FINC weekly write up
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TheInsuranceIndustry1.pptx
Insurance Companies
Part I
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Insurance Companies (ICs)
The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid
Insurance underwriters assesses and prices risks
Insurance brokers sells insurance contracts
Insurance is broadly classified into two groups
Life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement
Property-casualty insurance protects against property damage, personal injury and liability associated with specific events
Insurance companies also sell a variety of investment products, similar to other FIs
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Property and casualty insurers are risk intermediaries; life insurers are both risk and time intermediaries. Both allow households and other entities to limit some of the risks they face. Life insurers also provide methods to transfer wealth through time and to future generations. These days some insurers provide both type services and some diversified FIs own both types of insurers.
Life Insurance Companies
872 life insurance companies existed in the U.S. in 2015
Compares to over 2,300 in 1988
The industry has seen consolidation to take advantage of scale and scope economies
Aggregate industry assets were $6.47 trillion at the beginning of 2016
Compares to $1.12 trillion in 1988
The four largest life insurers wrote 30.5% of the industry’s over $681 billion premiums in 2015
Many of these policies are sold through commercial banks
For example, in 2015 commercial banks sold over 17% of all annuity contracts
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From the late 1980s to the late 2000s, the number of life insurers dropped from 2300 in 1988 to 872 in 2016, a decline of about 62%. Total assets over roughly the same period grew from $1.12 trillion in 1988 to $6.47 trillion at the start of 2016, a 478% increase. Economies of scale and scope and regulatory changes similar to those in the banking industry have encouraged growth and mergers of life insurers. The four largest in 2016 in terms of assets, MetLife, Prudential, New York Life, and TIAA Group wrote about 30.5% of the total premium income of $681 billion.
Life Insurance Companies Continued
Life insurers pool the risks of individuals to diversify away some of the customer-specific risk
Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own
This allows the transfer of income related uncertainties from the individual to the group
Other activities of life insurance companies:
Sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time
Manage pension plans (e.g., tax-deferred savings plans)
Provide accident and health insurance
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The core business of life insurers is to remove income uncertainty due to death or retirement from individuals. Insurers must decide which risks are worth accepting (or underwriting) and which should be rejected. Some insurers act as agents (or insurance sellers) while other act as underwriters and sellers. Because of cross selling allowed by regulators, many insurance products such as annuities, are sold by other types of FIs such as banks. AIG was at the heart of the financial crisis because the company sold extensive amounts of credit default swaps (CDSs). Traditionally insurers were mutually owned by policyholders. Most have now converted to stock ownership to facilitate capital raising and growth and to gain the ability to offer stock options to top employees.
Life Insurance Companies Concluded
Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums
Underwriting decisions determine which risks are accepted and which are not
Underwriting decisions determine how much to charge (in the form of premiums) for accepted risks
The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage
Actuaries reduce the risks of underwriting and selling insurance
With traditional life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance, annuities, and endowment policies
With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.
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Underwriting risks must be priced. If the insurer sets the price too high, it will not be competitive, too low and premiums will be insufficient to cover losses. Actuaries use Mortality tables and other information to price insurance contracts. Mortality tables have been developed to statistically estimate the percentage of a given population with certain demographics (age, sex, smoker/nonsmoker, health history) that will die in a given year. By offering insurance to large numbers of individuals, insurers are able to set reasonable insurance rates and make a profit commensurate with the risk the underwriter bears. Adverse selection is a problem with life insurance policies, as is moral hazard with property and casualty policies. Adverse selection arises when individuals who are more likely to need life insurance quickly (e.g., an individual with a terminal disease) seek out higher levels of coverage. Moral hazard occurs when an individual who is insured against a risk is more likely to engage in risky activities because of the insurance.
