product and geographic
diversification is a
key strategy of the
company that provides
balance to current
revenue and income as
well as better future
predictability of results.”
product and risk
this improvement in the
does present a relatively
modest but real
ACE performed well in 2011 with financial results that again distinguished our company in the costliest year on record for natural catastrophes globally. With a diversified spread of business by both product and geography, a conservative approach to risk management and underwriting, and a consistent focus on execution, we outperformed the property and casualty industry as measured by operating income, book value and premium revenue growth, and ROE. Our financial results were the product of a clear long-term strategy that we have patiently pursued over the years, and this should continue to benefit us well into the future. The remarkable growth and transformation of our company continued in 2011, and at year-end ACE was the fifth-largest global P&C insurer in the world by market cap – up from #11 just five years ago and #14 a decade ago.
From Japan’s powerful earthquake and devastating tsunami to earthquakes in New Zealand, floods in Australia and Thailand and severe tornadoes in the United States, 2011 was a year-long newsreel of natural disasters that impacted the industry’s balance sheet with estimated losses in excess of $105 billion, well more than double the $48 billion from 2010 and setting a new record for the industry globally. In addition to the catastrophes, overall business conditions remained quite challenging throughout the year with sluggish economic growth in developed economies, financial market volatility fed by the Euro crisis, and soft pricing in insurance markets globally, not to mention extraordinary geopolitical events such as the Arab Spring. In the context of this environment, ACE produced after-tax operating income of nearly $2.4 billion, down 11% from 2010 – a good result relative to the industry, with most companies down on average 20%-50% or more. Our earnings included about $860 million in pre-tax catastrophe losses or twice as much as we incurred in 2010. Excluding the impact of catastrophes from both years, ACE’s operating income increased 5% over 2010.
Our strong operating results benefited from both organic growth, particularly in Asia and Latin America, as well as our late-2010 and early-2011 acquisitions – Rain and Hail in the U.S., Jerneh Insurance in Malaysia and New York Life’s operations in Korea and Hong Kong. We expect these three acquisitions to continue delivering the benefits we envisioned at the time we acquired them – namely, their revenue and earnings potential as well as their long-term strategic value – enabling us to take advantage of powerful socioeconomic trends such as America’s growing food exports to the rest of the world and the rising middle class in fast-growing developing markets. These new businesses also provide us with enhanced diversification and sources of revenue not tied to the commercial P&C pricing cycle. In November, we acquired U.S. agribusiness insurer Penn Millers to enhance our capabilities in the agriculture market, and in December, we acquired Rio Guayas Compañia de Seguros y Reaseguros, the fourth-largest non-life insurer in Ecuador, which will double our premium volume and broaden our distribution in that country – one of nine markets in Latin America in which we are active. Whether organically or through acquisitions to complement our organic activity, we will continue on the path toward greater diversification, increasing our presence where we see opportunity, and this translates over time into future top-line growth, more stable earnings power and superior returns to shareholders.
The single best measure of long-term shareholder wealth creation is book value growth, and in 2011 our book value per share grew 6% while tangible book value per share grew 7% – not exactly in line with our long-term objective or recent past but quite good considering the catastrophe losses and 2%-3% investment yields. Over the last five years, these two measures have grown at a compound annual rate of about 12%. Share price is ultimately a function of earnings and book value growth. Our shareholders benefited last year from a 14% return on ACE’s common stock, which compares favorably with a 2% return for the S&P 500 and zero growth for the S&P Property & Casualty Insurance Index. ACE’s five-year total return to shareholders – a measure that captures the combination of share price appreciation and dividends – is 28%, one of the best performances of any insurance or financial services company in the world.
