Risks and Returns: Property/Casualty Insurance Compared with Other Industries

December 1995
Executive Summary

Record losses from natural catastrophes in recent years — and the possibility of still larger catastrophe losses — have raised concerns about the property/casualty insurance industry's capacity for providing financial protection. The industry's capacity depends on its capital, and the capital of any business ultimately depends on investors seeking the best balance between risk and return. This ISO study compares property/casualty insurers' risks and returns with those offered by a broad range of competing uses for capital.

Although some of the analyses in this study yield results that differ, the preponderance of evidence indicates that:

Property/casualty insurers have been less profitable than most of the competing uses of capital.
Insurers have faced at least as much risk as the competing uses of capital.

Primary Analysis
This study's primary analysis looks at rates of return on year-end net worth and their variability for the 20 largest insurers and the 20 largest firms in each of 30 non-insurance industry groups [1]1. In the primary analysis, the 30 "non-insurance" industry groups include the life/health insurance industry. from 1979 to 1993. The analysis uses three measures of variability to assess risk. The first measure, total variability, is based on all the variability in a firm's rate of return. The second measure, cycle-adjusted variability, excludes the variability attributable to industrywide cycles, much of which is foreseeable. The third measure, ISO's composite risk index, is an average of the first two measures.


Based on data for the 20 largest companies in each industry group, the median rate of return for property/casualty insurers was lower than the average of the corresponding medians for the 30 non-insurance industry groups studied. But, based on total variability and ISO's composite risk index, insurance was more risky than the non-insurance industry groups.	Based on all three measures of risk, about three times as many industry groups were superior to insurance as were inferior.

Figures 1 and 2 summarize the results of the primary analysis. The analysis shows that:

Large insurers were less profitable than large firms in other industry groups. From 1979 to 1993, the median rate of return for the 20 largest property/casualty insurers was 9.6% — 1.6 percentage points less than the average of the corresponding medians for the 20 largest firms in each of 30 non-insurance industry groups.
Based on total variability and ISO's composite risk index, large insurers faced as much or more risk than large firms in non-insurance industry groups.
Rankings based on each of the measures of risk indicate that insurance was more risky than the majority of non-insurance industry groups.
Considering risks and returns simultaneously, the number of industry groups superior to (more profitable and less risky than) insurance was about three times the number of industry groups inferior to insurance.

Broadening the analysis to include data not for just the 20 largest firms in each industry group, but for all firms in each industry group, ISO obtain similar results. Nevertheless, not all insurers fared poorly. About one-fourth of the individual insurers in this analysis were superior to the typical firm in the non-insurance industry groups.

Secondary Analyses
The secondary analyses in this study do not examine the risk and profitability of individual firms in different industry groups, but, rather, results for various aggregates. One secondary analysis compares results for the property/casualty industry overall with results for a wide range of non-insurance industries. Two other secondary analyses compare results for the insurance industry with various key composites, including the Standard & Poor's 500 and the Standard & Poor's Financials, and with risk-free U.S. Treasury bonds.

The secondary analyses show that:

During the two insurance cycles from 1978 to 1994, the property/casualty industry's rate of return was lower than the average for 51 non-insurance industries, but property/casualty insurers also faced less risk.
During the 17 years ending 1994, the property/casualty industry's rate of return on net worth average 10.1% — 1.8 percentage points lower than the corresponding average for 51 non-insurance industries.
During the same 17 years, the total variability measure of risk for the property/casualty insurance industry was 4.5 percentage points. The total variability measure of risk for 51 other industries averaged 6.2 percentage points.
Considering risks and returns simultaneously, about as many industries were superior to the property/casualty insurance industry as were inferior.
During the two insurance cycles from 1978 to 1994, the property/casualty insurance industry has suffered poor profitability and high risk compared with a selection of widely followed composites, including the Standard & Poor's 500 and the Standard & Poor's Financials.
The property/casualty industry's 10.1% average rate of return was lower than the corresponding average rates of return for five out of six key composites.
The property/casualty industry faced more risk than four out of six key composites.
Considering risks and returns simultaneously, four out of six key composites were superior to insurance, and only one was inferior.
From 1978 to 1994, insurers' average rate of return on net worth was 1.5 percentage points higher than the yield an investor could have earned investing in ten-year U.S. Treasury bonds. That is, insurers earned 1.5% more per year on their capital in exchange for accepting all the business risks associated with providing financial protection to their insureds.
Despite being higher on average, the property/casualty insurance industry's overall rate of return fell short of the comparable yield on ten-year Treasury bonds during 7 of the 17 years ending 1994.

Additional Analyses
This study contains six additional analyses that provide further insight into property/casualty insurers' risk-return tradeoffs. These analyses show that:

Property/casualty insurers faced a greater risk of failure than most other firms. From 1969 through 1994, an average of 0.9% of all U.S. property/casualty insurance companies failed each year. The failure rate for the economy overall averaged 0.7%.
Failure rates for the property/casualty industry have also exceeded failure rates for the life/health insurance and banking industries, but have fallen short of failure rates for the thrift industry.
Stockholder-owned insurers have earned higher returns, but faced greater risk, than mutuals.
Medium-sized and large insurers have been more profitable and less risky than small insurers.
Commercial-lines insurers have been more profitable, but have faced more risk, than personal-lines insurers.
Reinsurers have been more profitable than primary insurers. The risk analysis was inconclusive.
Agency companies have been more profitable, but more risky, than direct writers.
The major short-tailed property lines have been more profitable, but more risky, than the major long-tailed liability lines. Catastrophes contributed to the riskiness of the short-tailed lines, while year-to-year changes in reserve adequacy smoothed results for the long-tailed lines.
Summary statistics based on long-term data can obscure the sudden and dramatic effects of catastrophes on results for short-tailed property lines. For example, the operating ratio for earthquake insurance jumped from 29.2% in 1993 to 878.9% in 1994, as a result of the Northridge quake.
Insurers' tendency to strengthen reserves during the most profitable years of the underwriting cycle and to weaken reserves during the least profitable years has smoothed insurers' results. That is, insurers appear less risky than they would if the adequacy of loss reserves remained constant over time.
Though differences in accounting procedures have contributed to differences in reported results, U.S. property/casualty insurers at least appear to have been more profitable and to have faced greater risk than property/casualty insurers in several other industrialized nations.

The net amount of capital entering or leaving an industry is the net amount of capital being invested in or removed from individual firms in the industry. Therefore, the primary analysis in this study compares data for individual insurers with data for individual firms in non-insurance industry groups. Because the secondary analyses compare results for the insurance industry overall — not individual insurers — with results for other aggregates and with U.S. Treasury bond yields, ISO placed more importance on the primary analysis than on the secondary analyses when formulating this study's overall conclusions.

Also, retrospective analyses like the ones in this study measure on past risks and returns, and nothing guarantees that the future will mirror the past. For example, Hurricane Andrew established a new record for the amount of insured loss resulting from a single event. But even more devastating catastrophes are clearly possible. Some have estimated that Andrew might have caused two to three times as much insured damage if a slightly different path had taken the storm through downtown Miami. Historical analyses also fail to reveal the risk insurers face as a result of potentially vast payments for pending environmental and asbestos claims. Thus, historical analyses may understate the risk firms face now and in the future.

1. In the primary analysis, the 30 "non-insurance" industry groups include the life/health insurance industry.