Higher returns for evolving risks

Ahead of the Baden-Baden Reinsurance Week, Thorsten Steinmann, Head P&C Reinsurance, Northern Central and Eastern Europe, and Kristina Franke, Market Head Netherlands, Nordics and CIS, discuss one of the key topics of upcoming renewals – how to keep the insurance industry profitable despite the challenging economic environment and evolving risk landscape.

Kristina: This will have a significant impact, since insurers typically invest underwriting cashflows in a wide range of securities before making claims payments. On average, the asset side of an insurer is about 2.5 times the earned premium. This implies that 1% higher interest rates translate into a combined ratio improvement of 2.5%. For short-tail lines, this effect is of course lower, whereas for long-tail lines like workers compensation business this effect can go up to 9%. Higher interest rates improve the profitability of new business, so it seems attractive for insurers to sell more policies.

Thorsten: Yes, it's attractive for insurers to sell additional coverage. Yet, the amount of capital available to cover our liabilities and the amount we’re willing to pay out remain constrained in many lines despite the stronger profitability outlook. Higher interest rates cannot be separated from the inflation surge that prompted them, as well as social inflation, shocks such as the war in Ukraine, and uncertainty around claims trends, reserves and other risks. Capacity restraints are also partly driven by model uncertainty after years of above-average natural catastrophe losses. With investors hesitant and return expectations rising, issuing new equity is also less attractive.

Kristina: In the latest sigma, Swiss Re Institute shows that insurers did not earn their cost of equity capital globally in either the post-financial crisis era (2010-19) or pandemic period (2020-22). In 2023 we expect improving profitability for most non-life business, as we adjust our underwriting to account for claims trends, and higher portfolio yields boost net investment income. For example, non-life insurers could cover their cost of capital of 9.4% by generating a ROE of 10.7%, thereby generating a positive value for investors. So overall, at least non-life insurers did well but still haven't had a stellar performance.

Overall, I feel that the profitability gap will narrow in 2023, as increased profitability due to higher interest rates outweighs the effect of higher capital costs. This is also confirmed by analyst expectations, which improved considerably in 2023. Nevertheless, global profitability is still too low, so I would expect further rate hardening. The pressure depends a bit on the line of business, with motor certainly being the area that's under the most pressure, with insurers’ combined ratios in 2023 often far above 100%.

Thorsten: Higher interest rates transform the economics of insurance and put insurers on a more financially sustainable long-term path. Still, to narrow protection gaps, industry resources would need to grow in line with the growth in demand from evolving risks, such as catastrophes. 

Swiss Re Institute expects the disequilibrium in supply and demand of non-life insurance to persist, and thus a continuation of current hard market conditions, especially in property catastrophe lines. The demand for insurance protection has risen since 2017, driven by increased natural catastrophe activity as well as inflation, which is resulting in higher replacement values.

Swiss Re Institute estimates that, for example, in the US, property and casualty insurance industry capital has grown by 5% annually on average for the past 10 years. During the same time, the natural catastrophe protection need has grown at about 7% per year on average. So, higher growth in industry capital is needed to narrow large protection gaps worldwide.

Thorsten: Given the competing demands of higher demand and risk, and limited capacity, for non-life insurers, more efficient use of capital becomes key. This makes reinsurance a more attractive alternative to traditional capital due to its fundamentally different characteristics. Reinsurance is typically short term, provides more flexibility, is targeted towards a certain underwriting risk and also has the added benefit of privacy. Areas where reinsurance usually has a high benefit is for highly volatile or concentrated business. Also, retrospective covers such as loss portfolio transfers or adverse development covers, where reinsurers take over the risk that losses exceed loss reserves are an interesting instrument to protect insurers against inflation shocks especially for long-tail business.

Key takeaways:

• We expect improving profitability for most non-life business in 2023, due to higher interest rates and market hardening.
• Reinsurance can offer a flexible and efficient capital substitute for insurers.