Product and geographic diversification
ACE is predominantly a global commercial and specialty P&C insurance company, but we are patiently and successfully increasing the balance between products exposed to the commercial P&C pricing cycle and those that are not. This has been part of our long-term strategy. Our P&C product line covers traditional industrial commercial risks such as property insurance, workers’ compensation and general liability plans for large corporations and medium-size companies as well as specialty coverages ranging from environmental and professional liability to airport liability and oil rigs. We have two market-leading franchises, ACE USA and ACE International, which market both industrial commercial and specialty products primarily through retail insurance brokers globally. We also have three well-respected franchises that focus on specialty and harder-to-place risks, or excess and surplus lines products, distributed through wholesale brokers – ACE Westchester in the U.S., ACE Global Markets in the London market and our original company, ACE Bermuda. We also are a major writer of personal accident and supplemental health insurance globally and have a fast-growing, highly targeted personal lines business with presence in both the United States and many international markets. Complementing our P&C and A&H businesses is a relatively small but growing international life insurance business focused primarily in emerging markets. Lastly, we have a well-established P&C reinsurance business with operations globally. Products such as accident and health, life insurance, personal lines and crop insurance are far less impacted by the P&C pricing cycle, and in 2011, as the chart nearby illustrates, approximately 50% of our net premiums came from these lines.
In addition to product diversification, our broad geographic presence is a unique strength and places us in a very select group of global insurers. One-half of our business is in the U.S. with the balance conducted locally in 52 other countries, and this is illustrated in the nearby chart. Some of our fastest growth is occurring in the developing markets of Asia Pacific and Latin America – two regions that produced double-digit premium growth in 2011 and have doubled in size over the last five years.
This combination of product breadth and geographic presence enables us to reach a wide variety of customers through many different distribution channels. For example, we serve businesses of all sizes – from large multinational companies to small and medium-size local businesses through global and regional brokers and agents all over the world. We also serve companies and affinity groups looking to provide or offer supplemental health, accident and life insurance programs to their employees, customers or members through ACE’s telemarketing centers and bancassurance partners. And we serve individuals and their families purchasing personal accident, supplemental health, homeowners, automobile, life and other specialty coverage primarily through agents, travel agencies and the Internet.
Our tremendous product and geographic diversification, as I said earlier, is a key strategy of the company that provides balance to current revenue and income as well as better future opportunity and predictability of results. The strategy has served us well given the unpredictable nature and volatility of risk, the P&C industry pricing cycle and the notable differences in economic conditions between the developed and developing worlds.
Underwriting discipline – an ACE hallmark
All of our businesses share a common trait – we are underwriters, we take risk for a living. Underwriting is embedded in our ethos and one of the defining characteristics of our culture, and so we insist on always making a profit in our basic business of taking risk. As an underwriting company, we are dedicated to continuously improving and refining our underwriting capabilities, particularly through data analytics, portfolio management and the overall use of data-driven decision making. We are good, but there is much scope to improve and refine our process so that we might push the envelope of what it means to have superior risk selection given the tools available.
In 2011, we produced $731 million in P&C underwriting income while our P&C combined ratio, which measures our underwriting profit margin, was 94.6%. This is an excellent result that demonstrates ACE’s commitment to underwriting discipline and extends our track record of producing a cumulative underwriting profit since we were founded in 1985. The chart nearby illustrates our underwriting performance versus the industry and our peers over the last 10 years and what it means at ACE to be an underwriting company.
In the third quarter, our net income and book value were impacted by Euro crisis-related financial market volatility in interest rates, which fell to their lowest level in a century, as well as a plunging equity market. This resulted in a negative $706 million realized fair value-related mark associated with our variable annuity reinsurance business. As we have explained before, we are required to mark to market these long-term liabilities using derivative accounting even though we believe the mark is not a good representation of those liabilities. For operating income purposes, we use traditional life insurance GAAP accounting, which in our judgment is more representative of our ultimate liabilities since this is a traditional buy-and-hold long-term insurance portfolio and not a trading business. We believe while interest rates will remain low over the short and medium term, particularly given all of the liquidity that’s been injected into the global economy, rates will recover over time and a good portion of the mark will prove transient, though obviously there can be no guarantee.
Investment portfolio, balance sheet strength and capital
In addition to underwriting, investment income is our other primary source of operating income. We take a conservative approach to our investment activities because we are fiduciaries of these assets, which comprise the capital of our company and the loss reserves we hold to pay future policyholder claims. The prolonged low interest rate environment in 2011 continued to pressure investment yields and income from our predominantly investment-grade fixed income portfolio. Yet, our portfolio book yield remained essentially flat and net investment income increased 8% for the year to $2.2 billion, benefiting from both strong positive cash flow from operations and the addition of assets from companies we acquired. ACE’s invested assets increased by $4 billion during the year to $56 billion.