The Four Types of Life Insurance
#1 - Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage
Term life is the closest to pure life insurance; has no savings element attached
Whole life protects the individual over an entire lifetime rather than for a specified coverage period
Endowment life combines a pure (term) insurance element with a savings element
Variable life invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments
Universal life and variable universal life
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Ordinary life policies are marketed on an individual basis, typically in units of $1,000. Ordinary life policies constitute constituted 77.8% of life insurance policies in 2016. These include the following types:
Term life. Term life is pure insurance that pays a stated death benefit if the policyholder dies within the given term. Annual renewable term is common. Premiums increase as the policyholder ages. Variants include decreasing coverage amount with level premiums or fixed premiums for periods longer than one year. There is no savings feature with term life. Term policies become prohibitively expensive as the insured ages and most term life ends without the policy holder collecting anything. The remaining policies accrue a cash value over time. The insured overpays for the insurance in the early years of the policy and the excess payment is invested by the insurer. The earnings accrue tax free.
Whole life policies protect an individual for a lifetime. The insurer will pay a death benefit to the policy holder’s beneficiaries (as long as the insured pays the premiums.) Variant: Whole life paid up by a certain age.
Endowment life policies pay a death benefit if the insured dies before retirement (usually), if the insured is alive at retirement, he or she receives the face value of the policy.
Variable life policies invest fixed premiums into variable rate securities (mutual funds). The insured’s death benefit is a function of the premiums paid and the rate of return earned on the investments. The insured usually chooses the investment vehicle in which the cash value is invested.
Universal life policies allow the policy holder to change both the premium amount and the contract maturity over the life of the policy. Universal and variable universal life policies are more flexible in that they allow policy holders to change, or even skip premiums and change the maturity of the policy. If the cash value on a universal policy is invested in variable rate earning assets the policy is a variable universal life policy. These latter policies were created due to the decline of traditional whole life and endowment policies in the 1960s and 1970s as individual investors found cheaper ways to invest for retirement.
The Four Types of Life Insurance Continued
#2 - Group life insurance covers a large number of persons under a single policy
Contributory—both the employer and the employee cover a share of the premiums
Noncontributory—the costs are borne entirely by the employer
#3 - Credit life insurance protects lenders against borrower death prior to the repayment of a debt contract, such as a mortgage or car loan
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Group life insurance (21.6% of policies) is typically available through an employer. Group life is usually term insurance and will likely be the lowest cost form of insurance available to individuals as in many cases employers will contribute to some of the insurance cost (contributory plan). Cost economies and reduced adverse selection also generate lower costs in group plans.
Credit life (< 1% of policies) policies pay off an outstanding loan if a borrower dies during the term of the loan. It is typically more expensive than other plans.
The Four Types of Life Insurance Concluded
#4 – Other activities include the sale of annuities, private pension plans, and accident and health insurance
Annuities represent the reverse of life insurance principals
In 2016, life insurance companies were managing over $3.6 trillion in pension fund assets, equal to 41% of all private pension plans
More than $171 billion in premiums were written annually by life and health companies in accident-health in 2015
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Annuities
Annuities are either immediate or deferred payment contracts where life insurers make regular payments to an annuitant. The annuity’s features vary; the payments may be fixed or tied to the performance of an investment. The term may be for a set number of years, or it may continue for as long as the annuitant lives. Variants include continuing payments until the death of the longest living spouse or even continuing payments for a certain number of years to beneficiaries. Actuarial tables are used to estimate the likely number of payments in these cases, and the payments are then set accordingly. Policyholder payments into an annuity are not tax deductible, but they are allowed to accrue tax free until withdrawals begin. The amount that may be contributed to the tax deferred annuity (TDA) is not limited as to the amount per year as is the case with an IRA, and there is no income test involved for eligibility of use. Because of the favorable tax features and strong equity markets, annuity sales grew from $26.1 billion in 1996 to more than $356 billion in 2012 before dropping back to $236.7 billion in 2016. In 2012 about 44% of annuities sold were fixed annuities and 56% were variable.
Annuities Example
You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under three options.
