Strong Performance Aside, Commercial Insurers Face an Inflection Point

Despite the disruptions caused by the COVID-19 pandemic, the Russia-Ukraine war, and the resulting supply chain disruptions, global commercial property-casualty lines have delivered strong financial performance in recent years, according to a new report from McKinsey & Company.

In its Global Insurance Report 2023: Expanding Commercial P&C's Market Relevance, McKinsey notes that commercial insurers' premiums have been driven by extensive year-on-year risk-adjusted rate hardening.

The annual premium growth rate for commercial property-casualty lines has ranged between 6 and 8 percent since 2018, according to the February 16, 2023, McKinsey report, while insurers' combined ratios have improved.

Still, commercial insurers are at an inflection point, the report says, due to a variety of ongoing economic uncertainties including inflation, geopolitical issues, environmental challenges, and capital constraints.

"This gradual acceleration of macroeconomic trends across multiple events that are pressuring the insurance industry is different from previous shocks," the report says. "In combination with the structural changes in the nature of risks, commercial [insurers] today need to address four critical challenges."

The first of those challenges is that while rates are beginning to soften in some lines as capacity returns to the market, other lines continue to harden. Rising claims inflation and growing competition from distributors are squeezing insurers' profits, the McKinsey report says, though some are expecting to see significant investment returns due to rising interest rates.

The second challenge is the rapid evolution of risks, according to McKinsey. That evolution is particularly significant in the areas of natural catastrophes, the transition to net zero, and supply chain and cyber risks, the report says. "Rather than stepping back and reducing their exposure, commercial [insurers] have a significant opportunity to step forward to address the growing protection gaps—or risk losing relevance in a changing world," McKinsey says.

The third challenge confronting commercial property-casualty insurers is that the prior challenges are exacerbated by tightening capacity in both the traditional reinsurance market and the alternative capital markets, McKinsey says. Given the strong hardening of the reinsurance market seen at January renewals, the full extent and duration of that capacity squeeze remain uncertain.

The final challenge, according to McKinsey, is that to navigate the new nature of risks, commercial property-casualty insurers "must prepare to transform their capabilities and talent as underwriting and claims shift from an art to a science."

McKinsey outlines several steps commercial insurers must take to meet the challenges.

• Define a clear source of distinctiveness to protect margins by competing beyond rates.
• Be more relevant, using innovative products, improved pricing, and solutions to prevent and mitigate risk to close protection gaps.
• Secure capacity by being innovative in using alternative capital and addressing investor concerns about long-term profitability.
• Reinvent the insurer’s employee value proposition and develop the capabilities necessary to shift from art to science and address future risks.

With regard to defining distinctiveness and competing beyond rates, the McKinsey report suggests that the most successful commercial insurers have clearly done so and emphasized investment in those areas that make them distinctive. Specialist commercial insurers focusing on certain lines of business have frequently outperformed more diversified peers, the report says.

On the subject of expanding relevance, the McKinsey report calls declining relevance of commercial insurance lines the most critical issue facing the insurance industry today.

"Commercial [insurers] have not always kept pace with structural changes in the nature of risk, which are accelerating more rapidly than ever," the report says. "While premiums for commercial lines have been growing over the past 3 years at approximately 7 percent per year, rate hardening has driven most of this growth."

Adjusted for that rate growth, global commercial insurance premium growth lagged well behind real gross domestic product (GDP) growth over the same period, indicating a decline in commercial lines' relevance, McKinsey says.

Commercial insurers must move to expand their relevance by reducing protection gaps to meet society's desire for resilience in a changing environment, the report says. Parametric-based products can help close protection gaps in areas like natural catastrophe risks, McKinsey suggests, while tailoring coverages to meet the specific needs of certain business segments could also help increase the relevance of commercial insurance.

Insurers should use data and analytics to help adjust pricing models to the real cost of risk, McKinsey says. Meanwhile, investing in risk prevention and mitigation strategies in areas like cyber or natural catastrophe risks and educating stakeholders and increasing risk awareness can further contribute to insurers' relevance.

Closing protection gaps will also require progress on McKinsey's third suggestion for commercial property-casualty insurers: innovating in the use of alternative capital. Alternative capital will be critical to closing those gaps, McKinsey says.

McKinsey suggests commercial insurers could tailor their risk-linked offerings to meet different types of investor appetites, perhaps by pooling risks across multiple lines to diversify and tailor the risk profile of risk-linked funds to meet investor desires. It also might be possible to simplify some alternative capital products through standardized structures and contract language, according to the report.

In addition to insurance-linked securities markets, commercial insurers could look to public-private partnerships to provide for capacity for risks the private sector can't absorb on its own, McKinsey says. Pandemic and cyber risks are among the risks where such partnerships might be used to provide necessary capacity, the report says.

On the final suggestion regarding building needed capabilities and talent, McKinsey notes that many commercial insurers are making sizable investments in data and analytics to help address the changing nature of risks.

"To keep up with the speed of change, commercial [insurers] must attract and retain the necessary talent, as well as develop the capabilities of experienced employees," the report says. "This will necessitate a cultural shift because many underwriters and claims handlers still prefer to rely solely on their extensive experience rather than data-driven approaches and advanced technologies."

Meanwhile, the commercial property-casualty insurance industry is facing a large number of aging workers heading to retirement and a tight labor market, McKinsey says. "Indeed, the demand for expert underwriters, claims handlers, and data and analytics talent is fast outpacing supply," the report says. "MGAs, InsurTechs, and other industries (such as consumer and tech) are all competing for a limited pool of talent—and commercial [insurers] are not consistently the top employer of choice."

To attract the necessary talent, commercial insurers should emphasize the global and cross-industry nature of their business, McKinsey says, offering employees exposure to a diverse set of roles, industries, geographies and functional areas through cross-functional career paths.

"Commercial [insurers] also need to expand their talent pools beyond the insurance industry to target nontraditional profiles, such as those with deep technology expertise or a cyber-science background," the McKinsey report says.