Next to our people, our most important asset is our balance sheet, which grew stronger in the year with total capital increasing 5% to $29.4 billion at December 31. Tangible capital stands at $24.6 billion, an increase of 6% from year-end 2010. In November, ACE announced a 34% increase in the common stock dividend, signaling our confidence in ACE’s strong balance sheet and future earnings generation power. The measure was approved by shareholders in January and became effective with the first dividend payment of the 2012 calendar year. This substantial increase did not compromise or change our view of strategy in any way, and the company retains considerable capital flexibility and firepower for both risk and growth opportunities.
The most important component of an insurer’s balance sheet is on the liability side or the loss reserves, which back our promise to pay claims. We treat our loss reserves prudently and don’t just rely on ourselves in assessing their adequacy – we’re a leader in industry best practice by having outside actuaries review our reserves in detail every year. ACE’s net loss reserves grew 2% during the year and stood at $25 billion at year-end, even with $556 million in prior period reserve releases from older years.
As I have said before, capital is a measure of an insurer’s wherewithal to take risk and an efficient return on that capital over any extended period of time is one of our priorities. ACE’s operating return on equity for 2011 was 11% – an excellent return both relative to the industry, which generated an estimated average ROE of approximately 4%, and in absolute terms given the catastrophes and current environment. Over the last five years, our operating ROE has averaged 15%, which, as the nearby chart illustrates, exceeds that of most of our North American and global peers.
A changing market
Whether it was the tsunami that followed the Japanese earthquake, the floods in Australia and Thailand or the spring tornadoes in the U.S., most of the year’s record natural catastrophe losses were what we call non-modeled events. The mathematical risk and pricing models the industry uses to project losses from natural catastrophes didn’t include these events, and there is now an overall rise in the industry’s perception of risk. In my judgment, these non-modeled losses remind us how imprecise the science of catastrophe underwriting is, and this lesson applies to many other product areas where we use past experience to project the future. Unfortunately, the past is not necessarily representative of the future, as is often the case. Many casualty lines come to mind.
Despite the losses, the industry remains well capitalized and many competitors continue their pursuit of market share at the expense of an adequate underwriting profit or risk-adjusted return on capital. Their balance sheets and reserves overall might be OK, although that varies by company, but their ROEs and income statements are not. And the external environment remains troubled – slow economic growth, interest rates at historic lows, high catastrophe losses and prices that in most lines of business aren’t keeping up with loss cost trend. All this adds pressure to the rates insurers charge.
In the U.S., as the year progressed, a floor developed under pricing in most classes, rate decreases slowed and many classes began to achieve flat or modestly positive rate. This changing market continued to accelerate into the fourth quarter and beginning of ’012 with greater rate increases taking hold where the pain from losses in any given line – property or workers’ comp are good examples – becomes so acute that more substantial rate increases follow. For the balance of most classes, again, rates have flattened broadly or are rising modest single digit. Catastrophe-exposed property rates continue to rise more substantially while casualty prices are flat to up but generally not yet at a pace that exceeds loss costs. Outside the U.S., the market remains soft except in catastrophe-prone areas. In my judgment, this is not a balance sheet-driven hard market but rather an income statement-driven price correction and rate increases, therefore, will be more modest and take longer to materialize. We project industry combined ratios excluding catastrophes will continue to climb but at a slower rate. Nonetheless, these price increases are a good development and we are encouraged by the trend.
However, from what we observe today, with industry capital redundant, loss reserves reasonably adequate and operating cash flow positive, it will likely take some combination of external events such as catastrophes both natural and manmade, or a pick-up in inflation, together with continued underpricing, before we see a meaningful impact to the industry balance sheet and rates overall move with conviction to a level that produces a reasonable risk-adjusted ROE. For now, the industry is transitioning toward managing mediocrity with greater excellence. For ACE, given our product and risk selection capability, this improvement in the pricing environment does present a relatively modest but real growth opportunity.