In option 1, you will receive 10 years of monthly payments.
With option 2, you will receive a monthly payment until you die, which is expected to be in 14 years.
With option 3, you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years.
How much will you receive per month with each option (ignoring administrative costs and fees)?
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Annuities Example Continued
In option 1, you will receive 10 years of monthly payments.
With option 2, you will receive a monthly payment until you die, which is expected to be in 14 years.
With option 3, you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years.
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Balance Sheets and Recent Trends
Assets
Life insurers concentrate their asset investments at the longer end of the maturity spectrum
E.g., corporate bonds, equities, and government securities
In 2016, 10.8% of assets were invested in government securities, 67.6% in corporate bonds and stocks, and 6.8% in mortgages
Liabilities
Net policy reserves made up $2.9 trillion, or 44.1% of total liabilities and equity
To meet unexpected future losses, life insurers hold a capital and surplus reserve fund with which to meet such losses
Reserves for life insurers in 2016 totaled $280.8 billion, or 5.9% of total liabilities and capital
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Life insurers have long term claims (liabilities) so they invest in primarily long term assets.
Major assets include (2016): Change from 2013
Government securities 10.8% Down
Corporate bonds 37.5% Down
Corporate equities 30.1% Down
Mortgages 6.8% Up
Policy loans 2.5% Down
Miscellaneous 12.3% Up
Major liabilities and equity include: Change from 2013
Net policy reserves 44.1% Down
Separate account business 37.6% Up
Deposit type contracts (GICs) 4.3% Down
Equity capital 5.9% Same
Policy reserves are the estimated current worth of expected future payouts. Net policy reserves are monitored. Actuaries estimate the required level of policy reserves to meet expected payouts. Required levels are based on the present value of expected future payouts (which include death benefits, endowment policies and cash surrender value of policies).
Insurers can have unplanned liquidity needs due to unexpectedly high losses, greater than anticipated surrenders of policies, and/or lower than anticipated investment returns. Insurers pay the insured the surrender value of the policy (if any) if the policy is terminated. The surrender value may be substantially less than the cash value, particularly in the early years after contract origination.
Funds in separate account business (35.8%) are monies for which the insurer maintains separate accounting. These funds are for annuities and life insurance policies that allow policy holders to choose their own investments and earn variable rates of return.
Fairly low levels of capital (5.9%) indicate that the LI business is not overly risky. As will be shown in the next major section, P&C insurers must carry much higher capital levels to offset their risks. Investment in corporate equities peaked in the bull markets of the 1990s. Declining equity values have hurt profitability materially in the 2000s.
Most cash value policies allow the insured to borrow against the cash value.
Balance Sheets and Recent Trends Continued
Insurers earn profits by taking in more premium income than they pay out in policy payments
Firms can increase their spread between premium income and policy payouts in two ways:
#1 – Decrease future required payouts for any given level of premium payments
Accomplished by reducing the risk of the insured pool
#2 – Increase the profitability of interest income on net policy reserves
Treasury Department extended bailout funds to a number of struggling life insurers in late 2008/early 2009
E.g., AIG, Hartford Financial Services Group, Prudential Financial, Lincoln Financial, and Allstate
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The life insurance industry performed well while the stock markets and the economy performed well during the mid 2000s. As the crisis began insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds. With dropping equity markets, insurers also collected lower fees on their variable annuity products which are largely equity based. This means that insurers with large amounts of separate account activity had more extensive losses than other insurers. The very low interest rate environment meant that insurers could not lower crediting rates on new policies. This encouraged existing policyholders to surrender their policies if they were already at the minimum crediting rate. There were also large losses on common and preferred stock holdings in their own investments. The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments. AIG received government assistance worth $127 billion. The breakdown consisted of $45 billion from TARP, $77 billion to buy collateralized debt and mortgage backed securities and a $44 billion bridge loan. Hartford Financial Services Group, Prudential Financial, Lincoln National and Allstate all received TARP funds.
