Tumbling yields squeeze profits

Which challenges must casualty (re)insurers tackle to continue writing profitable business in 2009?

Jiten Voralia from Swiss Re’s Casualty expert team in Asia discusses why interest rate drops call for increases in technical premium. 

If we ever need an example of what a difference a year can make, 2008 will be the year to look back upon.  Twelve months ago, balance sheets were strong, investment returns stable and economic growth robust.  Now, amidst an unraveling global financial crisis, many economists suggest that things are likely to get worse before they get better. 

The coordinated interest rate cuts by global central banks over the past six months is unprecedented in both its scale and geographical scope. Such economic stimulus reflects the seriousness of the financial crisis. 

But what is the direct impact of interest rate cuts on casualty (re)insurers profitability during 2009?  The table below shows, for the main Asia-Pacific markets, the changes in official interest rates during the past 12 months.


 Investment outlook for P&C insurers

Property & Casualty (P&C) insurers' profitability can be divided into two broad categories: underwriting profits and investment income. 

One factor distinguishing the P&C industry from the Life & Health (L&H) industry is the nature of its investment activities.  Compared to L&H insurance, P&C future liabilities tend to be relatively short term, much less predictable and most claims are settled quickly.  

P&C insurers predominantly invest in liquid assets that they can quickly convert to cash.  Typically, government and corporate bond holdings constitute over 70% of P&C industry assets with equities accounting for less than 20%.  

The investment return most insurers can expect to earn during 2009 has shrunk significantly, and may fall further.  This reflects two key factors: lower interest rates have caused a significant reduction in bond yields which impacts all maturities, and insurers' appetite for investment risk has reduced in proportion to the erosion of capital bases.  Investment returns are, therefore, likely to track the risk-free rate over the short to medium term.

Impact of interest rates on premiums

Movements in interest rates is one of the drivers behind the cyclical swings in the P&C industry's profitability.  The key to this sensitivity is the nature of the insurance product. 

Insurers receive premiums in exchange for promises to pay claims in the future.  Assuming all other factors are constant, as interest rates rise, companies can lower technical premiums to meet future claims because of the investment income earned on the premiums. 

This fundamental relationship between technical pricing and interest rates suggests that insurers raise technical premiums when interest rates fall, and lower them when interest rates rise.  The magnitude of the change in actual market premiums will vary with the degree of interest rate change and competitive pressures that push insurers to deviate from technical premiums.

Impact of short vs long tail business

The effects of interest rate fluctuations on technical premium will be greater for insurance classes with longer intervals between the receipt of premiums and payment of claims.  Long tail casualty classes are, therefore, impacted by interest rates changes to a greater extent than short tail property classes. 

Casualty reinsurers underwriting non-proportional business are usually more interest rate sensitive than primary insurers.  Non-proportional excess-of-loss (XL) coverage is exposed to claims that exceed large attachment points and/or deductibles.  The XL component of claims usually takes longer to develop, and so reinsurance technical premiums are more sensitive to interest rate movements than primary insurance premiums.  In contrast, proportional reinsurance will be impacted to much the same degree as primary insurance. 

Impact on technical premiums

The table below shows, for two common classes, a hypothetical example of how much technical premiums need to increase for (re)insurers to maintain the same profit margins, due to the reduction in Australian government bond yields over the 12 months to March 2009, assuming all other factors are constant.


The table highlights that the longer the average settlement period the greater the required increase.  In contrast, during a stable interest rate environment, with interest rate levels unchanged from year to year, the required technical premium changes would be minimal.  Similar impacts for other Asia-Pacific countries can be observed allowing for the respective changes in local government bond yields and portfolio-specific settlement periods.

Reduced investment income is one of the challenges that casualty insurers face in determining technical premiums during 2009.  Other pricing considerations include shrinking rate adequacies, the prospect of increased litigation from the financial crisis, changes in the cost of capital, claims inflation, exposure changes and competitive pressures. 

Disciplined underwriting together with understanding and adapting to a rapidly changing environment will be the key to success if casualty (re)insurers are to continue writing profitable business during 2009.

April 2009

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