Current Interest Rate Environment Bodes Well for Non-Life Insurers

While insurers worldwide failed to earn their cost of equity capital in the low-interest-rate environment following the global financial crisis, the current higher-interest-rate environment is changing those dynamics, according to a new sigma report from Swiss Re.

In the current higher-yield environment, the insurance industry's cost of capital has risen to its highest level in more than a decade, Swiss Re says in the report titled Raising the Bar: Non-Life Insurance in a Higher Risk, Higher Return World. But, even as insurers' cost of capital has increased, profitability for new property-casualty business has benefited even more from the higher rates, the report says.

"We expect 2023 to be a transition year toward profitability for most P&C insurers," Swiss Re says. "They are likely to still miss their cost of capital in most markets we analyze, but by much less than in 2022."

Despite the improvements, however, profitability levels in the global non-life insurance sector will likely remain too low this year, according to Swiss Re, potentially resulting in hard market conditions carrying into 2024.

According to Swiss Re's No. 4/2023 report, higher interest rates transform the economics of insurance and put insurers on a more financially sustainable path over the long term. But, the reinsurer says, to narrow protection gaps, insurance industry resources must match the growth in demand for insurance resulting from risks such as catastrophes.

As an example, Swiss Re notes that stronger growth would benefit industry capital for the US property-casualty segment, which saw 5 percent average annual growth over the past 10 years, two points less than the estimated need to meet natural catastrophe losses of 7 percent growth. "In this environment, more efficient use of capital becomes key," Swiss Re says.

The report notes that the benefits of higher interest rates insurers realize on their investment results far outpace the increased cost of capital resulting from higher rates.

Swiss Re says that the cost of capital has increased in all major regions since central banks began increasing interest rates, with European insurers seeing the largest increase. But because of the extent to which the size of the average non-life insurer's investment portfolio exceeds its net premiums earned, an increase in investment yield contributes to a significant improvement in the insurer's combined ratio.

"Even with a likely deterioration in combined ratio between 2021 and 2023, higher interest rates improve the profitability of new business with respect to cost of capital, incentivizing stronger growth in 2023," Swiss Re says. "In contrast, the low interest rate years after the global financial crisis caused profitability headwinds for insurers. Non-life insurers' returns on equity (ROE) did not meet their cost of equity capital globally in either the post-financial crisis era (2010‒19) or pandemic period (2020‒22)."

During what Swiss Re sees as a transition year of improving profitability for non-life insurers in 2023, insurers will adjust underwriting measures to meet claims trends as higher portfolio yields boost net investment income, the report says.

The reinsurer estimates that this year property-casualty insurers in eight large markets will narrow their underwriting gaps by an average of six points from last year's level, though they'll still miss their cost of capital by about four points of combined ratio.

"While this represents a much-needed improvement, we see the global profitability level as still too low and so supportive of more rate hardening," the report says. "The cautious return of investors to the alternative capital (AC) market, despite higher returns on catastrophe bonds, reinforces our view that hard market conditions may persist into 2024."

While non-life insurers can benefit from the combination of writing new business at higher premium rates and improved investment returns, available risk capital and deployed capacity remain constrained in many lines despite the potential for improved profitability, Swiss Re says.

"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," the report says. "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."

The report acknowledges that all forecasts are subject to uncertainty, so Swiss Re says it considers the impact on the industry of alternative scenarios.

One such scenario envisions the US Federal Funds Rate peaking above 7 percent in 2024 with a renewed surge in inflation that would see the impact on non-life insurers' claims costs offsetting any benefits from higher investment returns.

Another scenario considers a severe global recession, which would see the US Federal Reserve cutting interest rates back to near zero next year. In that case, the lack of an inflationary boost on premiums and reduced investment returns would make the impacts of a severe global recession worse for the industry, according to Swiss Re.

Ultimately, though, the Swiss Re report suggests that non-life insurers' profitability appears set for significant improvement in coming years as high interest rates and hardened rates offset higher claims costs resulting from persistent inflation.

Despite the prospects for greater profitability, however, the supply and demand imbalance for non-life insurance will continue the hard market conditions in certain lines, Swiss Re says, particularly property catastrophe.

"Demand for insurance coverage has risen since 2017, with two key drivers: increased natural catastrophe activity, and inflation and higher replacement values raising exposures and losses," the Swiss Re report says. "These factors have especially affected property lines, and contributed to a hard market in property catastrophe reinsurance as well."

Swiss Re suggests that the profitability of long-tail lines might face pressure as well as a result of social inflation and inflation pressures on services and wages.

"Insurers are also facing heightened model/parameter uncertainty and investor concerns that the industry is not accurately quantifying loss trends," the Swiss Re report says. "Successive years of above-average catastrophe losses have crystallized those concerns."