Industry conditions improved in 2010 through 2012. In 2012 premium income stopped falling, net income reaching $40.9 billion, up from $28 billion in 2010. Low interest rates have compressed spreads and hurt sales of interest bearing products such as annuities however. In 2013, the Financial Stability Oversight Council (FSOC) designated AIG, Metlife and Prudential as systemically important non-banks. This is likely to lead to higher capital requirements and lower profitability rates as well as additional regulations on some of their non-traditional business lines such as credit default swaps.
According to KPMG’s Life Insurance Risk Profitability Update December 2016 insurance profits declined in the fourth quarter of 2016 as retail disability reported its fourth quarter of losses in a row and group life profits were down. On into 2017 low interest rates continued to contribute to profit pressures as life insurance investments continued to earn low returns.
Regulation
McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs
State insurance commissions charter and examine ICs
The National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system
States promote insurance guarantee funds
Funds are run by the insurance companies themselves
Contributions are paid only when an IC fails (except in NY)
The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC)
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The McCarran-Ferguson Act of 1945 left regulation of life insurers up to individual states. Chartering is entirely at the state level and different states may allow different activities. The National Association of Insurance Companies (NAIC) has created a national examination system used by state regulators to examine insurers. There was a bill before Congress as early as 2004 to introduce federal oversight of both life and P&C insurers. During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states. However the Dodd-Frank bill did create the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry. Regulators are supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage offering insurance to underserved segments.
The industry wants to allow markets to set insurance prices. Currently, states regulate the premiums and probably do not update rates as frequently as changing conditions warrant. The industry also wants a dual regulatory system at the state and federal level so that they can choose their regulator.
In 2004 Conseco was accused of providing special investment privileges to large investors that were denied to small investors. Conseco allegedly allowed certain important clients to shift funds between variable annuities while limiting similar attempts to move funds by smaller investors.
State guaranty funds may exist to prevent policyholder losses in the event that an insurer fails. They do not have federal backing, and virtually all states do not maintain a fund reserve. The amounts surviving insurers may be required to pay in a given year to cover policyholders of a defunct insurer vary from state to state. In some cases the guaranty funds will not receive enough money to immediately cover the loss, and long delays in payments are common. It is thus important that investors consider the creditworthiness of an insurer before placing funds with that company. A.M. Best is the leading source of insurance ratings and is an excellent resource for information about the insurance industry.
Insurance Companies
Part II
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Property-Casualty (P&C) Insurance Companies
Currently, 2,544 companies sell property-casualty (P&C) insurance, and approximately half of those firms write P&C business in all or more of the U.S.
Top 10 firms have a 50% market share
Top 200 firms have more than a 95% market share
In 2016, State Farm was the top firm, writing 11.3% of all P&C insurance premiums
Property insurance involves coverage related to the loss of real and personal property
Casualty insurance offers protection against legal liability exposure
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There are about 2,544 P&C insurers. The top10 firms write about 50% of the premiums, and the top 200 firms write 95% of all premiums. State Farm is the largest, followed by Berkshire Hathaway. Total assets in 2013 were about $1,863.6 billion, roughly 29% of the total assets of the life insurance industry.
P&C Lines
Fire insurance and allied lines
Protects against the perils of fire, lightning, and removal of property damaged in a fire
Homeowners multiple peril (MP) insurance
Protects against multiple perils of damage to a personal dwelling and personal property, as well as liability coverage against the financial consequences of legal liability resulting from the injury to others
Commercial multiple peril (MP) insurance
Protects commercial firms against perils similar to homeowners
Automobile liability and physical damage (PD) insurance
Provides protection against losses resulting from legal liability due to the ownership/use of the vehicle and theft or damage to vehicles
Liability insurance (other than auto)
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Property insurance covers the loss of real and personal property, whereas casualty insurance provides protection from legal liability exposures.
2016 data on major lines. Major lines are those lines that generate approximately 8% or more of total premiums.
