Methods Discounted Cash Flow (DCF) Uses current dividend yield & dividend (or earnings) growth rate Capital Asset Pricing Model (CAPM) Uses risk-free interest rate, risk premium & measure of relative risk, Beta (β) Factors currently affecting costs of capital Dividend yields very low (1.39% mid-2002), little growth expected; Recent earnings performance poor Interest rates very low (short-term rates < 1.8% mid-2002) Risk premium shrinking (return on alternatives to risk-free return are shrinking) Beta (β) low relative to overall stock market (stock price volatility slightly less than overall market: β = 0.96) CURRENT P/C COST OF CAPITAL IS: 11% - 12%
Factors Influencing the Cost of Capital
Real GDP Growth 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% 4.4% 3.5% 2.5% 5.7% 8.3% 5.6% 4.8% 2.2% 1.0% Economy is experiencing sluggish growth following the recession of 2001 (first recession since 1990/91) -0.6% -0.3% -1.6% 2.7% 5.0% 1.1% 3.2% 2.3% 1998 1999:I 1999:II 1999:III 1999:IV 2000:I 2000:II 2000:III 2000:IV 2001:I 2001:II 2001:III 2001:IV 2002:I 2002:II 2002E 2003F Source: US Department of Commerce, Blue Economic Indicators 9/02, Insurance Information Institute.
Economic Outlook for Major US Trading Partners (Real GDP Growth, %) 1.5 3.0 3.5-0.3 1.9 3.9-0.2-0.5 0.9 2.2 1.8 2.9 3.0 1.5 1.2 2.7-1.9 3.0 3.9 1.5 1.5 3.1 5.6 5.4 7.3 7.2 7.3 Real G DP Growth ( %) 2001 2002E 2003F 8 6 Economies of most major trading partners expected to improve in 2002/2003 Does US have a trade policy? 4 2 0-2 Canada Mexico Japan U.K. S. Korea Euroland Taiwan China Brazil Source: Blue Chip Economic Indicators, September 2002.
Interest Rates: Lower Than They ve Been in Decades 16% 14% 12% 10% Interest Rates Low for 2 Reasons 1. Weak Economy (= low inflation, less demand for cap) 2. Perception that federal budget will return to surplus If either of these changes, interest rates and CoC up 8% 6% 4% 2% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002* 3-Month T-Bill 1-Yr. T-Bill 10-Year T-Note *Average for week ending September 6, 2002. Source: Board of Governors, Federal Reserve System; Insurance Information Institute
Risky Business: Yield Spread Rising with Corporate Scandals* 3.00 Yield Spread Between Long-Term aaa Corporates and 10-Year US Treasury Securities Yield Spread (points) 2.50 2.00 1.50 1.00 Risk premium (2.46 points) reached all time high in Oct. 2001 (Enron problem surfaced) 0.50 0.00 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 *January 1990 through August 2002 Source: Board of Governors, Federal Reserve System; Insurance Information Institute
Treasury Yield Curve: Rates Down Across Every Maturity, esp. Short-Term 7% 6% Yield Curve 2 years before attack 5% 4% 3% 2% 1% 0% Yield Curve for the week before September 11 terrorist attack Yield Curve: Most Recent (1 st anniversary of 9/11 attack) 1-mo 3-mo 6-mo 1-yr 2-yr 3-yr 5-yr 7-yr 10-yr 20-yr 6-Sep-02 7-Sep-01 10-Sep-99 *Data are averages for all trading days for the week on the indicated date. Source: Board of Governors, Federal Reserve System; Insurance Information Institute
Net Investment Income $45 Investment income in 2002 could fall 5% to 6% Billions (US$) $36 $27 $18 Realized capital gains in the 1 st quarter of 2002 were down 89% Facts 1997 Peak = $41.5B 2000= $40.7B $9 2001 = $37.1B 2002E = $35.8B $0 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 Source: A.M. Best, Insurance Information Institute
Total Returns for Large Company Stocks: 1970-2002* 40% 30% 20% 10% 0% -10% -20% Headed for 3 rd consecutive year of decline for stocks Last happened 1939-1941 -30% 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002* Large Company Stocks *As of September 13, 2002. Source: Ibbotson Associates, Insurance Information Institute
Average Betas: Non-Life Insurers:1978 1998 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 UK Switzerland Source: Kielholz, Walter, The Cost of Capital for Insurance Companies, The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.
Average Betas: Non-Life Insurers:1978 1998 1.45 1.35 1.25 1.15 1.05 0.95 0.85 0.75 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 UK France Source: Kielholz, Walter, The Cost of Capital for Insurance Companies, The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.
Average Betas: Non-Life Insurers:1978 1998 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 UK Germany Source: Kielholz, Walter, The Cost of Capital for Insurance Companies, The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.
Average Betas: Non-Life Insurers:1978 1998 1.45 1.35 1.25 1.15 1.05 0.95 0.85 0.75 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 US UK Switzerland France Germany Source: Kielholz, Walter, The Cost of Capital for Insurance Companies, The Geneva Papers on Economic Activity, v 25, no. 1, January 2000.
