The Insurance Services Office (ISO) recently released combined financial figures for the year 2004 for the US property-casualty industry, and it was a very good year for the industry.
One measure of performance is the combined ratio, which calculates the percentage of loss payouts and expenses as compared to premium income. A ratio of 100 means that the insurers paid out in losses the same amount of money they took in as premiums; this does not mean that the insurer that year was not profitable – the insurer takes the premium and invests it, so an insurer still will be profitable even if, on a premium-in, claim-out basis, it has made no money. An insurer with a loss ratio of 102, where it has paid out $1.02 in claims for every $1.00 in premium collected, will still be profitable if its investment returns are more than 1.02 times premiums collected.
A combined ratio of less than 100 indicates that policyholders collectively paid more in premiums than the insurer paid out in claims. As Warren Buffett has explained, from the insurance company perspective this means that other people are paying it to invest money for the insurance company’s benefit. If the combined ratio is less than 100, the insurance company’s “cost of float” is less than zero, that is, the insurance company is getting paid to hold other people’s money or, as Mr. Buffett has put is, “float is better than free.”
In 2004, the US property-casualty industry had a combined combined ratio of 98.1%. The insurers made $39.6 billion in investment income, on top of their underwriting profit of $5 billion, and the industry’s overall net income (taking into account investment, underwriting, and other cash and paper profit) was $53.4 billion.
In addition to being investment machines, insurance companies pay losses, which in 2004 totaled $299.5 billion, including loss-adjustment expenses. Last year there were several significant catastrophes affecting the industry, notably the series of hurricanes hitting Florida and other parts of the US. Overall, there were estimated to be $15.2 billion in catastrophe losses. Roughly $4.9 billion was devoted to environmental and asbestos (“E&A”) losses last year, which was down about $1.5 billion from the year before (2003). According to ISO, if one holds aside the exceptional items of catastrophes, E&A, and some reserve adjustments, the combined ratio for insurers was 92.3 percent.
The profitability of the industry last year led to an increase in net worth, or what is called in insurance parlance “policyholder surplus.” The surplus last year was at a record high, both absolutely and adjusted for inflation, of $393.5 billion, even after paying $13.3 billion to their owners as dividends. The insurers have recovered from their capital losses between 2000 and 2002, racking up $50.8 billion in capital gains in 2003 and 2004 overtaking their capitals losses $35.7 billion at the dawn of the millennium. The insurers’ rate of return on capital was at its highest level in nearly a decade, producing a 9.4 percent return on average net worth. The average yield on insurers’ cash and invested assets has averaged 4.6 percent over the past five years.
Insurers, however, like to compare their financial results to other industries based on return on new worth, complaining that industries that actually make things earn more than they do. ISO estimates that median returns for the Fortune 500 in 2004 was 14.9 percent, which is 5.5 percent higher than the 9.4 percent return on net worth for the insurance industry as a whole and 4.8 percent higher than the large American insurers’ rate of return of 10.1 percent.
It’s never been clear to me that that is a salient comparison, in that, unlike Lake Wobegon where all the children are above average, not every company has to have high rates of return to make the enterprise worthwhile; just because leading industrial companies may make more money does not make the insurers woe-begotten.