Homeowners multiple peril (personal property and liability coverage) (15.1% of all premiums); the loss to premiums ratio was 50.1%. A lower loss ratio is better.
Private passenger auto liability (20.2% of all premiums); the loss to premiums ratio was 71.1%.
Private passenger auto physical damage (13.6% of all premiums); the loss to premiums ratio was 64.9%.
Other liability insurance (non-automobile) (9.7% of all premiums); the loss to premiums ratio was 58.7%.
Worker’s compensation (9.7% of all premiums) the loss to premiums ratio was 58.7%.
With the latest data, the losses to premium ratios were highest for ‘individual accident and health’ at 120.3%, ‘multiple peril crop’ at 72.4% and ‘private passenger auto liability at 71.1%. Of the major lines offered the ratio was highest for the ‘private passenger auto liability’ and ‘private passenger physical damage’ lines.
Balance Sheets of P&C Companies
Assets
P&C companies invest the majority of their assets in long-term securities, but hold a lower proportion in common stock than do life insurance companies
Bonds, preferred stock, and common stock made up 71.7% of total assets in 2016
Liabilities
Loss reserves and loss adjustment expenses are a major component (34.4% of total liabilities and capital)
Loss reserves are funds set aside to meet expected losses from underwriting the P&C lines
Loss adjustment expenses are the expected administrative and related costs of settling claims
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Unearned premiums, reserves set aside that contain the portion of a premium that has been paid before insurance coverage has been provided, are also a major liability and make up 13.2% of total liabilities and capital.
P&C insurers typically place the majority of their investments in long term assets, but they have more liquid asset holdings (%) than life insurers. This is because P&Cs have much less predictable claims than life insurers; thus, the P&C’s investment portfolio reflects their greater need for liquidity.
Major liabilities and equity include (beginning of 2016) Change from 2013
Loss reserves and loss adjustment expenses (LAE) 34.4% Down
Unearned premiums 13.2% Up
Other liabilities 13.5% Up
Policyholders’ surplus 37.9% Up
Loss reserves are funds held to offset expected payouts on insurance policies. Loss adjustment expenses are expenses related to administering and settling (adjusting) claims. Unearned premiums are premiums received before the coverage period so that they have not yet been earned. Net premiums written are the total amount of premiums received on all lines.
Underwriting Risk
Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income
Underwriting risk may result from:
Unexpected increases in loss rates
Unexpected increases in expenses
Unexpected decreases in investment yields
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The profitability of an insurance line can be calculated as follows:
Premiums received + income earned on premiums invested – cost of claims incurred – loss adjustment expenses – other expenses such as brokerage commissions.
If this amount is negative the line is generating losses. This usually happens if unexpectedly high or costly claims occur, or if adjustment expenses are higher than anticipated (perhaps due to additional lawsuits than anticipated) or if the rates of return on investments are lower than anticipated.
The expected loss rate on an insurance line is the expected frequency of loss times the severity (cost) of the loss. In general, property losses are more predictable than liability losses. Loss rates for high frequency, low severity events such as a fender bender are also more predictable than losses on low frequency, high severity events such as a flood, an earthquake or a terrorist attack.
Liability lines may suffer what are termed long tail losses, meaning that a claim is filed long after the occurrence of the insured event. Examples include asbestos claims, claims for toxic shock syndrome, tobacco use, breast implants, etc. These losses can be particularly hard to forecast, and these possibilities make it difficult to properly price the product line exante.
Price inflation is the major factor that increases costs on property lines and it is fairly predictable. Social inflation (increases in required insurance payouts associated with societal attitudes) may result in large cost changes on liability lines however if judges and juries award larger penalties for medical malpractice or other product liability cases. The tobacco lawsuits provide a recent example. As the text indicates the number of claims and jury awards for medical malpractice suits have increased dramatically in recent years. To offset this trend, a growing number of states are placing caps on malpractice awards beyond actual damages (the so called ‘pain and suffering’ awards). Certain areas such as Wyoming have had difficulty attracting sufficient numbers of medical personnel because of the high costs of malpractice insurance.
