Fitch Ratings just published a special report on the state of the Insurance Industry that should have all of us a bit concerned. by Bill Gee
(centrist)
Thursday, December 29, 2011
On December 21st, Fitch Ratings released a special report on the insurance industry that focused primarily on Bond Yields. The findings are sobering for those who believe that the insurance industry can simultaneously pay for the long-term consequences of climate change while keeping premium rates low. This year, many of us have already experienced premium rate increases in the 20% to 30% range, and given this report, we can expect that number to go up significantly in the near future.
How Insurance Works
For those who don’t fully understand how your insurance company can afford to replace your entire house in the event of a fire, hurricane or tornado when your premium payments for your entire lifetime would barely cover that cost, here’s a quick breakdown.
Let’s assume you purchase a homeowners policy from your friendly State Farm agent. Every month, you send some money to State Farm and in exchange, they promise that should your house get destroyed by some calamity (excluding flood), they’ll provide you the cash you need to rebuild your house plus pay for putting you up in temporary housing while the work gets done. When you think about it, that’s a really sweet deal considering that in the days prior to insurance, you would have been homeless and hopeless.
Now your pitiful premium payment could never cover the whole amount of a total loss on your house, so what your insurance company does is they pool your premium payment with the thousands of other people who also have State Farm policies. They also purchase Reinsurance that’ll kick in should you and hundreds of your other neighbors happen to lose your houses at the same time in the same catastrophic event.
Your state insurance regulator requires that your insurance company have what they call a Surplus of premium to risk in order to write new policies. What that means is that $1 of every $10 collected in premium must be set aside in order to pay future claims. What's important to note here is that an insurance company's Surplus does not count towards a company's profit margin. So in order to be profitable, your insurance company must not only set aside premium to pay claims, but it also has to factor in a reasonable profit. State rules also prohibit direct insurers from taking "excessive profits" in order to prevent them from charging too much to policiy holders. With such thin profit margins, it's no wonder that insurance companies need to turn to other revenue sources in order to protect their bottom lines.
The Role of Investments
If Insurance companies had to depend on premium collections alone in order to be profitable and stay in business, our premium rates would be extremely high in order to meet their Surplus requirements and meet their minimum profit needs in order to stay in business and keep shareholders happy. Therefore, your insurance company invests the premium it collects in order to make up the difference. Typically, the investment portfolio of an insurance company has a yield of between 5% to 8%, but that’s changing rapidly, which is what is concerning Fitch.
A Perfect Storm
As we close out 2011, the insurance industry is facing a perfect storm, which is threatening to take down many companies in its wake.
Worst Catastrophe Year Ever – 2011 had the most catastrophes with insured losses of over $1 billion than any other year since records have been kept, and that’s just in the United States. When we add the Japanese Earthquake, European Winter Storms, and Southeast Asian floods, the toll on the global insurance industry has been devastating. This has been a trend that has continued since 1970 and as global temperatures continue to rise, the atmosphere will continue to take on greater amounts of moisture, which will only further intensify major weather events.
As cash goes out the door to pay the hundreds of thousands of insurance claims due to these multiple disasters, insurance companies must raise their premium rates in order to rebuild their depleted Surplus reserves. Translation: Higher Premiums.
Decreasing Bond Yields – In an effort to further stimulate the economy, the Federal Reserve has pledged to keep interest rates at or near zero for at least the next three years. US Treasury Bond yields are at 60-year lows. According to Fitch, the average bond yield on the investment portfolios of the top-ten insurance companies are at or below 5% and decreasing each day. That’s because as older bonds with higher yields mature, they’re being replaced by low-yield bonds that do little more than hold the cash in a mattress. For bonds that are paying high yields, namely Euro Government bonds, the risk of default is so high that most insurance companies are forbidden to buy any by state law. (This is a good thing because nobody wants to see future claim money fall into a black hole!)
As investment yields can no longer be used to feed your insurance company’s surplus requirement, they have no choice but to increase premium rates on policyholders.
What This Means For You
In the short term what this means is that your premium rates will go up significantly, if they haven’t done so already. Many customers will see their premiums go up 100% or more within the next year, especially if you live in a high-risk area. If your state doesn’t require that you hold insurance, expect to be dropped by your insurance company regardless of your risk behavior, and you may have trouble finding another company who would be willing or able to sell you a policy.
What This Means For the Insurance Industry
With this level of Surplus vulnerability, your insurance company may only be one or two major catastrophes away from insolvency. Thankfully, your state Insurance Commissioner will still pay your claim for you even if your company cannot, but good luck finding another insurance carrier if several companies become insolvent due to a major catastrophe. 2009-2010 saw the highest number of bank failures in history. 2012 may be the year the same might happen for insurance companies, both large and small.
What This Means for the Economy
I have often said that “so goes the insurance industry, so goes the economy”. That’s because macroeconomic behavior is anchored by faith. We have faith that if we take out a $200 thousand loan to buy a house and should that house get destroyed by an Act of God, we will not be left on the hook to pay for the damages or be left homeless. Without insurance, we will be much less inclined to take on those kind of financial risks, which would have a ripple effect on all other sectors of the economy. The home foreclosure rate will likely see a resurgence by mid-year and unemployment in the housing sector will likely go back to 2009 levels and above.
What To Do
Barring prayer that the wind doesn’t blow in 2012, be prepared to pay higher premiums to your insurance company both next year and the year after. If you find that peace of mind is a luxury you can no longer afford, you’re probably better off trying to sell or handing your homestead back to the bank and using what money you were going to pay the mortgage to buy a home with wheels so you can easily get out of the way when Mother Nature decides to come knocking. Don’t even attempt to get insurance for your home on wheels because you won’t find any.
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The views expressed
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