The return of cat losses

Driven by the highest level of first quarter catastrophe losses since 2011, the underwriting results of the US property/casualty (P/C) industry deteriorated in 2016 from the prior year. The industry posted an underwriting gain of $2.1 billion for the first quarter of 2016, down from $3.9 billion in the same period of 2015. The resulting combined ratio of 97.4 was 1.6 points lower than the 95.8 posted last year.

Net investment income and realised gains also fell in the quarter compared with the first quarter 2015. This decline reflected increased market volatility early in the quarter and the continuing pressure on yields caused by the persistently lower rates on reinvestment.

With pre-tax operating income down 11.3 percent to $13.6 billion, pre-tax return on revenue fell to its lowest first quarter level of the recent five-year period. Despite remaining in double-digits at 10.7 percent, it is nearly a full point lower than the second lowest mark, 11.5 percent, posted in 2014. In addition, this quarter is down nearly 2 percentage points from 12.5 percent in the first quarter of 2015.

After a substantial decline during 2015, the negative change in the industry’s accumulated unrealised gain position slowed in the first quarter of 2016. However, that change, although partially offset by a reduction in shareholder dividend payments, adversely impacted surplus growth for the industry, growing only by 0.8 percent in the first quarter of 2016, to $685.2 billion. Similar to the pre-tax operating return decline, return on equity (ROE) fell to 2.0 percent, its lowest level of the past five years.

Net premiums written (NPW) growth for the quarter was 3.4 percent. While this is lower than the 4.2 percent NPW growth rate in the first quarter of 2015, it is above A.M. Best’s projection for the full year 2016. Premium growth was steady in personal lines, with many commercial lines showing signs of increasing competition. Ceded premiums increased year over year, outpacing growth in assumed business, thus negatively impacting growth in NPW. Net premiums earned (NPE) saw growth continue to decline, falling to 3.6 percent, the lowest level of the five-year period.

Industry underwriting results

The industry’s direct premiums written (DPW) increased 4.4 percent in the first quarter, up from 4.1 percent in the first quarter of 2015. The three largest lines on a direct basis—private passenger auto liability, auto physical damage, and homeowners & farmowners multi-peril—posted continued solid growth, with the auto lines growing at a rate exceeding the industry average.

In the auto lines, companies continue to achieve rate increases due to the increased loss frequency that has resulted from more miles driven. While a few companies have leveraged telematics technology to incorporate actual miles driven into their rating plans, most companies use information on miles driven provided by their insureds at policy issuance and renewal.

Since this information is updated less frequently, there is a lag between the activity that drives the increased losses (the higher miles driven) and the ability to increase rates to reflect it. Physical damage premiums continue to benefit from a high rate of new vehicle sales, which through March were on pace to meet 2015’s record level.

Other lines with strong DPW growth include surety—which continues to benefit from increased construction spending that in March reached its highest level since October 2007, according to the US Commerce Department—and fire & allied lines, which was up 7.8 percent overall. While the fire line was down 4.4 percent, maintaining the downward trend that has affected property business for several years, allied lines grew 15.3 percent, driven primarily by changes in the recognition of crop policy premium written at QBE North America, which resulted in accelerated premium recognition relative to prior years.

Ocean and inland marine and medical professional liability were the only lines that saw a decline in DPW in the first quarter of 2016. Premiums for the accident & health (A&H) lines—which had been declining on uncertainties related to implementation of the Patient Protection and Affordable Care Act (ACA)—increased in the quarter. The strongest growth among the A&H sublines was the ‘other’ subline, which includes individual A&H products.

Overall, NPW growth remained solid at 3.4 percent for the industry, although the growth rate varied by line of business, based on A.M. Best’s Quarterly Underwriting Survey. Allied Lines NPW was up 33.5 percent as a result of the previously mentioned accounting change. Mirroring growth in DPW, personal auto physical damage and liability saw the next largest increases of all lines, with homeowners also providing solid premium growth. Commercial lines NPW was down in total, with the steepest declines in other and products liability. Only four commercial lines reported increased NPW over the first quarter of 2015: commercial auto liability, commercial auto physical damage, inland marine, and allied lines.

