Higher interest rates are raising the bar for US property & casualty insurance profitability

Our recent sigma, Raising the bar: Non-life insurance in a higher-risk, higher-return world, assesses the profitability outlook for non-life insurers against the backdrop of the most intense monetary policy tightening since the 1980s. Almost 95% of central banks have hiked policy interest rates since 2021 due to high inflation post-pandemic. The impact of the new interest rate regime on non-life insurance is profound, generating significantly higher returns on invested assets but also raising the cost of equity capital for the industry to its highest level in more than a decade. Insurers must now clear a higher bar to reach sustainable profitability and grow the constrained industry capacity contributing to the current hard market in certain property & casualty segments.

We find the benefit of higher interest rates on insurers' investment results far outpaces the increased cost of capital that accompanies it, but the benefit only materializes gradually while the higher cost of capital is immediate. Since the average non-life investment portfolio is 2.5 times net premiums earned, an additional 100 basis points (bps) of investment yield is roughly equivalent to 250bps improvement in the combined ratio for new business. Interest rate increases between 2021 and 2023 have increased US insurers' cost of capital some 320bps while improving the operating ratio for new business by 630bps.

The benefit for overall results materializes gradually: the industry bond portfolio has an average time to maturity of 6 years, so portfolio yields lag market yields. We expect some 50bps higher average portfolio yields in 2023 compared to two years prior, roughly equivalent to an estimated 130bps improvement in the non-life industry operating ratio, falling short of the 320bps increase in the cost of equity capital. 

In 2023 we see improving profitability for most non-life business, as underwriting measures adjust to claims trends on top of the boost from higher investment income. Our analysis suggests that in 2023 US property & casualty insurers will narrow the underwriting gap (profit margin compared to target returns) by eight points of net premiums earned on average from 2022 but still miss their cost of capital targets by about four points of combined ratio. This is a global phenomenon with similar trends in other key markets. We see this level of profitability as still too low and therefore supportive of more rate hardening. 

Non-life insurers might benefit from writing new business at the current level of premium rates and investment returns, yet available risk capital and capacity deployed remain constrained in many lines. Higher interest rates cannot be separated from the inflation surge that prompted them, as well as social inflation, shocks such as the wars in Ukraine and the Middle East, 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 higher, raising new capital is also more difficult. In this environment, more efficient use of capital becomes key. Reinsurance can function as a capital substitute to ease these pressures by improving capital flexibility and efficiency - providing certainty for legacy liabilities and supporting the growth of new business. 

In the long run, higher interest rates will transform the economics of insurance and put insurers on a more financially sustainable long-term path. The insurance industry needs to grow its capital and assets at a significant pace to match the growing global demand from evolving risks such as catastrophes, digital risks and social inflation. For example, US Property & Casualty (P&C) industry capital grew 5% annually on average in the past 10 years, two points less than the estimated demand for natural catastrophe protection at 7%. Additionally, US liability claims grew at an average 9.7% over the last decade, drawing on the industry's risk capital.  

We project that insured losses will continue to grow relentlessly, irrespective of year-on-year volatility and even as inflation subsides. Development and asset accumulation in high-risk areas are key factors for exposure growth. Higher construction costs are an additional factor, as aging infrastructure and inflation have boosted repair costs in recent years. Finally, hazard intensification will likely also contribute more to increasing losses in the coming decade as the world heats up. To close protection gaps, the industry needs to outgrow exposures.