A View From The Press Box

From my experience, the investor, regardless of his portfolio, wants to make the maximum return possible, at the least risk. Okay, the markets don't work that way, but in an ideal market, that would be the scenario.

If you asked the average citizen to invest a million dollars with the chances of it earning zero or losing it all, or in fact owing more than they invested at the end of the year, they would say you're crazy. Regardless if they made double digits in the markets the past several years, they would still be directing you to the nearest psych clinic for even suggesting such a gamble on their part.

Yet, here we are in such a similar situation, being blamed for making a good profit some years while losing our proverbial tail others. Hmm, yet nobody seems to remember those really bad years beside those of us who plowed through them and somehow survived!

The investor who continually loses money in the market takes his marbles and puts them in another game. We don't do that; it's the only game we have.

Sure, we diversify and play the markets like anyone else, and try to gain a decent return on the investments we make. But in the final analysis, why should we make limited profits during the good years, and then lose our shirts during the bad years?

Too many have done exactly that through poor management and investment skills, and are no longer players in any game. That list is almost endless. If we all did that, who would be left to insure anyone?

As to your point that many "view insurance as a public utility [limited] to single-digit profits," profit is a reward for risk. Insurance, in general, is required to be purchased by your state or your financial source for home and auto loans.

The inherent security of this business model's revenue base does not warrant more than below-average profits.

The relative profitability of the insurance industry is also evidenced by the large number of new companies continuously entering the market. What better gauge do you need of how attractive an industry is to investors?

Also, as you, Sam, have asked in the past, are we talking about the industry relative ROE with or without the inclusion of the mutuals?

I thought so.

SAM RESPONDS:

When I posed the question raised by Bob Hunter all the time about the mutuals and its impact on industry ROE, this particular analyst (who was speaking off the record, so I will not identify him) said since he only cares about publicly traded companies as a stock analyst, his index only included publc insurers--not mutuals--and the industry ROE was still lower than the Fortune 500's.

Consumers and their well-paid representatives need to sit back and do a little self-analysis.

You have a choice who you buy insurance from--the market is open to everyone. You can choose who you pay your premium dollar to.

You also can influence costs by purchasing from a supplier that acts as you wish them to--it's called capitalism, folks!!!

No one seems to be decrying the multi-million dollar salary packages of entertainers, athletes, or film stars. Talk about a rate of return!!! Haven't seen a consumer group against $250.00 hockey tickets or concert tickets.

Let's get real, folks. Begrudging an insurance company a profit is highly selective rationale.

SAM RESPONDS:
You make some interesting points, but since insurance is a "necessary evil" in the minds of most consumers--they have to have it to buy/protect their home/car/life/business--it's a lot more "personal" to them than whether A-Rod makes $28 million or not.

Also, not too many working families are laying out $250 for a hockey tickets. Most likely, those prices are paid by the corporate season ticket holders...such as insurers!

As for the "well-paid" consumer representatives, before Bob Hunter blows a fuse, my understanding is that the consumer crowd ain't exactly rock stars. Indeed, Mr. Hunter informed me he takes no salary from the Consumer Federation of America, if I recall correctly, making his living in consulting work.

MARC RESPONDS:
Sure looks like a lot of ordinary folks in the stands to me!

However, if insurance is a necessary evil, market forces still come to bear. Even though you gotta have it, you still get to choose who to buy it from.

Markets ebb and flow according to consumer preference. The consumer has the choice to make their voices heard through market choice.

Mutuals were founded on the neighbor helping neighbor premise.The problem is finding a bunch of neighbors silly enough to want to place their dollars in a pool insuring folks who should of had enough sense not to build where Mother Nature shows her mettle.

If building codes were adhered to and some sense shown, would we be in this mess?

Let's not begrudge folks making a buck.As I said, capitalism prevails. We don't whine about other corporate entities making much larger profits. My apolgy to Bob Hunter--I was not singling him out.

Sam is right about the average consumer. If you don't know that, Marc, then your insurance paycheck is putting you out of touch.

Marc, you say, "We don't whine about other corporate entities making much larger profits."

The main point I was making is that, unlike insurance, banks and state law do not "REQUIRE" you to purchse the products and services of those "other corporate entities." Their business risk is higher, so their profits should reflect that.

Insurers seem to confuse "being in the business of risk" with "actually taking a risk."

What about utility companies and oil companies? Last time I checked we required their products and services.

Also even though it is "required," you can still choose who to buy it from. The consumer can choose to make a preference statement something you don't see in some sectors. Gasoline anyone?

Marc,

As concisely as possible: Your choice of the utility industry only reinforces my argument. Government has generally recognized the lack of choice and the "requirement" to purchase utilities, which is exactly why they have historically been so heavily regulated AND a perennial favorite low-risk, low-return investment for Wall Street, as I believe insurance 'should' be, but isn't.

Your selection of gasoline, however, is a poor choice. The insurance and petroleum markets couldn't be more different. The 'cost of goods sold' for petroleum refiners is determined on the world commodities market purely by supply and demand (discounting the artificial, but unavoidable, influences of OPEC and politics). The COGS for insurance is determined by ISO (McCarran Ferguson anyone?)

