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Low losses, high rates boost insurer profits

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A lack of major U.S. catastrophes combined with reserve redundancies and continued hard market rates are leading to strong, if not record-breaking, profitability for property/casualty insurers.

Results for the quarter ended Sept. 30 and the nine-month period "are some of the best results that we can remember," said Adam Klauber, director of equity research for Cochran Caronia Waller, a Chicago-based insurance industry investment banking firm.

Whether it be insurers' combined ratios, return on equity or growth in earnings, "we're looking at pretty close to record levels for most of the sector," Mr. Klauber said.

But 2006 is likely to be the peak year in profitability for the industry because the market is softening and there is a likelihood of increased catastrophe activity in 2007, observers say.

Fourteen major commercial property/casualty insurers surveyed by Business Insurance reported $23.49 billion in net income for the nine months ended Sept. 30, an increase of 28.6%.

Among other survey results:

c Insurers posted an improved combined ratio of 90.2% vs. a 98.1% combined ratio for the comparable nine-month period in 2005.

c Net premiums written increased 4.5%, to $105.52 billion.

c Policyholder surplus increased 15.7%, to $87.41 billion.

Weather was a factor in the strong results. With catastrophes having disrupted results for the previous two years, this year's nine-month results "are off the charts" comparatively, said Jeffrey Berg, a vp and senior analyst with Moody's Investors Service Inc. in New York.

However, John L. Ward, chief executive officer of Cincinnati-based Cincinnatus Partners L.L.C., an advisory firm that specializes in the insurance industry, said the favorable cat experience "was only a small part of the overall positive story."

Other factors include reserve development, he said. Reserve development "has hurt the industry the last few years, but the reserve development in the third quarter (of 2006) was very positive, and not only is there the absence of unfavorable development charges, but most companies actually reported a positive reserve development," Mr. Ward said.

James B. Auden, senior director at Chicago-based Fitch Ratings, said after five years of reporting unfavorable reserve development, this year's positive reserve development should improve the industry's combined ratio by 1.5 to 2 percentage points.

Gary Ransom, managing director at Fox-Pitt, Kelton Inc. in Hartford, Conn., said while the lack of catastrophes has boosted results, "a lot of it was just because we're still having premiums being earned at fairly high and profitable rates. Even though rates may be declining now, the underwriting margins are some of the strongest we've seen in a long time."

Jay A. Cohen, an analyst with Merrill Lynch L.L.C. in New York, said "pricing has remained fairly reasonable. You're seeing competition, but it has not deteriorated into a price war."

Mr. Ward said price softening is the only negative factor from insurers' perspective in the nine-month results. "There's definitely, for virtually all commercial lines of business, a flat to downward bias in the pricing scenario," he said.

John Iten, a director at rating agency Standard & Poor's Corp. in New York, said the industry's combined ratio is likely to deteriorate somewhat in the fourth quarter—although remain very good—because that is when companies historically boost their reserves. "We don't expect anything huge, but there will be some reserve strengthening," he said.

While it has been a strong year for P/C insurers, observers say 2007 results are unlikely to match this year.

"I think 2006 will prove to have been a peak year for two reasons," said Cliff Gallant, an analyst with investment bank Keefe, Bruyette & Woods Inc. in New York. One is that weather "will be more normal in the future. I think it's more of a reasonable expectation there will be more bad weather, if nothing else, more hail and small storms." Furthermore, he said, "pricing seems to be topping off" and "now it will start to squeeze margins as well."

"Most companies have ample, if not excess capital," Mr. Cohen said. "It is fair to expect competition to continue and prices to move lower.... The next conclusion would be that the current underwriting margins are probably not sustainable."

He added, "We think the deterioration will be gradual, but you'll begin to see it in 2007," along with "a more normal level of catastrophes."

Mr. Ransom said one unanswered question is "what is going on with loss cost trends." It is "hard to know with long-tailed casualty lines," he said. "We've put in a lot of higher terms and conditions during the hard market, which everyone says are still there." This means the industry might have "better combined ratios for a longer period than people expect."

Mr. Ward said one big issue for the industry is evaluating how it will handle the excess capital that it is building at "record-breaking levels." Indications are that commercial insurers "are planning to pursue significant stock repurchase plans and increase dividends. If so, "that will be a positive factor in avoiding the temptation by the industry to use the excess capital to dramatically cut rates and write bad business at rates they shouldn't write it at," he said.

Acquisitions are another possible use of the excess capital, observers say.

"The environment is becoming more conducive to consolidation," Mr. Cohen said. With rate increases slowing, organic growth "is more of a challenge," he said.

In addition, "balance sheets have gotten a lot better, so potential buyers may have excess capital and potential targets probably have more adequate loss reserves," which would make them more attractive targets. "We're still not expecting a rush of deals to occur, but would expect the pace to pick up modestly," said Mr. Cohen.

Suitors are "not as skittish as they were a few years back when actuaries, external and internal, were still grappling" with the 1998-2001 accident years, said Daniel Ryan, vp in Oldwick, N.J.-based A.M. Best Co. Inc.'s property/casualty division.

However, "because it's really been one of the best of times" in the property/casualty insurance industry, many potential acquisition targets "basically want to stay independent" so "there's give and take there," said Best Vp Andrew Colannino.

John Gwynn, managing director at Memphis, Tenn.-based Morgan Keegan & Co. said, "I think we'll continue to see a fairly muted amount of activity for the same old reason it's been muted over the past year—people don't like buying other people's reserves, because there's always issues over reserves," despite the overall redundancy.