Loss Risk and Expense Risk
Loss risk is a function of actuarial predictability
Property vs. liability
Severity vs. frequency
Long tail vs. short tail
Product inflation vs. social inflation
Loss risk is a measure of pure losses incurred to premiums earned
Premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed
Expense risk occurs from two major sources:
Loss adjustment expenses (LAE)
Commissions and other expenses
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The loss ratio measures the actual losses on a specific policy (this ratio may include actual claim payouts and loss adjustment expenses) relative to earned premiums. A loss ratio over 100% implies the line is unprofitable on its own. Loss ratios have risen from the 60% range in the 1960s to over 70% or even 80% today on many lines. Expense ratios include items such as general expenses and broker commissions measured relative to premiums earned. Expense ratios are quite high. In 2016 expense ratios averaged about 27.6% of premiums written. The gross premium charged on a line is the sum of the ‘pure premium’ (found as frequency of loss times average loss) plus a load fee that represents the firm’s profit margin.
The advent of the Internet and computer technology should reduce expenses considerably. At first, many industry observers believed that the Internet would make insurance agents and brick and mortar offices obsolete. This is unlikely in the near future. Technology should allow insurers to offer better service to their customers in managing their accounts and reduce back office processing costs, which in turn may allow the customer to receive better deals. The insurance industry has never been known for its innovation and it is likely that technology will help insurance firms cut costs to a greater degree than we have seen in the past. Indeed, this will likely have to happen given the poor profit record of many insurers in recent years.
Property-Casualty (P&C) Key Ratios
The combined ratio is a measure of overall profitability
Equals the loss ratio plus the ratios of loss-adjusted expenses to premium earned as well as commission and other acquisition costs to premiums written plus any dividends paid to policyholders as a proportion of premiums earned
Investment yield is measured as net interest income divided by premiums earned
The operating ratio is also a measure of overall profitability
Equals the combined ratio minus the investment yield
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The combined ratio is the sum of the loss and expense ratios. The combined ratio also may include dividends paid out to policyholders. If the combined ratio after dividends is less than 100%, insurance underwriting was profitable that year. Underwriting insurance was unprofitable every year during the 1990s and the early 2000s. For instance, the combined ratio after dividends was 105.6% in 1998, 115.7 in 2001 (the worst ever), 107.2% in 2002, and 100.1% in 2003 and the lines finally became profitable in 2004 with a combined ratio of 98.7. If the combined ratio is greater than 100%, the insurer can maintain profitability only by generating a high enough rate of return on invested premiums (see the example below).
Hurricanes Charley, Frances, and Ivan all occurred in 2004 generating estimated losses of over $25 billion. In 2005 Hurricanes Katrina, Wilma and Rita added to the industry’s losses with estimated costs of $57.7 billion. The 2005 P&C industry combined ratio was 100.9. Without these catastrophic losses the 2004 and 2005 combined ratios would have been 94.5 and 92.9 respectively. 2006 and 2007 had much smaller catastrophic losses and most lines did very well yielding combined ratios of 92.4 and 93.5 respectively. The industry is again profitable overall, but it has become dependent on sufficiently high rates of return on invested premiums to maintain profitability in the face of very volatile loss experiences. Underwriting profits appear to cycle through time as high loss experiences occur periodically and reduce profits. These events eventually get priced into insurance contracts and then they stop occurring for a while and industry profits are quite good for a time.