Once gasoline is produced, it is again sold on the commodities exchange to the highest bidder--classic supply and demand. Refiners benefit tremendously by this--but it is not due to any underhanded practices, although consumers would like to believe that. The price of gasoline is largely beyond the influence of any single group--even one as large as the U.S. government.

So only utilities are even remotely similar to insurance. However, going one step further, there are no state laws requiring me to purchase gasoline or electricity.

I am suggesting that as the insurance industry is the benefactor of the legal requirement to purchase their products, they need to be--more so than any other industry--accountable to the public need above their own.

Let's change gears. Answer me an honest question: Why is the insurance industry (honestly now) so opposed to any expansion of government P/C insurance programs?

Sam: a blog topic idea perhaps?

SAM RESPONDS:
Now that you have raised it, it's already a blog topic idea--but the answer you might get would likely be two-fold...One, a genuine interest in keeping the government out of private markets, and two, a self-serving interest in keeping out government competition.

Informed Consumer states: "However, going one step further, there are no state laws requiring me to purchase gasoline or electricity."

Quite true, you need do neither unless you wish to drive, cook, use appliances or live in a modern age. Very likely no one will require they purchase any type insurance if they pay cash for a home, don't drive, and have a sufficient bankroll to cover all potential personal liability and casualty losses, future illness and burial expenses.

So, insurance in total, other than a 100% self-insured retention, becomes a moot point, and there is absolutely no government requirement that it be purchased.

If every consumer could be that fortunate, we'd all be in great shape--likely multi-millionaires and not in need of any coverage whatsoever.

Gasoline prices, at least at the consumer level, reflect a "whatever the traffic will bear" attitude on the part of the oil companies, with prices rising long before the daily crude costs ever hit the pipelines or refineries.

The prices at the pump are projected on future costs, and if the insurance markets projected the increased costs of a suggested bad hurricane season due to season forecast projections by NOAA, there would be hell to pay in the regulatory sector as well as the consumer markets.

Yet that happens every day with fuel prices, and it seems that's no problem in Washington or anywhere else, as petroleum producer profits--even following Hurricane Katrina and their down time--went through the roof.

No matter how much or how little the industry makes, we're going to be villified.

The fact that a given product or service is compulsory doesn't necessitate that government price controls are necessary or that the business is necessarily low risk.

The P&C insurance business as a whole can't be classified as low risk or high risk, but sub-classes of business can. Lines of business such as personal auto coverage have little volatility or accumulation risk, and I would agree would earn below-average returns.

Lines of business such as property coverage in catastrophe-exposed areas of the country or large commercial general liability coverages are extremely risky with large accumulation risk--whether natural (hurricanes and earthquakes) or legal (asbestos and environmental).

These lines of business will require large expected returns to incent investors to deploy capital to these lines of business.

At the end of the day, heavy-handed intervention via rate regulation isn't necessary in competitive markets. In most lines of business and regions of the country, there are hundreds of companies fiercely competing for business.

When government steps in with rate controls, it discourages investment in lines of business and coverages that need new entrants the most.

In fact, I would argue that government intervention in rate regulation is almost uniformly harmful to consumers. It results in cross-subsidization of higher-risk insureds, encouraging further risky behavior that further exacerbates the frequency and severity of loss.

It also discourages innovation and erects barriers to entry for potential new companies.

Furthermore, where there is inadequate competition in a given region or line of busineess, it is almost always the result of excessive and unreasonable regulation that sets rates at a level below that acceptable to investors for the risk they assume.

Usually this situation is greeted with a downward spiral of still greater regulation until the private market is completely driven out (see Florida homeowners).

Lastly, ISO most certainly does not set the Cost of Goods Sold for the insurance industry. It does attempt to estimate COGS, but only after excessive meddling and interference by state regulators.

Also, their estimates have been known to vary widely from the actual results (and thus the true COGS). Not to mention many companies do not subscribe to ISO and file their own rates.

What follows is a couple of sections copied from the Consumer Federation of America's white paper on insurance profits from earlier this year. The footnotes showing sources and explaining certain statements are not replicated.

While the data could be updated, this section explains in some detail why P/C insurers, even just the stock insurers, do not need RORs as big as the S&P 500. Certainly, no one should include mutuals in any comparison of P/C RORs with the S&P figures!

"If one owns a property/casualty insurance company stock, one has, with few exceptions, bought into a low-risk business, lower in risk that the market in general. This is shown in ValueLine statistics, which assess the riskiness of particular stocks.

One key measure is the stock’s Beta, which is the sensitivity of a stock's returns to the returns a particular market index, such as the Standard & Poors 500.

A beta between 0 and 1 represents a low-volatility investment, such as most utility stocks. A Beta equal to 1 matches the index, such as the returns yielded by an S&P index fund. A Beta greater than 1 is anything more volatile than average, such as most “small cap” funds.

Another measure of a shareholder’s risk is the Financial Safety Index, with a range of 1 to 5, 1 being safest and 5 being least safe; 3 is an average risk.

