Fitch believes that the market has crossed a tipping point in the underwriting cycle, such that industry returns on capital for current accident-year business has slipped to inadequate levels, though a number of more proficient individual underwriters will still produce sufficient returns. The market environment is anticipated to deteriorate further going forward, and it is difficult to project the length and extent of the current soft market, and the circumstances that will promote a shift to hardening market rates.
The industry’s statutory profitability remained favorable with a return on surplus of 12.3% in 2007, but declined moderately from the record results of 2006. As is typical for this point in the underwriting cycle, premium revenue growth has slowed considerably from the early hard market years of 2002 and 2003. Net written premium actually declined for the first time in memory in 2007, while net earned premium revenue for the industry aggregate increased by a modest 1.2% in 2007 to $446 billion.
Underwriting performance deteriorated in 2007 relative to the prior year, but the market still experienced a strong underwriting profit with a combined ratio of 95.6%, reporting its third underwriting profit in the last four years. Prior to 2004, the industry went 25 consecutive years without earning an underwriting profit. Investment earnings in 2007 increased significantly due to growth in invested assets and a substantial increase in realized investment gains.
The deterioration in underwriting performance reflects the softening pricing environment currently encompassing nearly all business segments, and a gradual increase in expense ratios in the last few years reflective of slow revenue growth. Offsetting these factors, the market benefited from another relatively benign natural catastrophe season in 2007. Fitch estimates that net insured catastrophe losses represented only 1.4% of net earned premium for the industry in 2006 compared with 2.1% in 2006 and 8.6% in 2005.
The industry also benefited in calendar-year 2007 from favorable prior-period loss reserve development. For the second consecutive year, loss reserves developed favorably, promoting a 1.8% reduction in the industry combined ratio versus a 1.6% decrease in 2006, following a 0.1% increase from adverse reserve development in 2005. While this favorable development boosts current year profitability, it is important to note that accident-year underwriting performance is somewhat worse than calendar-year results, and the industry likely did not produce an adequate return on capital for the 2007 accident year.
Surplus Growth Slows, Excess Capital Spurs Competitive Threats
The industry’s policyholders’ surplus expanded to another record level in 2007. However, surplus growth of 6.7% was the lowest experienced in the last five years. As the table above reveals, capital formation from strong earnings continued in 2007, but unrealized investment gains were flat. The key driver of this more modest surplus growth is the level of capital moving out of the industry through shareholder dividend payments. Net capital outflows, which considers capital contribution inflows and dividend outflows, increased by 44% in 2007.
This capital movement is in response to the strong internal capital formation in recent years, coupled with more limited revenue growth and profit opportunities in the soft market.
While Fitch’s Prism economic capital model demonstrates the recent improvement in capital adequacy for the market, this improvement is also revealed when examining more traditional leverage measures. The ratio of net written premiums to surplus matched historical lows at year-end 2007. Likewise net leverage, which compares liabilities and premiums to surplus, and gross leverage, which considers premium and liability exposures before the impact of reinsurance, have also declined significantly in recent years.
These leverage figures are indicative of excess capital in the industry. Continued stiffer price competition in most market sectors is a function of this excess capacity as well as a response to the business’ previous success, and points to profit deterioration going forward
Forecast for 2008
With a trend of deteriorating underwriting performance developing and continued declines in premium rates across the broader market, the projected industry combined ratio has shifted from a 98.1% combined ratio to a modest underwriting loss for the year. This underwriting result, coupled with a modest decline in estimated investment income, has led to a corresponding decline in projected net income, such that the estimated return on surplus is now 7.6%, down from 9.2% previously.
The combined ratio increase from 2007 is attributable to an increase in run-rate incurred losses, with a sharper deterioration occurring in the commercial lines segment than personal lines, as well as a return to historical average insured losses from natural catastrophes from experience that was below norm in 2006 and 2007.
Calendar-year underwriting performance will continue to benefit from favorable loss reserve development from prior underwriting periods. Though it is difficult to predict the timing of reserve releases, Fitch believes that the industry still has a modest reserve redundancy, and plans on publishing a report detailing our analysis of loss reserves in coming months.
Looking ahead to 2009, underwriting results and operating profits are likely to continue their downward trend. Though the industry is not producing returns on par with its cost of capital, strong market capacity and other competitive factors are still driving prices to less attractive levels. Currently there is no catalyst evident for a shift to a hardening market trend, and it will likely take larger underwriting losses or some other significant event that removes capital from the market for pricing to shift. Fitch does not envision any meaningful shift in pricing trends until the second half of 2009 at the earliest.
