Evolution & Structure of U.S. Insurance: Focus on Life & Property-Liability Sectors - Prof, Study notes of Introduction to Business Management

Download Evolution & Structure of U.S. Insurance: Focus on Life & Property-Liability Sectors - Prof and more Study notes Introduction to Business Management in PDF only on Docsity! 12/28/2007 The Structure and Performance of the US Insurance Industry By Robert W. Klein A. Evolution of the U.S. Insurance Industry Dramatic changes have occurred in the US insurance industry since its beginnings in the late 1600s (Hanson, et. al., 1974). In its early years, small local and regional carriers, writing primarily fire and traditional life insurance, dominated the industry. Since then, it has grown tremendously in terms of the amount and variety of insurance products and the number of insurers. Today, companies of various sizes selling a vast array of products across state and national boundaries populate the industry. A wide range of insurance services has become available to buyers, reflecting the growing national economy and diversity of buyer needs and tastes for insurance protection. The industry continues to evolve as it consolidates, insurers restructure their product lines and companies extend their global operations. The tremendous growth of the private insurance industry in the United States is reflected in Figure 1, which plots industry income (premiums and investment income), in constant dollars, relative to gross domestic product (GDP) over the period 1960 to 2000. Total industry income increased from $184 billion (measured in 2000 dollars) in 1960 to $1,168 billion in 2000, a 534 percent rise in real terms. The industry grew considerably faster than the overall U.S. economy. Insurance represented approximately 7.4 percent of GDP in 1960, compared to 11.9 percent in 2000.1 The number of insurance companies 1 The comparison of industry income with GDP should be qualified because they are defined differently. Industry income essentially reflects all revenues flowing through the industry, while GDP only reflects the value added by each industry. Hence, the value added by the insurance industry, i.e., the value of the actual services provided by the insurance industry, is less than its revenues which include benefit payments. 1 also increased from 4,580 in 1970 to 6,094 in 1990 (III, 1998; ACLI, 1998).2 This figure has since dropped to 4,009 in 2004 – 2,700 property-casualty insurers and 1,309 life- health insurers – which reflects the consolidation of the industry (III, 2007; ACLI, 2007). The fact that the number of insurers has not increased as rapidly as their real income indicates that the average size of an insurer has increased, which has been furthered spurred by mergers and acquisitions. Industry growth also is reflected in the rise in industry employment from 1.5 million in 1970 to 2.3 million in 2005 (III, 2007). Structural trends affecting the insurance industry are discussed in some detail below for each sector. One trend common to all sectors is increasing financial risk. This increased risk, combined with other economic events, caused the number and size of insurer failures to increase significantly in the early 1980s until the early 1990s, as shown in Figures 2 and 3. Only 20 insurers failed every year, on average, over the period 1976- 1984, compared to 70 failures per year for the period 1984-1993. The number of property-liability insolvencies began increasing in 1983 (as the commercial lines market softened) and did not begin to drop until 1993. Life-health insolvencies did not begin their rise until 1986 and began to decline in 1992. Life-health insolvencies were particularly frequent in the years 1989-1992, when life-health insurers struggled with asset problems. Both property-liability and life-health guaranty fund assessments However, the comparison does provide a crude indicator of the relative growth of insurance in terms of its control of resources. 