P&C Industry Underwriting Ratios
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Notice the increases in loss and expense ratios beginning in 2007 and rising until 2011. The dividend ratio fell as profitability decreased. The industry lines as a whole were unprofitable from 2008 through 2012 (before net interest income on investments). Standard and Poor’s (S&P) issued a statement in June 2011 indicating concern about profitability of commercial lines due to price declines and competition coupled with poor investment income. Premiums written increased in 2010 after a 3 year drop and have continued to improve. Nevertheless 2011 was a bad year with large catastrophe losses ($33.6 billion, the fifth worst year ever). Net income fell from $35.2 billion in 2010 to $19.2 billion, a 46% drop. Even with Hurricane Sandy, profits improved in 2012 as the combined ratio fell from 108.2 in 2011 to 103.2 in 2012. Net income surged to $33.5 billion for the year. The year 2013 was better still with a much lower combined ratio, even though the investment yield also fell. The loss ratio again grew in 2016 and industry net income fell from $56.8 billion in 2015 to $42.6 billion in 2016 as the industry had underwriting losses of $4.7 billion for the year. See Property/Casualty Insurance Results: 2016, Beth Fitzgerald and Robert Gordon, ISO Verisk Insurance Solutions, PCI, http://www.verisk.com/downloads/InsuranceResultsReport2016Q4.pdf.
P&C Recent Trends
Many catastrophes of historically high severity have occurred recently
U.S. catastrophes between 1949 and 2016
An underwriting cycle is a pattern that the profits in the P&C industry tend to follow
The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters
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Uncertain loss ratios, high expense ratios, the need to pay dividends, a lack of flexibility to adjust premiums and uncertain investment yields all indicate the need for large policy surpluses, which the industry currently has (equal to 37.9% of assets).
Many low frequency, high severity losses occurred in the 1990s and 2000s including many natural disasters such as the strong El Nino, the many severe hurricanes, including Katrina, earthquakes, tsunamis, cyclones, tornadoes and flooding, and some manmade disasters such as asbestos and tobacco liability claims and the attack on the World Trade Center. These have generated abnormally large losses. Some have estimated that the dollar cost of the terrorist attacks was as high as $40 billion. The federal government now has a terrorism insurance program. The government is responsible for 90% of insurance industry losses that arise from a terrorist incident if the losses exceed a certain amount. Each insurer would have to pay 15% of its commercial P&C premiums. Nevertheless the cost to insure high probability targets remains expensive.
The text mentions the court decision that allowed Halliburton to resolve its asbestos liability (asbestos causes lung cancer and workers and community members in production sites such as Libby, Montana have suffered decades of higher cancer rates) by bankrupting one of its subsidiaries. This could help keep liability insurance down but it may set a disturbing precedent and may encourage other firms to engage in unethical behavior because the potential penalties may now be perceived as lower.
Insurance companies can attempt to share risks by buying insurance from other insurance companies. This growing practice is called reinsurance. About 10% of all insurance contracts world wide are ‘reinsured.’ P&C insurers engage in reinsurance to a greater extent than life insurers due to the greater unpredictability of P&C claims. Foreign insurance firms write about 75% of the reinsurance contracts used by U.S. insurers. Catastrophe bonds are a unique form of reinsurance. Different bonds may have different structures but the basic idea is that the bond’s principal and interest are reduced if a given catastrophe occurs. The reduction in the bond issuer’s payments then can offset the additional losses on the insurance line. As the text mentions, Munich Re issued a $250 million deep discount catastrophe bond in 2010 that would pay principle of 100(1-) at maturity. The equals the losses incurred on all reinsurer policies over a 24 hour period should an event such as a flood or hurricane occur if losses are above a minimum threshold. As of 2016 there was about $22.5 billion of catastrophe bonds outstanding and new issuance was $5.4 billion.
Property-Casualty (P&C) Insurance Regulation
P&C insurers are chartered at the state level
P&C insurers are regulated by state commissioners
State guarantee funds provide (some) protection to policyholders, similar to the manner described for life insurance companies
The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS)
Given the social welfare importance of some lines (e.g., workers’ compensation and auto insurance), state commissioners often set ceilings on the premiums and premium increases in these lines
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P&C insurers are chartered and regulated at the state level. Some states regulate the premiums insurers may charge; this has also contributed to the high loss ratios of the 1990s. The NAIC assists state regulators in providing examination forms and data on ratios at insurers.
