Natural Disasters Pummel Property and Casualty Insurers

By Gavin Magor | October 5, 2011

Property and casualty insurers are having a tough year. Natural disasters cost money, and guess who ultimately pays — the consumer.

Devastating drought, failing crops, Hurricane Irene’s rage, Texas wildfires, hundreds of tornadoes throughout the Midwest, Tropical Storm Lee and record-breaking rainfall are just a few of the year’s weather disasters that have pummeled property and casualty insurers.

The property and casualty industry report of a $3.4 billion loss for the second quarter of 2011 compared with an $8.95 billion profit during the same period of 2010 is proof of just how costly weather disasters can be. And it isn’t likely that the third quarter will bring much relief to an industry weary of events they can’t always anticipate and definitely can’t control.

Weiss Ratings financial analyst Gavin Magor commented,

“These losses are not good news for anyone. The property and casualty industry suffered enormous losses first from bond insurers, then mortgage insurers as they weathered the financial crisis. Now the contagion has spread to the insurers that all households rely upon, home and auto companies.

“It is likely that we will see some insurers come under significant pressure in the coming year, making mergers and failures highly probable.”

The homeowners insurance segment has been under pressure for some time. And it is more than likely that insurers’ high claim costs will be passed along to homeowners who will see a significant rise in premiums next year.

Property and casualty insurers, especially those offering auto and homeowner policies, earn income from the difference in premiums and expenses, as well as investment income. For many years it’s been accepted industry practice for the insurance companies to take small losses on the premiums they charge for coverage because the money they were making investing those premiums more than covered that loss.

But just like every other investor, insurers’ investment income has taken a big hit, dropping 14.2% from $56.5 billion in 2007 to $48.5 billion in 2010. This is particularly concerning, because insurers generally invest primarily in high-quality AAA-rated bonds that would normally hold their value. But today’s investment world is different.

With their income stream damaged, and the probability of lower investment returns for the foreseeable future, property and casualty insurers will be forced to raise premiums to offset their losses. And that will increase the pressure on individual household budgets at a time when families are already struggling to keep up with the rising costs of essential consumer goods like food and gas.

Families that are unable to absorb premium increases may be forced to reduce or eliminate their insurance coverage. Consequently, insurers will undoubtedly face reduced premium income. Left with less cash to invest, insurers will be pressured to improve their investment returns to make up the difference. But just how they can do that in today’s unstable securities markets remains to be seen. It’s the proverbial “Catch 22” scenario.

Because of their obligation to pay claims from premiums they receive, insurers have historically invested in high-quality securities, settling for lower returns in order to safeguard their principal investments. The conservative investment approach gave some certainty to their ability to pay claims.

But in order to maintain the returns they need to meet current and anticipated claims, insurers have already been forced to invest in riskier instruments. This departure from conservative investing is evidenced by a 50% increase in the amount they’ve invested in junk bonds since 2007.

A reduction in premium income will aggravate the situation further, but there are few alternative investments that will produce the returns they need. The consequences of this strategy could be severe for insurers and their clients, especially if the overall economy deteriorates further and significant losses result.

Gavin Magor, senior financial analyst at Weiss Ratings, has more than 25 years of international experience in credit-risk management, insurance, commercial lending and analysis. He leads the firm’s insurance ratings division and developed the methodology for Weiss’ Sovereign Debt Ratings.