2 This estimate of the number of insurance companies may be somewhat conservative and does not include non-traditional insurers. 2 to the strengthening of insurer solvency regulation in the late 1980s and early 1990s. After 1994, insurer insolvencies decreased dramatically to prior levels only to rise again during the period 2000-2002 in the property-liability sector as a consequence of soft market conditions in the last half of the 1990s and early 2000s. Property-liability insolvencies fell again after 2002 as weak insurers were weeded out and market conditions improved. The numbers of life-health insolvencies has remained relatively low since the early 1990s. Despite more recent favorable trends, the industry still faces a number of threats such as natural and man-made catastrophes, uncertain asbestos and pollution liability obligations, soft pricing, competition from other financial institutions and cyclical downturns in the economy continue to pose a threat to insurers’ financial health. Hence, regulators must be vigilant in detecting and responding to adverse trends to maintain the industry’s financial solidity. B. Property-Liability Insurance Markets The nature of the property-liability insurance business is quite different today than it was 50 years ago. In the industry’s infancy, local stock companies and mutual protection associations formed to provide property and fire insurance in a particular community (Hanson, et. al., 1974). Over time, property-liability companies have expanded the types of insurance they offer and the geographic area of their operations. Property-liability insurers now cover a wide range of exposures, from residential fire to managerial liability. The industry continues to innovate in developing new products, as 5 well as retuning old ones. This has increased the complexity of the business and, in some instances, its risk and uncertainty. One of the significant factors causing increased risk in property-liability insurance is the long payout pattern for commercial liability lines, which makes proper pricing and reserving difficult and subject to manipulation. Shifting liability rules also increase the margin for error and insolvency risk. Cyclical pricing and periodic crises, prompted by severe loss shocks, have plagued the industry (Cummins, et. al., 1991). Significant cost inflation in certain commercial lines has induced some buyers to purchase coverage from alternative sources, such as surplus lines insurers and risk retention groups or become self-insured. Another alternative available to some businesses is the formation of a captive insurer or affiliating with other similar businesses to form a group captive insurer. These developments have increased competitive pressure on traditional insurers. Weather changes, severe storms, earthquakes, terrorist risks and extensive building in high- exposure areas have increased catastrophe hazards in property lines. Insurers’ profits increased in 2002-2004 due to hard market conditions, but in the long term, greater risk will continue to pose significant challenges for property-liability insurers. 1. Standard Market a. Market Structure Table 1 provides historical trends on the portion of the property-liability insurance industry represented by traditional or standard insurers (i.e., insurers domiciled and licensed in the United States). There are still a significant number of small, independent insurers selling property-liability insurance in a limited geographic area. 6 However, large national carriers now account for a larger share of many markets, relegating other insurers to niches they are better positioned to serve. The top 10 property-liability insurers accounted for 45.7 percent of direct premiums written in 2005, compared with 34.4 percent in 1960. Foreign