Financial disaster, like lightening, seldom strikes the same place twice. Government Employes Insurance Corp. went to the brink of bankruptcy during the latest round of rate cutting in the casualty-insurance industry, and a different company will suffer a similar fate before the current round of price cutting ends.
There is an adage in this competitive business that the casualty-insurance industry can't stand prosperity. After a few years of good profits, rate cutting breaks out and continues until some disaster frightens insurance; executives enough to cause them to start raising rates again.
It took a double-barrelled disaster to end the rate war of the mid-1970's. Unexpected inflation pushed underwriting losses to their worst level in history, while a bear market in stocks eroded the value of insurors' assets. As Geico teetered on the edge of insolvency, frightened insurors switched from competitive rate cuts to competitive rate increases.
Rising policy rates led to large profits in the late 1970's, and those large profits in turn led to the current outbreak of rate cutting. While rounds of rate cutting are a normal part of this competitive business, this particular round has enough unique features to make it both interesting to observers and agonizing to participants.
Underwriting losses this time are likely to be the worst in history. The old record was set in 1975 when insurors lost 8 percent on every dollar of premiums they received. This time the loss is likely to be much larger because investment income is so much larger.
Most insurors make the bulk of their profits from investing money between the time it comes in as premiums and the time it goes out as claims and expenses. As interest rates rose far into double digits, they provided lost 4 percent on each premium dollar it received, but that loss was more than offset by the yield on debt instruments, which spent much of the year above 15 percent.
The desire to go on enjoying that investment income is a major driving force behind the current rebound of price cutting. Underwriting losses this year are likely to hit a record 10 percent of each premium dollar received, but even that level is bearable when the yield on investment income is even higher. Guessing how bad underwriting losses will get is a popular pastime for insurance executives and analysts.
High interest rates are a very mixed blessing. They raise the level of investment income generated on new investments while lowering the market value of older, low coupon bonds. Insurors, alas, have a good many of those older bonds.
After absorbing large losses in stocks during the bear market of 1973-4, insurance executives vowed never to make that mistake again.Instead they made the different mistake of investing heavily in long-term bonds just before interest rates soared to record levels. If insurors carried their bonds at market value rather than at cost, they would suffer dramatic declines in their net worths. Analysts at the First Boston Co. estimate that valuing bonds at market prices would reduce Aetna's net worth from $40.77 per share to $8.14 and Travelers' net worth from $62.60 per share to $18.08.
Due to what may be the worst accounting practice in American business, insurors need not value their bonds at current market prices. They must value stocks at market prices but can value bonds at cost until they are sold.
This accounting practice would be only a quaint fiction except for its potential impact on rate cutting. Any insuror that tries to drop out of the rate-cutting war faces the prospect of losing business. Losing business also means losing assets, so the insuror may be forced to sell low coupon bonds and recognize the loss in its accounting statements. Since no insuror wants to recognize losses, there is a strong incentive to compete vigorously by rate cutting to hold the business it has.
Rate cutting generally ends in disaster, but Aetna is trying to stop well short of that. Recently Aetna announced it will raise policy rates in response to a competitive marketplace which has "reached an intensity unparalleled in this business."
In a less competitive industry, Aetna's attempt at price leadership might work. Because there are scores of casualty insurers selling uniform policies to price-sensitive buyers, no single company can hope to stop competition. The response of other insurors to Aetna's initiative is likely to be a chorus of agreement and a continuation of rate cutting as usual.