A third measure is the Stock Price Stability assessment, reported in five percentile intervals with 5 signifying the lowest stability and 100 the highest stability. 50 is average stability.

Consider Allstate. At the same time the company has taken draconian steps to sharply raise premiums and/or cutback coverage for many homeowners in coastal areas , it has presented shareholders with very low risk: Beta = 0.90; Financial Safety = 1, and Stock Price Stability = 95.

ValueLine posts results for 26 property/casualty insurers. The simple averages for these carriers are: Beta = 0.97; Financial Safety = 2.4, and Stock Price Stability = 83.

By all three measures, property/casualty insurance stocks are of below-average risk, safer than buying an S&P 500 index fund. Therefore, long-term below-average returns for insurers should be expected given the low-risk nature of this investment.

The low returns demonstrate that the capital market is performing efficiently by awarding below-average returns to a below-average risk industry.

This aggregate data actually understates industrywide returns on equity for several reasons:

1. Industry aggregate data includes information from mutual companies like State Farm with massive capitalization. As a non-public mutual company, State Farm has no need to achieve a target return on equity as it must only satisfy policyholders, not shareholders.

State Farm had 7.6 percent of industry net income, compared to 11.9 percent of industry surplus. In other words, State Farm has much more capital than a typical insurer, dragging down apparent industry-wide earnings because of its massive capital base.

If data on State Farm’s return on equity is removed, the industry-wide average increases by more than half a percent.

2. Publicly-traded insurers have achieved returns on equity in 2005 and 2006 that are much greater than the "Fortune 500” average.

For example, Allstate reported a return on equity of 23 percent for the year ending on Sept. 30, 2006. Progressive reported a nine-month return on equity of 24.3 percent on mean surplus.

3. The property/casualty insurance industry is tremendously overcapitalized. It is bringing in too much capital to warrant a higher return on equity.

The excess capital is evidenced not only by the low industrywide premium-to-surplus-ratio mentioned below, but also by the premium-to-surplus ratios of the most profitable insurers.

For example, Allstate and Progressive not only have premium-to-surplus ratios much greater than the industry average, but are also buying back their own stock because they have too much capital to reasonably or profitably deploy.

In October 2006, Allstate announced a new $3 billion share repurchase plan starting in 2007 that will “complement” the $12.8 billion program that was completed at the end of 2006.

The fact that Allstate still has a stock buyback program in place at the same time it is sharply reducing or eliminating coverage because it says it is financially threatened by the risk of future weather catastrophes is stunning.

Similarly, Progressive announced that it was buying back 1.1 million shares in April 2006. A representative of the investment firm Bear Sterns stated that the share repurchase was necessary because “both management and the board are working to address the company’s significant excess capital position.”

In August, Safeco announced a $1.4 billion repurchase for almost 20 percent of its outstanding shares.

4. Proof that the investing in insurance companies represents a below-average risk is also found in the market action of the property/casualty insurer stocks.

Since June 17, 2002--the date S&P started to track insurance stocks-- S&P 500 stocks have increased by 43 percent through year-end 2006, while the S&P Insurance Index, weighted down with life insurance stocks, increased only 33 percent. During that time, however, the value of Allstate’s stock rose by 65 percent and Progressive’s by 62 percent.

The simple average increase of the property/casualty insurance company stocks in the S&P Insurance Index was 48 percent over that period--slightly higher than the S&P 500 and more proof that the property/casualty insurance industry overall does just fine with returns on equity less than that of the S&P 500."

I'd like to reiterate my earlier comment.

At the risk of stating the obvious, not all P&C insurance risk is created equal. While State Farm's personal auto book of business and much of their homeowners business is very low-risk and would not require huge capitalization for shareholders or policyholders, catastrophe-driven business is much different.

Allstate has decided through internal policy and reinsurance purchases to get as far away from the cat game as possible. For companies that assume this catastrophic risk, it is necessary and appropriate that they earn above-average returns over the long run for the significant risk they assume.

The idea of industry capitalization is a misnomer. The industry as a whole doesn't pay individual losses--individual companies do. There are mutuals and non-cat and non-mega-tort carriers that are certainly excessively capitalized. However, this is of little benefit to other market participants that do assume this risk.

If I am an undercapitalized company writing Florida homeowners, I can't ask Progressive to pay my claims (with the glaring exception of insolvency funds, which is another topic). Many of the participants in this sector of the market are facing significant capital constraints, and their limited capacity is appropriately translating into higher prices for coverage.

Lastly, I see no reason why an insurance company should willingly under-price catastrophe risk, knowingly allowing good risks to subsidize the poor. It's poor policy and irresponsible to policyholders.

Actually, I don't know why I bother to argue this point. The market response of carriers and investors to price ceilings on catrastrophe coverage is blatantly obvious.

Without acceptable returns, the capacity will NEVER be there in the private market. The alternative of having the public (i.e. government) fund the risk is the inevitable under-pricing of risk, which leads to even larger losses and higher costs in the long-run because of lack of incentive for insureds to avoid risk.