In its recent 2014 fourth quarter P&C Insurance review, Morgan Stanley Research reports strong results capping off a solid 2014, with benign CAT losses and strong earnings per share continuing a trend of upbeat earnings that spans eight consecutive quarters. But analysts also sees a variety of factors, including flat returns on investment and pricing approaching negative rates, that could pinch insurers in 2015.
“We cited four fundamental headwinds,” said Morgan Stanley Property & Casualty Insurance analyst Kai Pan, one of the report’s authors. The most notable is downward pressure on pricing, due in part to excess capital.
After three years of steady improvement, prices flattened in 2014. Increases in mergers and acquisitions seen in 2014 are expected to continue and even to accelerate, helping to deploy some of this excess capital, but not enough to bolster pricing.
“Pricing will continue to decelerate and could turn into negative territory for the commercial line pricing this year,” said Pan.
If this downward pressure pushes prices below the loss cost trend, or inflation, underwriting margins could deteriorate, creating a second significant headwind. Over the last three years, prices have increased at four to five percent, significantly above the loss cost trend, contributing to an expansion of margin.
Pan cautions that, “Going forward…if pricing is going to be flat or negative, and the loss cost or inflation trend is still positive, there will be a negative spread between the top line premiums and expenses, the claims. Therefore, there could be some underwriting margin compression or contraction going forward.”
Among the primary factors contributing to the industry’s positive performance in 2014 was earnings from the release of prior year reserves made possible by relatively benign CAT activity, but there is no reason to believe that will persist.
“Over the past five years, the companies we cover, the underwriters, about 30 percent of their earnings have been coming from prior year reserve releases,” said Pan.
“If the earnings from prior year reserve releases is going to be slowing down, that is another headwind.”
Pan also cites relatively low earnings from the investment side, something those prior year reserve releases have helped to offset. Industry data shows that 60 to 80 percent of industry earnings comes from investments, and an average of 60 percent of industry investment portfolios are composed of fixed income instruments like bonds.
“The yield on these fixed income instruments has been under pressure for many years,” said Pan. “The 10-year U.S. treasury yield is around two percent.”
Pan points out that even if bond yields improve, investment earnings may continue to suffer. Unless yields increase by 100 basis points or more — something few forecasters expect — as older, higher-yield bonds mature, they will be replaced with new lower-yield bonds.
Robert Hartwig, President of the Insurance Information Institute, acknowledges these possible headwinds, but is still upbeat.
“No one should construe anything in this report as meaning that the insurance industry is anything other than rock solid financially,” said Hartwig.
While he concedes that all of these headwinds “exist to varying extents for different insurers,” he sees them mitigated by a variety of factors.
The trend toward consolidation could help expand margins. Modest inflation and a benign tort environment also help brighten the outlook.
The Federal Reserve’s anticipated interest rate increases will help boost investment earnings. Some of the cited headwinds could actually mitigate each other. Higher CAT activity and a decline in reserve releases, if they occur, would both ease downward pressures on price.
Most encouraging is the overall economic trend, and the industry’s recent track record of outpacing it, Hartwig said.
“We would expect overall premium values to grow somewhere around the 4 percent range and that is substantially better than the overall economic growth, which is 2.5 to 3 percent. So that means the P&C Insurance industry is benefiting from the tailwind of economic growth,” said Hartwig.
“I would certainly expect to exceed economic growth by a point or a point and a half in 2015.”
Pan sees earning requirements as creating a floor on negative pricing, but insurers may find themselves increasingly squeezed between competitive and other downward pressures on price, and a need to maintain a level of underwriting income that can offset weak investment yields.
While navigating that narrowing range may be a challenge, Pan does not see a situation where policies are left unwritten.
“Every company models risk differently,” he said, “so they might have a different pricing strategy and will make different pricing decisions.”
Buyers may see prices decrease, but they may also find themselves having to search a little harder to find insurers willing to write the policies they seek at the price they want.
Hartwig said he has faith insurers will govern themselves effectively.
“You’re not seeing undisciplined pricing in the market today,” he said.
“You’re seeing a very competitive market… There may be some margin compression but you’re not seeing irrational pricing in the marketplace.”
Pan and Hartwig both see insurers benefiting from new tools to help them make pricing decisions.
“There’s no question that insurers have better management information systems in place that allow them …to make sure that any adjustments that need to be made can be made more quickly than in the past,” said Hartwig, something that will help diminish recognition lags as well as the amplitude of the industry’s inevitable cycles.
“Advances in technology in terms of data and analytics, will help [insurers] make more informed underwriting decisions, to maintain a desirable underwriting margin,” said Pan.
“But you will find some players probably underpriced.”