The property-casualty insurance industry remains profitable. But is rapidly growing capital masking shrinking demand?

After taxes, net income for private U.S. p-c insurers fell to $37.7 billion in nine-months 2014 from $42.7 billion in nine-months 2013, according to p-c insurance industry results from ISO and the Property Casualty Insurers Association (PCI).

Overall profitability, as measured by annualized rate of return on average policyholders' surplus, slipped to 7.6% in nine-months 2014 from 9.4% in nine-months 2013 and the combined ratio deteriorated to 97.7% for nine-months 2014 from 95.8% for nine-months 2013. Meanwhile, policyholders’ surplus—insurers' net worth measured according to Statutory Accounting Principles—grew to a record $673.9 billion from $653.4 billion at year-end 2013.

That’s about 70% surplus growth over the last decade, according to Robert Gordon, senior vice president, policy development and research at PCI. And the premium-to-surplus ratio, a measurement of risk and leveraging in the p-c industry, currently stands at a record low .73—only about half the average 1.5 over the last 55 years.

“What that means is there’s too much capital in the industry,” explains David Paul, principal at ALIRT Insurance Research, LLC. “To get to those returns on equity with today’s big surplus base, you basically need to have much better underwriting results—and that’s just not going to happen.”

To sustain its historical long-term average rate of return of 9%, ISO estimates the p-c industry would need to achieve a 95.4 combined ratio—which experts agree is unlikely. “The combined ratio has only been that good or better once in the 54 years between 1959 and 2013,” says Michael Murray, assistant vice president, financial analysis at ISO Insurance Programs and Analytic Services, who notes it hit 92.4 back in 2006 in the wake of the catastrophic hurricane losses associated with Katrina, Rita and other storms. “I wouldn’t expect to get to a combined ratio of 95.4 anytime soon without the benefit of really, really good luck.”

Even with the combined ratio of 97.7% in nine-months 2014, “the industry was profitable—and would probably remain profitable even with a modestly higher combined ratio,” Murray notes. “It’s just that it might not be quite as profitable as it used to be.” And any underwriting profit is rare for the p-c industry—it’s happened only five times in the last 11 years and hadn’t occurred since the 1970s prior to 2004, according to Paul.

But in addition to investment income and another low cat year, profitability in nine-months 2014 is largely attributable to “prior-year reserves being released into earnings,” Paul says. Although reserve development dropped to $8.9 billion in nine-months 2014 from $13.6 billion in nine-months 2013, it was still favorable in 2014—perhaps attributable to an inflation rate that’s been “much more moderate than insurers expected when they set their reserves,” Murray says.

Reserve releases differ by line of business—“personal lines will tend to have smaller aggregate changes because it’s an easier line to reserve for, whereas commercial lines is very fragmented,” Paul explains—but their role in last year’s profitability draws into question the sustainability of insurers’ earnings. “You never want to depend on reserve redundancies,” Paul says. “The big question on everyone’s mind is are these reserves truly redundant? And if they are, by how much? How much more lift are we going to get from that moving forward?”

In light of a declining unemployment rate and strengthening economy, “it seems rather inevitable that eventually wage increases and overall inflation will accelerate,” Murray says. “Whether this ultimately means that insurers will have to add to loss reserves and take a bite out of underwriting profitability depends on how actual inflation in the future compares to what insurers anticipated when they put up their reserves.”

According to Gordon, the industry is also experiencing a “troublesome trend of industry profits reverting to being increasingly dependent on investment income as opposed to focusing on underwriting returns”—especially when it comes to the enormous influx of capital from outside sources like hedge funds.

“One of the concerns is if you have a lot of outside investors who are dabbling in the marketplace, what happens when the next major event inevitably hits?” Gordon asks. “Everybody’s been debating how much of that investor influx of capital is permanent and how much is temporary based on their perceived risk appetite and the alternative investment returns available.”

“When you have such a significant growth in surplus compared to a decline in real terms in underwriting premiums, what you also have is record safety and soundness in the industry,” Gordon says. But deteriorating combined ratios coupled with unusually low interest rates and the fact that “growth in the industry has been somewhere between 11-13% over the last decade” paints a troubling picture, he adds. “That’s roughly only half the rate of inflation and close to only a third of the growth in nominal GDP—and that suggests an industry that has rapidly growing capital but shrinking real demand in the traditional markets.”

What do the results mean for carrier stability in 2015 and the long-term future of industry market cycles? Keep an eye on IAmagazine.com and upcoming issues of the News & Views e-newsletter to find out.

Jacquelyn Connelly is IA senior editor.