American International Group (AIG) Inc., formerly the second largest P&C insurer in the world by revenues, became embroiled in several scandals in the mid 2000s. AIG allegedly assisted one or more firms in implementing fraudulent accounting to smooth the client’s earnings by engaging in payments that looked like insurance transactions but were not. AIG paid $126 million in penalties and costs, but admitted no wrongdoing. The scandals cost the CEO his job however. Marsh and McLennan (M&M) (an insurance broker) received $845 million in kickbacks associated with bid rigging. M&M allegedly directed clients to higher cost insurance packages in order to earn the high fees.
Not all insurers acted honorably during some of the recent crises. For instance, State Farm and others tried to classify the Katrina storm surge as flood damage which was not covered under many homeowners’ policies. The courts disagreed and ruled that State Farm was liable for actual and punitive damages.
Global Issues
The U.S., Japan, China, the U.K., and France are the world’s five largest countries in terms of insurance premiums written
Worldwide, 2012 was the third costliest year for the worldwide insurance industry (after 2011 and 2005)
Natural disasters cost insurers $65 billion in 2012
Losses in the U.S. accounted for 90% of the total
In 2012, total economic costs from natural disasters amounted to $160 billion, compared with $400 billion in 2011
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The insurance industry is becoming more global and there have been several large cross border mergers recently although insurers have probably not participated in globalization to the same extent as banks and other financial service providers. About 79% of total global insurance premiums written are generated by five countries: the U.S., Japan the China, France and Germany. The world’s largest life insurer by revenue in 2016 was AXA Group with revenue of $129.3 billion. The largest P&C insurer was Berkshire Hathaway with $210.8 billion in revenue.
The years 2011 and 2012 were poor years for insurers worldwide. Although there were fewer catastrophe related deaths than in prior years there were still over $111 billion insured losses in 2011 and $65 billion in 2012. In 2012 the bulk of the losses were in the U.S. In earlier years the catastrophes were more global and included greater loss of lives. In 2008 over 240,000 people died in over 130 natural disasters and 174 man-made disasters with the largest losses in Asia. About half the global losses were associated with the massive earthquake in China. The financial crisis reduced sales of equity linked products and the general malaise also saw reductions in revenue from other lines, particularly in P&C lines at that time. Profits improved in 2013 as losses from disasters declined substantially and premium income grew. The Nepalese earthquake in 2015 was a significant event but there weren’t many other large catastrophes that year. However in 2016 global losses grew once more with an increase in natural disasters. Losses were already running higher than in 2015 when an earthquake struck Italy. However, losses to insurers were projected to be fairly low because many people were not insured. Losses were not expected to top 100 million to 200 million euros. See, “Lack of Italy earthquake coverage limits insurers' losses,” Reuters, August 26, 2016, http://www.reuters.com/article/italy-quake-insurance-idUSL8N1B654U.
With higher losses and slowing premium growth 2016 was not as profitable a year for P&C insurers. The year 2016 actually had 43 catastrophic events, a much higher number than in the previous decade. The combined ratio fell across most major lines and investment income and capital gains were reduced in 2016.
$2,651.64
0.004167
1.004167
1
1
250,000
Payment
120
=
-
=
$2,072.18
0.004167
1.004167
1
1
250,000
Payment
168
=
-
=
$1,563.20
0.004167
1.004167
1
1
250,000
Payment
264
=
-
=
Example 1: Calculating ratios for a hypothetical individual line
Premiums
$9,455,122
Losses
$7,456,789
Expenses
$2,578,100
Dividends
4.00% of premiums
Loss ratio
78.87% losses to premiums
Expense ratio
27.27% expenses & commissions to premiums
Combined ratio
110.13% (sum of loss, expense and dividend ratios)
