At first glance, there is little reason to think that the casualty insurance industry is heading for trouble. Last year, the industry earned record profits. Insurance executives swore they never would repeat the debacle of 1974-75 when the industry suffered record losses and Government Employees Insurance Co. nearly became insolvent. Today, however, there are signs that it is starting to happen again. The reason in simply competition.
Everything went wrong in 1974-75. After a few years of record profits, rate cutting broke out as companies competed to enlarge their share of what they though would be a lucrative business. It didn't turn out that way, largely due to unexpected double-digit inflation.
Expected inflation doesn't hurt casualty insurers because actuaries include it in their calculations of future costs. The insurance business is one of the few industires that must price its product before it knows its costs, so accurate cost projections are vital. Few actuaries in 1973 expected either the general inflation in the economy or the social inflation of the juries becoming much more generous.
Anticipated profits turned to large losses as insurance companies had to pay inflated claims costs. In 1975, the industry lost a record 7 cents for every $1.00 it received in premiums. This underwriting loss was cushioned to a large degree by earnings on investments, but even that cushion was a mixed blessing because many companies invested heavily in common stocks that declined sharply in the bear market of 1974.
Large losses among casualty companies produced a feeling of near panic. Geico, once a permier insurer, came perilously close to insolvency, and executives of other companies feared the same fate for their own firms. Rate cutting was a thing of the past as companies raised rates 30 percent or more in some cases simply to survive. State insurance commissioners joined in by approving sharply higher rates to prevent insurance companies from pulling out as Geico did in New Jersey.
The sharp rate increases of 1975-77 led to the current high level of profits, but that high level of profits in turn led to a renewed outburst of rate competition. Competition now takes the form of keeping rates roughly level while inflation raises costs by 10 percent or more each year. That kind of trend quickly reduces profits and turns them to losses if it continues. It is likely to continue as companies seem willing to accept an underwriting loss in order to obtain the funds to enhance their investment income.
Contrary to popular belief, the casualty insurance industry does not make much of an underwriting profit. For every $1.00 it collects in premiums from its customers, it pays out roughly that amount in claims and administrative costs. The major source of profit is the income earned on the funds kept between the time they come in as premiums and the time they go out as costs and claims. This investment income has become even more important as bond rates have climbed in recent years.
It is perfectly rational for an insurance company to accept a 4 percent underwriting loss if it can offset that loss with 10 percent income earned on invesments such as bonds. That seems likely to happen, and even the most hopeful observers expect the industry to experience an underwriting loss next year.
In 1974-75, rate-cutting competition ended with a bang as panic over unexpected inflation and fear of insolvency forced large, quick rate increases. This time, inflation is no surprise so panic is less likely. The most likely outcome is an extended period of rate competition because few companies will raise rates if that means giving away business and thus reducing the premiums that generate investment income.
For Geico in particular, it means a new challenge. The first challenge for John Byrne, its new chairman, was to save the company during a period when, if the full extent of the disaster had been known at the time, the company might have been left to die. Through a combination of rate increases and painful cost cutting, Byrne started Geico back in the right direction from near insolvency. Losses were so great at one point that the company no longer was hemorrhaging red ink because it nearly had run out of capital, so Byrne arranged a transfusion in the form of a preferred stock offering plus aid from other insurers.
The rescue operation was a complete success. Geico is now a solidly profitable company. From a position of being starved for capital, Geico has generated enough surplus to buy stock of its sister companies and to reduce its own equity through a recent exchange of debt for stock.
Geico's next challenge is to survive the coming period of rate competition. During this lean period, the critical factors will be Geico's ability to control costs and its willingness to give up unprofitable business even at the expense of reduced investment income. Byrne has made an excellent start toward restoring Geico as a superbly managed company, but only time will tell if the company comes through the next few lean years intact.
There is an adage that the casualty insurance business cannot stand prosperity. any period of prosperity generally leads to rate competition among the scores of insurers selling a standardized product to price-sensitive consumers. The current rate competition among casualty companies is a classic example of how free competition reduces unusually large profits, motivates managements to reduce costs, and in general provides the consumer with a good product at a fair price.