Premium growth from acquisitions and organic activity
During the year, we continued to balance underwriting discipline with opportunities to grow. Total company net written premiums in 2011 were $15.4 billion, up 12% compared with 2010. While we are primarily builders and focused first on organic growth, a substantial portion of last year’s increase was attributed to recent acquisitions, the largest being our expanded agriculture business in North America through Rain and Hail, the #2 crop insurer in the U.S. Growth also benefited broadly from contributions across our range of businesses, particularly our overseas P&C operations and our global A&H business, demonstrating once again the benefits of our diversification by product and geography and growing balance between cyclical and non-cyclical business.
- In commercial and specialty P&C insurance, our largest and most predominant business representing about 60% of the company’s total net premiums, net written premiums for the year were $9 billion, up 13%. Excluding agriculture, our renewable commercial and specialty P&C insurance business globally declined 3%. We experienced double-digit growth in Asia and Latin America, where economies experienced more robust economic conditions, while the U.S. and Europe declined modestly due to a competitive environment and weak economies.
- Our personal accident and supplemental health insurance business is one of the most distinctive in the industry, representing about 25% of the company’s net premiums. Total net A&H premiums were up 8% for the year, with international up over 16%, led by Asia and Latin America, our U.S. broker-based business up 9% and our Combined Insurance franchise down 4%. Sales in the United States and Western Europe for our Combined Insurance unit remain under pressure given the sluggish state of those economies and their impact on lower- and middle-income individuals as well as regulatory issues in the U.K. and Ireland. Profitability in all of our A&H businesses was very good.
- Net premiums declined about 9% in 2011 in our global reinsurance business, which faced continued competitive market conditions despite improved pricing in certain property catastrophe-exposed lines. Competitors were willing to write at an underwriting loss; we were not. As a result, our reinsurance business, which represents approximately 6% of ACE’s net premiums, had another excellent year with a combined ratio of 85.6%.
- Our global personal lines business is young and fast-growing with operations in both the developed and developing worlds. In the United States, for example, we underwrite and market insurance coverage to affluent and high net worth customers for their homes, autos, boats and valuables, while overseas we sell a diverse range of products – from traditional homeowners and auto insurance plans to unique mobile technology insurance products for cell phones and laptops that cover the cost of replacing or repairing these devices against damage, loss or theft. Although these are still early days and we are planting the seeds for the future by making prudent investments in people, infrastructure and systems, this business surpassed $1.1 billion in net premiums in 2011 and now represents about 7% of the company’s net written premiums.
- Lastly, ACE’s international life insurance business, which represents about 3% of the company’s net premiums, focuses almost entirely on developing markets where a rising middle class needs the traditional savings and protection plans we sell. During the year, we successfully integrated our two recent acquisitions in Korea and Hong Kong. Today, in Asia, our largest region by premium and agency force, ACE Life has more than 15,000 exclusive agents while Huatai Life, our 36%-owned joint venture in China and the third-largest foreign invested life insurer, has more than 25,000. Overall, our life insurance business achieved break-even in 2011 and we expect it will make a positive contribution to earnings in ’012.
Regulatory assault in the U.S. and Europe
In the U.S. and much of Europe, we face an unrelenting assault on business by government. Rather than creating an environment of certainty where business thrives, government is discouraging risk-taking and investment through increased regulation and a misguided view that prosperity is created by government rather than the private sector. There is also a notion prevalent among some regulators and political leaders that somehow the primary job of government is to protect its citizens from the evils of business. By contrast, the political and government leadership of the major developing nations of the world is focused on wealth creation and what it takes to build a superior capability to win.
In the short-to-medium term, we can expect continued slow growth in developed economies, which will impact growth in developing nations. It is a globalized world. In addition, high unemployment will continue to plague the developed world while emerging countries need to create large amounts of employment. Add to this the dynamic of the Euro crisis, an election year in the U.S. and a once-in-a-decade leadership change in China. Taken together, these economic and political conditions are breeding more protectionism, which manifests itself in the form of predatory trade and regulation. There has been little effective global leadership on the issue and the natural instinct for all countries to act in their own interests is powerful. Politics is always local.
