Insurer Financial Results: 1995

June 1996
Executive Summary

Net Income and Return on Net Worth
The property/casualty insurance industry earned record after-tax income of $20.1 billion in 1995, surpassing the previous record of $19.3 billion in 1993. Compared with results in 1994 — a year marked by high catastrophe losses and weak investment results — net income after taxes in 1995 increased 85.3%, and return on average net worth increased from 5.6% to 8.2%. Table 1 summarizes insurers' overall financial results for the past two years. A significant decrease in underwriting losses and increases in realized capital gains and investment income were the main reasons for the $9.3 billion increase in industry net income.

NOTES: Figures may not balance because of rounding.
NM=Not Meaningful
*Difference in percentage points.

Catastrophe losses were significantly lower in 1995 than in 1994, but 1995 still ranks as the third-worst year for catastrophe losses. Total insured catastrophe losses amounted to $8.3 billion.

With the stock market soaring in 1995, the industry's total capital gains rose to $26.3 billion, compared with a small capital loss in 1994. Realized capital gains increased $4.1 billion from $1.7 billion in 1994 to $5.8 billion in 1995. Unrealized capital gains totaled $20.5 billion in 1995, compared with unrealized capital losses of $1.8 billion in 1994. Because of significantly improved underwriting results in 1995, insurers relied less on available capital gains to bolster income. Realized capital gains accounted for only 23.2% of statutory pretax income in 1995. This contrasts with the results in 1993, another record-breaking year for profits, when the industry's realized capital gains accounted for 40.3% of statutory pretax income.

Net investment income grew 7.5% in 1995. After five years of record low growth, including two years of declines, 7.5% is the largest increase since 1989. Investment income grew even though interest rates fell significantly. Average yields on ten-year U.S. Treasury bonds dropped from 7.1% in 1994 to 6.6% in 1995, but the embedded yield on the industry's portfolio of invested assets remained 5.7% — its lowest level since 1977.

While insurers' statutory pretax income increased 88.4% in 1995, their federal income taxes increased 102.5%. Insurers paid $4.9 billion in federal income taxes, resulting in an effective tax rate of 19.4%. In 1994, this rate was 18.1%. But the 1995 effective tax rate remained much lower than the average effective tax rate of 20.6% for the prior eight years since the Tax Reform Act of 1986 took effect.

Surplus
In 1995, the property/casualty industry's surplus, or statutory net worth, grew $38.4 billion, or 19.9%, to $231.7 billion. Total capital gains of $26.3 billion and operating income of $19.2 billion were the primary contributors to the change in surplus. Stockholder dividends offset the industry's new funds of $6.9 billion. Federal income taxes and miscellaneous charges against surplus account for the rest of the difference. (See Table 2.)

NOTES: Figures may not balance because of rounding.
NM=Not Meaningful

Underwriting Results
Continuing the industry's seven-year pattern of slow growth, written premiums rose just 3.3% in 1995, held back by an approximate 10% drop in workers compensation written premium. Industry average premium growth during the eight years from 1988 to 1995 was 3.8%.

Despite a combination of high catastrophe losses and high environmental and asbestos (E&A) losses, the industry's underwriting results in 1995 were better than the results in any year since 1988, with the combined ratio declining to 106.3%. Based on a sample of insurers representing 60% to 90% of the industry's 1994 premium volume by line, the pure loss ratio of allied lines (including earthquake) dropped from 230% to 68%; homeowners dropped from 75% to 70%; commercial multiple peril dropped from 66% to 61%; workers compensation dropped from 61% to 55%; and medical malpractice dropped from 48% to 40%. Only general liability experienced significant deterioration, with its pure loss ratio increasing from 69% to 83%. This deterioration was due to rising E&A losses.