companies also are making increasing inroads into the U.S. domestic market while some U.S. insurers are establishing a significant presence overseas. Fierce competition has forced insurers in all sectors to streamline their operations and abandon unprofitable lines. A number of insurers have sold marginal segments of their business and are concentrating on areas where they believe their core competencies and best opportunities lie. This is reflected in increased market concentration in certain lines of business. Table 1 Property-Liability Insurance Trends 1960-2005 1960 1970 1980 1990 1995 2000 2005 No. of Companies NA 2,800 2,953 3,899 3,358 3,215 2,700 Assets ($M) 30,132 55,315 197,67 8 556,31 4 765,23 0 1,034,09 0 1,398,24 5 Revenues ($M) 15,741 36,524 108,74 5 252,99 1 296,63 7 341,590 475,200 Net Premiums Written (%) 95.1 94.3 89.6 86.9 87.6 87.7 89.6 Investment Income (%) 4.9 5.7 10.4 13.1 12.4 12.3 10.4 Market Share of 10 34.4 36.8 38.2 40.3 40.0 43.7 45.7 Largest Insurer Groups (%) Premiums/Surplus (%) 125.5 210.2 183.4 157.6 113.0 75.6 89.9 Return on Net Worth (%) NA 11.6 13.1 8.5 9.0 6.8 10.4 Source: NAIC, A.M.Best, and Insurance Information Institute 7 Table 3 By State in 2003 State Premiums Written by Non-Domestic Domestic Non-Domestic Market Companies Companies Share (%) Alabama 900,267,139 5,682,833,055 82.3 Alaska 181,618,892 1,251,095,797 85.3 Arizona 777,792,149 6,983,568,872 80.6 Arkansas 208,162,822 3,539,151,073 94.5 California 16,444,163,882 53,564,292,065 58.1 Colorado 305,468,054 7,509,547,461 95.1 Connecticut 1,004,889,877 6,611,371,977 84.5 Delaware 257,977,300 1,947,315,041 73.9 Dist. Columbia 40,994,919 1,396,217,240 96.3 Florida 7,000,337,797 30,205,241,554 81.9 Georgia 1,333,434,342 11,954,557,512 86.7 Hawaii 624,614,480 1,856,233,351 72.5 Idaho 245,655,043 1,561,671,504 75.0 Illinois 9,406,087,286 21,812,758,794 41.8 Indiana 2,862,147,129 9,581,771,361 65.6 Iowa 1,060,770,477 4,128,100,505 69.4 Kansas 467,927,183 4,145,818,129 82.5 Kentucky 846,064,629 5,414,909,907 83.0 Louisiana 1,556,745,408 7,254,972,572 84.0 Maine 497,972,606 1,836,930,609 74.6 Maryland 1,007,373,785 7,778,168,558 87.1 Massachusetts 5,082,705,459 11,277,608,668 51.2 Michigan 7,961,061,383 15,709,284,717 53.3 Minnesota 1,124,174,295 8,433,772,082 81.2 Mississippi 599,664,509 3,423,030,208 80.9 Missouri 1,187,683,816 8,359,710,190 85.8 Montana 23,577,570 1,333,500,188 97.5 Nebraska 378,961,825 2,907,660,924 78.8 Nevada 208,548,809 3,471,672,085 98.4 New Hampshire 315,152,575 2,019,554,522 84.9 New Jersey 5,073,485,682 16,026,944,394 65.8 New Mexico 132,641,449 2,150,620,627 93.2 New York 7,627,300,719 32,032,342,653 74.3 North Carolina 1,579,142,677 10,439,127,039 83.6 North Dakota 142,588,397 1,122,559,371 80.6 Ohio 8,195,800,548 16,455,185,269 45.0 Oklahoma 759,774,362 4,757,007,172 85.5 Oregon 1,178,073,042 4,808,862,112 74.7 Pennsylvania 4,778,991,489 18,277,074,520 70.7 Rhode Island 374,998,056 1,823,583,349 78.5 South Carolina 418,173,096 5,380,129,924 76.1 South Dakota 118,465,808 1,315,879,123 90.6 Tennessee 1,117,064,866 7,612,450,215 85.4 Texas 14,149,114,782 32,180,911,664 60.5 Utah 297,793,384 2,730,275,227 86.9 Vermont 110,876,122 964,210,713 88.9 Virginia 330,727,811 9,303,159,237 96.2 Washington 1,577,084,606 7,987,349,617 73.9 West Virginia 73,405,599 2,151,599,237 96.3 Wisconsin 3,382,697,162 7,465,107,344 54.2 Wyoming 52,892,190 712,093,410 93.1 Guam 84,625,760 104,962,412 11.5 Puerto Rico 1,666,854,272 1,944,584,116 15.8 U.S. Virgin Islands 26,632,902 84,247,681 87.5 Total 117,161,200,221 440,782,586,947 79.0 Source: NAIC Data Premiums Written by Non-Domestic Property-Liability Insurers 10 b. Market Performance Some indicators of insurers’ profitability, one of the principal measures of market performance, are provided in Figure 4 and Table 4. Insurers’ return on net worth has generally ranged between 5 percent