Commercial auto is expected to be the standout in terms of commercial lines NPW growth in 2016, reflecting rate increases taken as the line demonstrated increased accident frequency and severity in recent years. In what may be a sign of good news, companies reported a decline in the commercial auto liability loss ratio in 2016 compared to 2015 based on our Quarterly Underwriting Survey. However, any relief the decline in liability losses offers is tempered by an increase in the loss ratio on physical damage, for both commercial and private passenger lines.

The increase in auto physical damage losses may relate to the increase in catastrophe claims in the quarter, with the industry posting its highest first quarter catastrophe losses since 2011. Among key events driving losses in the quarter were a series of severe storms that impacted nearly all sections of the country in March; a significant winter storm in mid-February that was followed later in the month by systems that brought both winter and spring storm conditions across the central and eastern sections of the country; and flooding and severe weather in California in January.

The National Weather Service Storm Prediction Center statistics indicate that the 102 confirmed tornadoes in February 2016 were the highest number recorded in the month of February since 2008. The total number of tornadoes in the first quarter was 205, making it the fifth most active first quarter since 2000.

Current estimates are that the combined ratio for the total industry underwent a 4.0-point impact from catastrophe losses in the quarter, up from 3.2 points in 2015. Total catastrophe losses for the quarter were $5.1 billion, based on A.M. Best’s Quarterly Underwriting Survey. This is the highest reported first quarter catastrophe loss since 2011’s $6.4 billion—which included not just US storm losses, but losses from two major international events: the Christchurch, New Zealand earthquake and the Tohoku earthquake and tsunami in Japan.

The 2011 losses included $2.7 billion in losses for the US reinsurance segment; currently, that segment’s catastrophe losses for the first quarter of 2016 are estimated at only $175 million, making the impact on the domestic primary market greater than the effects of 2011.

The industry’s underwriting results were also impacted by a decline in the level of favourable development of prior years’ loss reserves. Favourable development of reserves overall is typically driven by a modest level of adverse development of losses for asbestos and environmental (A&E) claims offset by favourable development of core reserves. While the overall trend continued in the first quarter of 2016, favourable development of core reserves declined by nearly a point—to 4.3 points from 5.1 points in the prior year—while adverse development of A&E remained constant at 0.2 points. Reflecting rounding, the overall benefit to the industry from favourable development of loss reserves in the first quarter of 2016 was 4.2 points, down from 4.9 points in the first quarter of 2015 and the lowest level of the past five years.

Over the past several years, A.M. Best has observed a trend toward more rapid recognition of favourable development of accident years. A number of changes in claims practices—including more effective initial reserve selection, use of dedicated staff to handle severe claims, deployment of advanced analytics, and greater focus on settlements—are likely contributing to this trend. However, with both recent and older accident years having already seen reserves reduced, A.M. Best anticipates that the overall level of favourable reserve development will continue to decline.

Even as catastrophe losses increased and the benefit of favourable loss reserve development declined, the industry’s core underwriting results remained steady. The normalised accident year combined ratio improved by 0.1 points, to 97.5 from 97.6, driven primarily by improvement in commercial lines. A.M. Best’s Quarterly Underwriting Survey indicated that the loss ratio for all commercial lines improved by 3.9 points year over year, with the most significant improvements in workers’ compensation and products liability. Offsetting the improvement in commercial lines was a 2.1-point increase in the loss ratio for personal lines, driven by the impact of the catastrophe losses.

Incurred losses for the quarter increased by 5.8 percent to $72.5 billion, driving a 1.2-point deterioration in the loss ratio, which rose to 57.1 from 55.9. These results were driven by the catastrophe and loss reserve results in the quarter, offset by the modest improvement in core performance.

