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Special to Business Insurance

PROPERTY/CASUALTY insurance stocks have been poor stock market performers all year, and the recent stock market drubbing just made things worse.

After the Aug. 31 dive, our screen of 22 property/casualty insurers was down, on average, 16.2% from their year-end 1997 closings. This compares with a 1.4% decline for the Standard & Poor's 500 Index.

Property/casualty stocks have been one of the worst performers on a year-to-date basis within the insurance sector and clearly have been the worst performers since the end of the second quarter.

This thrashing, in part, reflects investor disappointment about the evaporation of a relative earnings story, earlier concern about the prospect of rising interest rates and its impact on group valuations, and increasing angst among some relatively new investors and observers about the depth and tenure of the "underwriting cycle."

In the past, when underwriting cycles were more readily defined, one found that the pendulum always swung to the extremes on both sides. The current operating environment with its elongated downdraft is certainly no exception. In fact, for some insurers, the pit may turn out to be much deeper and darker than it is currently perceived by both management and investors.

The key is obviously to find those entities that will avoid the depths of the pit and not fall prey to the swings of the pendulum. We continue to get conflicting signals about premium growth trends at specific companies, with softer numbers for many and stronger-than-expected numbers for a few. The devil lies in the details of the hows and the whys.

The pit may be deeper than some currently perceived, because of what we believe has been and may continue to be the erosion of balance sheet strengths by many insurers that are compromising the integrity of their balance sheet to buttress near-term earnings.

We have seen many small to medium-sized property/casualty companies belly up to the bar and address reserve deficiencies. It appears that it is becoming increasingly difficult for these smaller insurers to cover past misdeeds. There even seems to be an instance where an insurer already is addressing 1998 and 1997 reserves.

As a general rule of thumb, we do not hear any cries of "uncle." Notwithstanding some crimping of cash flows, the huge capital cache that most insurers have continues to be viewed as an almost impenetrable barrier.

In the more recent past, Wall Street has sent up rave reviews about reserve additions because it meant that managements were cleaning up the book, perhaps for a suitor. It remains to be seen if this euphoria will be maintained.

As the degree of difficulty that some insurers have put themselves in becomes evident, the enthusiasm for retrofits may give way to fear of taints. Indeed, savvy buyers with cash and valuable currencies have become increasingly sensitized to values and what they are willing to pay for acquisitions.

There are two functional income or loss components within the property/casualty industry: underwriting and investments. The stock segment of the industry has not achieved an underwriting profit since 1978 -- that works out to be 19 years!

For the most part, the industry has kept its head above water during this period, with its growth in net investment income and the harvesting of capital gains.

Even though this defies logic, logic dictates that some changes will have to take root sooner rather than later. At some point, industry executives' awareness of declining cash flows and continued slippage in the yield curve has to rise. Indeed, current talk of a disinflationary environment adds fuel to the fire.

For year-end 1997, net investment income of $34.48 billion -- again just for the stock segment of the industry -- represented 18.5% of earned premiums. Back in 1972, net investment income, which is largely tied to the industry's bond holdings (59.2% of year-end 1997 assets), underscores the profound impact that increases or decreases in the yield curve have on investment income generation.

Over the past seven or eight years, yields have dropped about 350 basis points. This had not only resulted in a plethora of calls on high-yielding bonds but also has exacerbated investment income growth as the older investments are replaced with lower-yielding pieces of paper.

The perversity of the situation is that declining yields also produce higher bond prices.

Because most insurers now mark their portfolios to market, they have come to feel healthier and wealthier notwithstanding the facets of deficient commercial pricing and the "borrowing-from-Paul-to-pay-Peter syndrome" on the balance sheet. In an effort to enhance net investment income growth, many insurers also have some funds run by outside managers that sometimes take more aggressive investment shares.

There used to be a rule of thumb in the business that a half-point decline in the portfolio yield of the property/casualty industry needed a one-point drop in the combined ratio to maintain the return on equity. The stock insurers closed out 1997 with a combined ratio, after policy dividends, of 101.5%.

The last time the industry's combined ratio approached par or below par was in the 1977-79 period. It is difficult to see that ratio improving given the current dynamic of the business.

Hence, one would like to think that the industry is going to have to get back to basics and underwrite risks at realistic prices to offset the pressures of slowing net investment income growth. This is a great theory. Our problem is that in our tenure at observing this business, we have seen many trees die. However, it has taken multiple periods before the tree falls down.

Myron M. Picoult is a director and senior insurance analyst at Wasserstein Perella Securities Inc. in New York. He is the past president of the Assn. of Insurance & Financial Analysts and a member of the New York Society of Security Analysts. An archive of Mr Picoult's columns for Business Insurance can be viewed on the World Wide Web at: ticker/headlines.html.