and 10 percent, which is below the rate of return earned in other industries (see Figure 4). This indicates that insurers generally have not been earning excessive profits. Figures on loss ratios and historical profits on insurance transactions by line (see Table 4) show fairly low profit margins in many lines. Profits also fluctuate in certain markets, with insurers experiencing some “good” years and some “bad” years. These fluctuations reflect the effects of market cycles and other factors affecting these specific lines. Table 4 Property-Liability Insurance Market Performance 1993-2002 Profit on Insurance Losses Incurred Transactions Line 2002 1993- 2002 2002 1993- 2002 Personal Auto 67.5 66.7 -0.5 2.3 Commercial Auto 63.9 67.8 0.3 -0.1 Homeowners 68.5 69.8 -4.1 -5.1 Farmowners 66.4 70.2 -6.0 -5.1 Commercial Multi-Peril 56.9 63.0 0.1 -2.2 Fire 53.3 61.3 9.2 0.4 Allied Lines 69.6 75.5 3.4 -6.6 Inland Marine 45.8 53.6 11.2 3.9 Medical Malpractice 85.8 66.7 -17.9 6.7 Other Liability 85.5 68.2 -14.0 5.5 Workers' Compensation 74.4 67.0 -0.8 6.8 All Other 70.6 68.1 2.8 6.0 All Lines 68.9 66.9 -1.3 2.3 Source: NAIC Report on Profitability By Line By State 2002 11 Figure 4 Rate of Return on Net Worth -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 R O R (% ) P-L Insurance L-H Insurance Diversified Financial Diversified Financial Life-Health Insurance Property-Liability Insurance Source: Insurance Information Institute 2. Alternative Markets and Self-Insurance One of the most significant developments in the commercial lines market has been the emergence of what is generally described as the "alternative market." In reality, the alternative market is not a single market, but a collection of risk-management and financing options that offer commercial buyers an alternative to traditional commercial insurers. These options include but not limited to surplus lines or non-admitted insurers, direct purchase from non-licensed foreign insurers, risk-retention groups and purchasing groups, captive insurers and self-insurance. Various devices have and will continue to emerge as a substitute for or complement to insurance and reinsurance. These devices include finite risk contracts, weather derivatives, catastrophe bonds and financial instruments that securitize risk transfer or offer access to contingent capital. Together, 12 b. Market Performance Table 6 provides information on the performance of traditional accident-health insurers. The table shows accident-health insurers’ premiums, total income and net gain after tax in dollars and as a percentage of premiums. The net gain for group and other accident-health insurance has ranged between -0.9 percent and 5.3 percent. Profits rebounded somewhat in the years 2001-2003, reflecting increased premiums and perhaps greater efficiencies from consolidation. Still, these profit levels would not be considered excessive. 2. Alternative Health Insurance Entities The explosion in medical costs over the past two decades has prompted a number of alternatives to traditional health insurers as a source of medical coverage. These options include health maintenance organizations (HMOs), preferred provider organizations (PPOs), provider-sponsored organizations (PSOs) and point-of-service (POS) plans, in addition to various self-funding arrangements. A number of employers have taken advantage of federal Employee Retirement Income Security Act (ERISA) pre- emptions of state regulation to set up their own group health plans and contract with various providers and vendors for certain services to help them administer their plans. These developments have occurred within the context of a general movement toward managed care and away from traditional fee-for-service or indemnity insurance contracts. 