If catastrophe losses had been at long-term average levels, underwriting income would have been $10.5 billion greater in 1994 and $4.1 billion greater in 1995. (See Table 3.) In addition, the 1995 combined ratio would have been 104.6%, rather than 106.3%. The catastrophe-adjusted combined ratio for 1995 was the second best since 1980 and just 0.5 percentage points above 1994's catastrophe-adjusted combined ratio of 104.1%. Taking tax effects into account, the industry's 1995 return on net worth would have been 9.2%, rather than 8.2%.

*Reflects an adjustment for losses from the Northridge, California, earthquake ceded to foreign reinsurers.

E&A losses have dragged down industry results in recent years, although most of these losses came from claims against policies issued before 1986. ISO estimates that the industry incurred $30.4 billion in losses and allocated loss adjustment expenses (ALAE) for E&A exposures in the last five years. The industry incurred $10.1 billion of that in 1995. In the absence of E&A losses, the industry's combined ratio would have been 2.5 percentage points lower, on average, over the last five years, and 4 percentage points lower in 1995.

Adjusting for the effects of E&A and catastrophe losses in 1995 further highlights the apparent improvement in underwriting results for business not related to either catastrophe coverage or E&A coverage on pre-1986 policies. The 1995 combined ratio, adjusted to long-term average catastrophe levels and to exclude E&A losses, is 100.6% — 1.4 percentage points lower than in 1994 and 5.7 percentage points lower than its 1995 unadjusted level. However, if insurers weakened reserves not related to E&A exposures, it is possible that this result overstates the improvement.

Comparisons with Other Industries
From 1978 to 1994, property/casualty insurers' returns on net worth averaged 10.7%, compared with an average of 11.9% for other industries in Standard & Poor's COMPUSTAT data base. In a ranking of industries from most to least profitable during these years, property/casualty insurance ranked 36 out of 56 industries. In 1995, a record year for after-tax income, the industry's rate of return on net worth increased to 8.2%. Nonetheless, this percentage is still significantly lower than the industry's long-term average and the 14.8% median return on net worth for the Fortune 500 in 1995.

Uncertainties Affecting the Property/Casualty Insurance Industry
Though both insurers' net income and surplus rose sharply in 1995, the outlook for insurers and the property/casualty industry remains uncertain. The challenges confronting insurers include:

• Continuing exposure to vast catastrophe losses — During the seven years ending 1995, inflation-adjusted catastrophe losses totaled $74.8 billion. This total was $24.8 billion, or 50%, more than all such losses during the 39 years from 1950 to 1988.
• Potential financial responsibility for cleaning up thousands of the nation's hazardous waste sites — ISO estimates that insurers have recognized (paid or reserved for) at least $22.7 billion in environmental losses through year-end 1995. Some recent studies estimate that insurers' undiscounted ultimate cost for cleaning up abandoned hazardous waste sites could range from $25 billion to $91 billion.
• The possibility of a major restructuring of the property/casualty industry through mergers and acquisitions — Data compiled by Conning & Company indicates that the number of mergers and acquisitions in the U.S. property/casualty industry rose from 33 in 1993 to 68 in 1995. The reported dollar value of property/casualty mergers and acquisitions has risen even more sharply, climbing from $1.9 billion in 1993 to $11.5 billion in 1995.
• Potential further inroads by alternative providers, including insureds themselves — Various estimates indicate that self-insurance, captives, risk retention groups, and similar alternative insurance mechanisms account for perhaps 33% to 44% of the commercial risk financing market. Substantial pieces of the U.S. insurance market have also been lost to government entities and foreign firms.
• Effect of judicial decisions on state regulation — Despite the McCarran-Ferguson Act, federal involvement in the insurance industry has grown over the years.
• Adapting to new technologies that may revolutionize distribution mechanisms and other aspects of the insurance business — The rise of the Internet and the World Wide Web may well revolutionize commerce in general and the business of insurance in particular.
• The ever-present possibility of sudden reversals in financial markets — The Standard & Poor's (S&P) 500 rose 34.1% in 1995, but it has declined in more than one out of every five years from 1970 to 1995 and, at times, it has fallen precipitously. During 1973 to 1974, the S&P 500 plunged 42%.