Loss adjustment expenses (LAE) increased by 7.8 percent, reflecting additional costs associated with catastrophe claims adjustment. As a result, the LAE ratio increased to 12.0 points from 11.6 points in the prior year. Underwriting expense growth slowed to 3.1 percent from 3.5 percent in the first quarter of 2015, in line with growth over the past five years, but produced a 0.1-point reduction in the underwriting expense ratio.

Overall, the combined ratio deteriorated by 1.6 points, to 97.4 from 95.8 in 2015. This is the highest first quarter combined ratio of the recent five-year period, but is only slightly higher than the 97.3 and 97.1 posted in the first quarters of 2012 and 2014, respectively. Net underwriting income declined by 46.2 percent to $2.1 billion from $3.9 billion year-over-year.

Industry investment results

Net investment income earned declined by 4.2 percent in the first quarter of 2016 to $11.1 billion, reflecting new money rates that remain significantly below those on maturing or redeemed securities. The industry’s bond portfolio continues to increase, up 1.8 percent year over year and 1.1 percent year to date. At March 31, 2016, bonds represented approximately 62.0 percent of the industry’s total invested assets, up slightly from 61.5 percent a year earlier. However, the overall allocation to bonds in the portfolio has been declining over the five-year period, from its peak of 66.3 percent at March 31, 2012.

Funds previously invested in bonds have been allocated among other broad asset classes of equities (common and preferred), cash & short term investments, and other investments. At March 31, 2016, equities accounted for 21.8 percent of the portfolio, followed by other assets at 10.8 percent and cash & short term investments at 5.5 percent.

The equity portfolio comprised 22.5 percent of the industry’s investments at March 31, 2015 and 22.2 percent at year-end 2015. The 1.0 percent decline in the value of the equity portfolio in the first quarter of 2016 primarily reflected declines in market value, which accounted for a substantial portion of the $1.9 billion decline in the industry’s unrealised gain position in the first quarter of 2016.

Other assets increased 6.6 percent from March 31, 2015 and 8.5 percent from year-end 2015 and account for 10.8 percent of the industry’s invested assets at the end of the first quarter of 2016. The overall allocation to these assets is at its highest first-quarter end level of the five-year period, although the range has been relatively narrow, with a low point of 9.7 percent at March 31, 2013. Assets in this category include real estate (both company-occupied and investment), direct loans (including mortgages), and positions in private equity and hedge funds. These investments typically have lower liquidity than other assets, have more opaque pricing, and may require commitments for future investment. In addition, investors may have less control over the timing of distributions.

As a result, these investments tend to carry higher capital charges and have not been widely used in the P/C industry. While the allocation to other assets has increased over the past five years, these holdings tend to be concentrated in larger organisations with sophisticated asset management strategies.

In addition to the reduction in net investment income in the first quarter, the industry also had a reduced level of realised gains. Realised gains declined 47.5 percent from their first quarter 2015 level, to $2.5 billion from $4.7 billion.

Industry surplus

Starting from the lowest net income recorded in the first quarter over the past five years, the industry overcame a number of challenges to produce a slight increase to surplus on a year-over-year and year-to-date basis. The industry’s unrealised gain position declined by $1.9 billion in the quarter, as a result of volatile equity markets that fell sharply in February before recovering most of the losses in March. Other surplus losses of $800 million were offset by $861 million in contributed capital.

Stockholder dividends were reduced by 45.5 percent for the quarter, falling to $6.8 billion from $12.4 billion in the prior year. The first quarter of 2015 included the accrual of a dividend payment to Berkshire Hathaway by National Indemnity Corporation that was significantly larger than those paid in either the first quarter of 2014 or 2016.

The net effect of these items was a year-over-year and year-to-date 0.8 percent increase in surplus to $685.2 billion. After-tax ROE measured 2.0 percent for the quarter, the lowest first quarter ROE posted by the industry over the past five years.

A.M. Best published this research on July 6, 2016.

Jennifer Marshall is assistant vice president at A.M. Best. She can be contacted at: jennifer.marshall@ambest.com

David Blades is senior industry research analyst at A.M. Best. He can be contacted at: david.blades@ambest.com