15 Premium Total Net Gain Net Gain/ Year Income Income After Tax Premiums 1994 57,289,309 62,598,370 1,679,675 2.9% 1995 60,305,224 66,869,910 1,562,541 2.6% 1996 62,453,346 68,937,397 548,139 0.9% 1997 61,600,533 67,567,803 411,535 0.7% 1998 62,829,805 68,744,768 -423,382 -0.7% 1999 66,002,782 72,859,672 -615,640 -0.9% 2000 69,580,238 76,879,047 1,899,239 2.7% 2001 68,093,106 74,908,573 670,830 1.0% 2002 71,197,678 77,261,391 2,298,357 3.2% 2003 77,668,340 83,770,005 4,135,048 5.3% 1994 22,722,519 26,576,793 504,822 2.2% 1995 24,627,497 28,858,291 391,049 1.6% 1996 24,198,328 28,522,734 465,920 1.9% 1997 24,662,370 29,378,703 595,634 2.4% 1998 25,433,963 30,489,739 520,190 2.0% 1999 27,007,205 32,931,404 487,178 1.8% 2000 29,650,035 37,463,806 -260,608 -0.9% 2001 28,374,366 37,102,242 1,144,432 4.0% 2002 33,289,978 41,210,146 1,314,994 4.0% 2003 36,501,587 45,457,975 1,903,631 5.2% Source: A.M. Best Other A&H Group A&H Table 6 Accident-Health Insurance Operating Results (in $000s) 16 Insurance companies have responded by establishing their own managed care plans and contracting with HMOs and PPOs to lower costs. There appears to be some convergence of the different types of health insurance plans, as HMOs have relaxed some of their controls while other insurers have incorporated more elements of managed care into their plans.7 These trends will continue to challenge the regulators who track and oversee health insurance markets. D. Life Insurance and Annuities Markets For many years, life insurers’ “bread and butter” were standard term and whole life policies that emphasized death benefits and offered a modest savings component (for whole life policies). That environment has dramatically changed, as life insurers now offer an expansive menu of life insurance policies, annuities and other interest-sensitive contracts with different risk-return characteristics. This shift is reflected in the fact that life insurers’ reserves for retirement-related products (individual and group annuities and supplemental contracts with life contingencies) grew from 27.2 percent of life insurance reserves in 1950 to 69.1 percent in 2000 (see Table 7).8 This figure fell to 62.4 percent in 2002 but still represents the bulk of life insurers’ policy reserves. The increased significance of interest-sensitive products and insurers’ greater exposure to disintermediation (i.e., policy loans, surrenders and lapses) has increased the importance of appropriate asset-liability matching strategies. At the same time, 7 It is difficult to assess the structure and performance of the alternative health insurance market because of the lack of a consistent and comprehensive database on alternative health care financing providers. Hopefully, over time, data on all heath care financing mechanisms will be become available to develop a more comprehensive picture of the overall market for health insurance. 8Wright (1991) provides an insightful review of structural changes in the life insurance industry. 17 1. Market Structure Table 8 presents 2003 data on the structure of different segments of the life and annuity sectors, according to financial information reported by life insurers to the NAIC. As in the property-liability sector, there are numerous insurers selling various life and annuity products. A total of 937 life insurer groups (including stand-alone companies) reported data to the NAIC and several hundred insurers offer products in each of the Table 8 Life Insurance Market Structure (2003) Pct. of Sector Number of Since 1998 Line Reserves Insurers CR10(%) HHI Entries(%) Exits(%) Life Industrial 0.6% 89 89.3 1,736 21.4 32.0 Ordinary 39.6% 774 17.2 309 6.8 23.6 Credit 0.1% 240 63.3 895 8.0 42.1 Group 2.3% 435 54.1 549 9.4 31.0 Annuities Individual 39.4% 575 43.0 438 17.1 22.0 Group 17.6% 287 22.4 382 56.0 19.3 Other 0.4% 364 41.5 296 32.8 38.8 All lines combined 100.0% 937 NA 213 4.1 33.1 Source: NAIC Data various lines. The only exception to this is industrial life, which is a relatively small market. In general, market concentration is relatively low in the other broad lines and entry and exit activity relatively high. Exits have exceeded entries, consistent with 20 industry consolidation and the decline in the number of life insurance companies and groups.9 The data on the relative market penetration by domiciliary and non-domiciliary life-health insurers (see Table 9) also reflects a pattern similar to that for property- liability insurers, with an even greater predominance of non-domestic insurers in each state. 