World s Most Dangerous Lines of Insurance (Combined Ratio + 1 Std. Deviation) Earthquake Med Mal Other Liability Reinsurance Homeowners Allied Lines Aircraft Comm. Multi Peril Comm. Auto Liab. Workers Comp Farm Multi Peril Commercial--All Ocean Marine Fire All Lines PP Auto Liab Personal--All Lines Comm Auto PD Boiler & Machine Group A&H Other A&H Priv Pass PD Inland Marine Fidelity Other Surety Burglary & Theft 84.1 112.9 111 109.7 109.1 107 106.6 103.4 102.9 101.7 101.3 100 121.8 119.3 118.7 117.1 116.3 115.1 114.6 135.6 135.1 133.9 133.3 131.6 129.3 Cost of capital will vary significantly by line and mix of business, according to risk assumed 80 90 100 110 120 130 140 150 Source: Insurance Information Institute, calculated from A.M. Best combined ratio data. 407.3
P/C Performance Volatile, but Better than S&P 500 Lately P/C S&P 500 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% 43.4% 21.0% -1.2% -3.7% -9.1% -10.9% -21.7% -25.7% 1999 2000 2001 2002* *Through September 13, 2002. Source: SNL Securities, Insurance Information Institute
Insurer Stock Price Performance: Before & After 9/11 5.0 Total Return All Multi L/H P/C Broker S&P500-29.5-23.0-25.5-26.2-21.6-21.7-18.3-20.0-21.1-21.7-16.5-13.2-15.9-7.6-10.2-9.7-11.2-10.9-7.0-8.2-1.2-3.7-2.6 1.2 0.0-5.0-10.0-15.0 Percent -20.0-25.0-30.0-35.0 Source: SNL Securities, Insurance Information Institute 10-Sep-01 21-Sep-01 28-Dec-02 1 Jan - 13 Sep '02
Special Factors Influencing Insurers Cost of Capital Terrorists Trial Lawyers Tycoons Tempests
Sept. 11 Industry Loss Estimates ($ Billions) Other Liability $10.0 (25%) Life $2.7 (7%) Property - WTC 1 & 2 $3.5 (9%) Property - Other $6.0 (15%) Aviation Liability $3.5 (9%) Event Cancellation $1.0 (2%) Aviation Hull $0.5 (1%) Workers Comp $2.0 (5%) Biz Interruption $11.0 (27%) Insured Losses Estimate: $40.2B Source: Insurance Information Institute, July 2002
Accounting Problems are Getting Many Companies into Trouble Enron fallout much worse than anticipated Many companies restating earnings
Average Jury Awards 1994 vs. 2000 $7,000 $6,000 $5,000 1994 2000 6,817 ($000) $4,000 $3,000 3,482 3,566 $2,000 $1,000 $0 419 1,168 Overall 759 1,727 Business Negligence 698 187 269 333 Vehicular Liability* Premises Liability 1,140 1,185 Medical Malpractice Wrongful Death 1,744 Products Liability Source: Jury Verdict Research; Insurance Information Institute.
Who Will Pay for the US Asbestos Mess? Estimated Total US Settlements & Expenses = $200 billion Asbestos Defendants 39% $78 billion $60 billion US Insurers 30% $62 billion Source: Tillinghast-Towers Perrin; Insurance Information Institute Foreign Insurers 31%
U.S. Insured 30 25 20 15 10 5 0 $ Billions $22.9 $7.5 $2.7 $4.7 $5.5 Catastrophe Losses CAT Losses for 2001 Set a Record 20 events (lowest since 1969) 1.5 million claims 9/11: $20.3B = 51,000 claims $16.9 $10.1 $8.3 $7.3 $8.3 $4.3 $2.6 $28.1 89 90 91 92 93 94 95 96 97 98 99 00 01 * Includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims. Source: Property Claims Service, Insurance Information Institute
Insurance Mergers and Acquisitions Value of M & As ($Billions) $180 $160 $140 $120 $100 $80 $60 $40 $20 Number of M&As was down 39.4% during the first half of 2002 vs. first half 2001. Value of deals was down 80.8%. None of the top deals were in the P/C sector 243 246 171 188 149 221 7.1 6.9 8.6 5.0 8.5 12.5 27.0 349 382 433 468 56.2 40.8 1998: 565 deals valued at $165.4 B 295 300 55.7 41.7 41.5 109 6.6 600 500 400 300 200 100 Number of M & As $0 89 90 91 92 93 94 95 96 97 98 99 00 01 02* 0 Value of Deals Number of Deals Source: Compiled from Conning & Company reports.
Summary Industry not even close to earnings its cost of capital Hard market must continue for it to be earned Lots of new capital seeking high rate of return Not all companies will be able to meet investor expectations Shareholders like to be more impatient (have give p/c stocks benefit of the doubt) Increase in M&A activity possible to squeeze excess capacity from industry, but not anytime soon.
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