Industry Suffers From Economic and Deflation Threat

The U.S. economy continues to experience slow economic growth with the overhang of a global slowdown from weakness in the European community. While the U.S. Government pushes for greater government stimulus (i.e. spending) among the G20, most European countries are focused on budget restraints. This is in part due to strain on the euro, the market’s common currency as well as budgets that are exceeding current receipts unless governments bring some cost constraints into play. Without such limitations on current account expenditures in a number of countries (k/a the PIIGS) their existing debt burden in relation to GDP will become unsustainable as debt costs rise. Several countries have already seen their credit ratings drop in recent months raising debt service costs. The U.S. faces similar issues on debt carrying costs assuming there is a ready market for our debt securities in foreign countries such as China.

We just can not discount the global leverage implications on the U.S. economy as well as our own fiscal requirements as part of the world economy. Some are predicting a double-dip recession while some of us think we have not left the previous recession that we described as a “U” shaped recovery.

Insurance and the Economic Environment

One of the market barometers has been the broker survey produced by the Council of Insurance Agents and Brokers with the latest 2^nd Quarter 2010 results shown below.

Source: Council of Insurance Agents and Brokers, quarterly survey reports (3Q and 4Q 2010 estimates by CR Market Strategies Inc

This 14 quarterly surveys (plus 2 quarterly estimates we provided) clearly shows just how competitive this market has been over an extended period of time. Although the market looked as if it was ending its competitive market cycle during 2008 as rating declines subsided, the economic reality of the “Great Recession” altered that direction into a period of sustained rate competition. The recent data shows that it has become more intense as the economic recovery has stalled.

The Reality of the 2010 Economic Environment

If the commercial insurance market reflects the economic reality, what is the market outlook? It might be appropriate to look at the market components to see just how they impact the insurance market.

GDP Data: This overall measure of the economic activity can provide an overview to the general health. The overall economy grew by 2.4% in the second quarter a decline from the previous quarters of 3.7% and 5.0% respectively. We have technically not been declared “out of the recession” so any claim of recovery is premature, at best.

GDP-Consumer Consumption: The components of Real GDP at times will mask the actual consumption rate that indicates  how significant the consumer is participating in the economic recovery.

Employment: I have discussed this at length in previous Newsletters #36 but the overall concern is that 14 million workers are still unemployed. That translates into a significant loss of consumer discretionary spending discounting spending via unemployment benefits.  Notwithstanding the drop in the unemployment rate from 9.9% to 9.5% last month, that was partially reflective of census and other workers dropping out of the work force….. a statistical variance. With our “under-employment” rate still at 14% the consumer spending levels are suppressed that can’t be entirely replaced by temporary government or “stimulus” spending.

Real Estate: The housing market bubble that was seen as the catalysts for the ignition of the recession is still attempting a recovery but with little success given potential buyers without jobs!  Single family home starts that exceeded 1.7 million in 2006 are now at 434,000 in June 2010. Home prices are down in virtually all markets, some more then others with banks withholding some listings of foreclosed properties so as not to flood the market and cascade market prices lower. There are a reported 18.9 million homes vacant (new and resale) and second quarter home seized reached 269,962 (per Realty Trac Inc) with foreclosures likely to top 1 million this year. Unemployment is causing more delinquencies and overall home ownership rates are falling.

Debt Leverage: While mortgage rates are at historic lows it has not produced any surge in the housing market as unemployment weighs heavily on new construction and the re-sale market. The amount of debt that households incurred was unsustainable once jobs were lost and real estate values declined. Consumers are no longer as active in this new economy (see Final Sales Chart above) so government has stepped up spending but that is only a very short term stimulus. Households have been reducing debt but some of that has come from a major increase in bankruptcy rather then voluntary pay down of obligations. Government debt has escalated based on current spending and the long term outlook that could hamper future economic development. It also suffers from the legacy of public pension plan costs that can no longer be supported by borrowing or tax revenue.

• Sales Tax Revenue is down as consumption declines;
• RE Tax Revenue is down based on assessed valuations geared to declining property market values so municipal budgets are being scaled back;
• Income Tax Revenue is down as unemployment is high.

Corporations Sitting on Cash

A report earlier this year (May) by Fitch Ratings studied 308 U.S. companies finding that capital expenditures fell16.6% in 2009 but had growth plans of only 3.1% for 2010 and 1.4% for 2011.

Source: CFO Magazine July/August 2010

So it seems companies are holding onto cash given the uncertainty of the economic outlook with some multinationals holding more of their cash outside the U.S. since repatriating income earned would generate U.S. tax. As long as companies hold back cash investment and banks hold up lending because of uncertainty, the market recovery will be stalled.

Does that mean a “double-dip” recession or the possibility of deflation is on the horizon?

Deflation….should we be worried?

While the Fed has its monetary policy focused on inflation the potential of a double dip recession may not be likely nor is the prospect of deflation. Although the Fed has used much of its tools to combat the financial crises, it would still have some room should the economy falter as it appears to be on the verge of doing. Deflation isn’t necessarily bad if it comes from increased productivity in combination with strong consumer demand. But if demand is weak against production, the lack of pricing power will push prices lower that in turn reduces future production capacity and employment.

For insurers the operational problem with deflation is the intense competition it would generate even beyond the pricing competition of today. The decline in asset values in all sectors coupled with competition would create a potential over-supply of capital chasing a much smaller market. Profitability would be impaired as underwriting expenses might not drop as quickly or dramatically as premium income. On the investment side the value of insurance investments as well as other assets would decline in value thereby shrinking the market resources against yet unsettled liabilities.

We have had several recessionary periods in the past decades and we are likely to have another one but we would like some recovery space between these episodes. If today we can see light at the end of this tunnel, let us hope it is not the deflationary express train heading toward us!