2. Market Performance Data on the profitability and overall financial performance of life insurers is difficult to calculate on a by-line basis, but figures on the general performance of the industry are provided in Table 7. Since 1980, the estimated return on equity for the largest life insurers has remained generally within competitive parameters. The 7 percent rate of return on equity (ROE) earned by major life insurers in 2001 indicates the sector’s vulnerability to changes in the economy and financial markets. Capital/asset ratios also have moderately increased, indicating greater financial strength. Life insurers will need to operate from a position of strength to compete with the penetration of other financial institutions into some of their traditional markets, as well as expand into new markets. 9 Many exits may represent mergers and acquisitions of life insurers into large holding companies. 21 Table 9 Premiums Written by Non-Domestic Life-Health Insurers By State in 1996 State Premiums Written by Non-Domestic Domestic Non-Domestic Market Companies Companies Share (%) Alabama 365,491,125 3,012,250,890 89.2 Alaska - 733,222,004 100.0 Arizona 165,503,458 4,214,209,822 96.2 Arkansas 616,227,791 1,862,143,787 75.1 California 1,985,328,966 30,040,511,216 93.8 Colorado 247,374,747 4,719,666,645 95.0 Connecticut 3,842,918,858 4,233,039,555 52.4 Delaware 185,442,432 1,957,793,616 91.3 Dist. Columbia 946,857 1,679,699,637 99.9 Florida 2,189,655,547 16,568,144,860 88.3 Georgia 275,617,678 7,200,078,980 96.3 Hawaii 66,083,197 1,131,675,028 94.5 Idaho 564,826,660 979,002,864 63.4 Illinois 4,544,700,485 15,519,628,417 77.3 Indiana 951,327,856 5,977,936,851 86.3 Iowa 1,951,736,818 2,756,303,254 58.5 Kansas 175,922,492 2,769,193,121 94.0 Kentucky 296,468,370 2,731,875,650 90.2 Louisiana 695,503,555 3,745,671,615 84.3 Maine 51,026,454 1,209,686,499 96.0 Maryland 216,900,503 5,880,262,183 96.4 Massachusetts 1,258,371,738 7,843,576,586 86.2 Michigan 920,610,129 10,127,279,157 91.7 Minnesota 1,092,615,868 4,757,697,510 81.3 Mississippi 591,199,904 1,867,579,002 76.0 Missouri 1,081,242,339 5,858,679,253 84.4 Montana 1,128,594 762,934,902 99.9 Nebraska 782,551,254 2,182,950,560 73.6 Nevada 12,504,529 1,534,844,428 99.2 New Hampshire 23,999,852 1,320,820,229 98.2 New Jersey 1,407,081,088 10,729,073,465 88.4 New Mexico 93,584 1,496,214,935 100.0 New York 11,756,370,294 13,440,962,821 53.3 North Carolina 502,226,768 7,985,574,271 94.1 North Dakota 22,733,175 676,805,045 96.8 Ohio 2,249,618,877 11,848,813,509 84.0 Oklahoma 198,062,253 2,692,247,919 93.1 Oregon 340,091,834 2,933,260,417 89.6 Pennsylvania 716,435,646 13,473,803,342 95.0 Rhode Island 28,565,999 1,118,721,688 97.5 South Carolina 174,529,610 3,242,597,738 94.9 South Dakota 62,438,739 868,578,200 93.3 Tennessee 410,177,491 5,344,271,945 92.9 Texas 7,149,751,073 16,825,170,395 70.2 Utah 336,612,119 1,670,782,212 83.2 Vermont 20,217,409 607,576,492 96.8 Virginia 1,953,047,124 6,645,206,058 77.3 Washington 807,716,783 5,105,724,965 86.3 West Virginia 3,833,452 1,526,697,321 99.7 Wisconsin 1,160,755,954 5,228,429,889 81.8 Wyoming 240,455 493,405,203 100.0 American Samoa - 4,781,987 100.0 Guam - 56,537,846 100.0 Puerto Rico 423,157,830 430,973,818 50.5 US Virgin Islands - 85,901,835 100.0 Total 54,876,985,613 269,710,471,437 83.1 Source: NAIC Data 22