In the medium-to-longer term, the global economy is in the process of rebalancing, with the center of gravity shifting to Asia, led by China and, to a lesser degree, India, as well as Latin America – regions where major wealth creation will take place for decades to come. The shift is and will be a source of great tension, and add to that the stress created by different economic models: state capitalism and market-based capitalism, with the former practiced by the largest developing countries as exemplified by China and the latter practiced by the largest developed countries as led by the U.S. With considerable geopolitical and socioeconomic implications, these profound changes represent opportunities as well as risks to global companies like ACE. We are acutely aware of both and will need to remain nimble and knowledgeable to succeed given the uncertainties these forces represent.
Concerning financial services and insurance regulation, there is a strong effort underway among numerous regulators, particularly European, pursuing the idea that there should be one prescriptive and universal protocol for insurance regulation, and that it should apply to all countries, addressing capital, governance and risk management standards. In my judgment, this is simply wrong-headed and ignores the cultural, social and economic realities of different countries. When it comes to regulation, one size does not fit all.
Rather than absolute uniformity and an overly prescriptive, process-oriented approach, a framework of minimum standards of regulation that results in similar desired outcomes is far more practical and effective. For example, while it certainly has its weaknesses, the U.S. system of regulation has proven its ability over the years to reasonably regulate our industry’s solvency. The fundamental philosophy of the U.S. system is solvency to protect policyholders, and in the event of insurer failure, enough capital in the company and a solvency fund to ensure policyholders are made whole. Under the U.S. system, insurers have a reasonable level of freedom to succeed or fail.
By contrast, Solvency II, the new European system of insurance regulation, though perhaps not its intention, is designed to essentially prevent any insurer failure and to protect all constituents – policyholders, bondholders, shareholders and employees. It is overly bureaucratic, process-oriented, costly, and, by the way, untested. Yet, this is the system European regulators envision for the world and believe should be used as the measure to judge the equivalency of all others for purposes of reciprocity. Our industry fared well during the financial crisis, so I am not sure what problem we are trying to solve by pressing to adopt a Solvency II-like system as our global standard of regulation. In fact, I believe such an approach would do great harm. If we aren’t careful, we will turn our industry into a utility.
I am all for modernizing our regulatory structures to take advantage of advances in risk management, technology and finance that have occurred over the past 20 years. Frankly, there are parts of Solvency II that have merit. But let’s be thoughtful and clear about our objectives. To begin with, the U.S., led by the new Federal Insurance Office with the support and knowledge of the NAIC and state regulators, can together bring a powerful voice and an alternative approach to this debate.
The ACE culture: optimism
During the year we had a number of changes to our senior management team. John Keogh was appointed chief operating officer of the company, with responsibility for P&C insurance operations globally, in addition to his duties as chairman of the Overseas General business segment. John Lupica was named chairman of the company’s North American insurance operations, succeeding Brian Dowd in this role. After 17 years with ACE, Brian retired from full-time employment but remains an active and vital member of our Office of the Chairman working with me and other members of the management team focused on underwriting strategy and other related matters. He has much to contribute and we will continue to benefit from his knowledge of this business. John Keogh and John Lupica are two experienced and impressive leaders with over 25 years each in our industry. The depth, breadth and continuity of our management team globally are truly a source of strength for our company.
And so, to my fellow employees, my senior management team colleagues and our outstanding board of directors, I thank you all for your contributions to a very good year at ACE. I also wish to thank, in particular, Bruce Crockett and John Krol, two long-serving directors who have announced they are retiring. Bruce has served on the board since 1995 and John since 2001; I am grateful to both for their wisdom and counsel over many years.
We live in very difficult and complex times that will likely persist, and we strive to recognize that in our planning because we are realists. But at ACE we are also optimists – we have a quiet confidence and a culture of optimism for good reason: We believe in the opportunity that surrounds us and we are committed as a team to working hard to take advantage of it. The professional women and men of ACE around the globe distinguish our company every day by their expertise, discipline, youthful energy and passion. I am very proud to be but one member of this tremendous family.
Evan G. Greenberg
Chairman and Chief Executive Officer