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Economic Considerations
for Property & Casualty
Insurers
In this article, I highlight some of the complex interactions between the economy, P&C
underwriting results and investment assets, and set out to demonstrate the ways in which
smart companies can benefit from viewing investment risk management in combination with
their underwriting.
James Norman
[email protected]
The P&C underwriting cycle and the economy
P&C underwriting returns are not independent of the economy or financial markets. At an industry
level, the U.S. P&C market combined ratio1 shows significant relationships with interest rates and
real GDP growth. Research conducted by Barrie & Hibbert analysed the industry combined ratio
from 1970-2010 (source: A.M. Best) in comparison to several economic series. Figure 1 shows
the relative sensitivities of the change in the industry combined ratio to three economic factors:
the 5-year Treasury yield; the slope of the yield curve; and the change in the real GDP growth
rate2. The analysis also identified the previous year’s combined ratio as an important factor.
50%
Figure 1: Standardised
regression coefficients
for change in industry
combined ratio. These
can be regarded as the
correlation between the
combined ratio and the
variable, keeping the
other variables constant.
40%
30%
20%
10%
0%
-10%
-20%
5-year Bond Yield
Change in Yield
Curve Slope
Change in Real GDP
Growth Rate
Previous Year's
Combined Ratio
-30%
-40%
-50%
-60%
There are many potential explanations for why the economic environment impacts underwriting
profitability: interest rates strongly influence the investment returns on the fixed income assets
of P&C insurers, and higher bond yields mean that premiums required for ‘breakeven’ profit can
be lower. Furthermore, it is not surprising to find a negative relationship between the combined
ratio and GDP. This is because a demand for insurance weakens during recessions, leading to
downwards pressure on exposure levels and premium rates. On top of this, claims experience
can also deteriorate.
1.
2.
The combined ratio is the sum of claims and expenses, per unit premium. A combined ratio below
100% indicates an underwriting profit, while above 100% indicates an underwriting loss.
This is not intended to be an exhaustive list of possible economic effects. Other economic indicators
could also be analysed but for the sake of brevity they are not included here.
Recessions tend to be associated with more fraudulent claims, an increased propensity for
policyholders to claim, and to increased crime rates, which in turn lead to higher theft
claims. Recessions tend to lead to particularly bad claims experience in Mortgage and
Financial guarantee lines due to the strong link between the insured events and the
economic environment in these lines.
To find such a strong relationship between the combined ratio and the slope of the yield
curve is perhaps more surprising. The slope of the yield curve may be serving as a proxy
for expectations of changes in future inflation, which would feed into loss reserves.
Other economic and financial market links can be identified which impact specific lines.
For example, in Directors and Officers insurance, increased claims tend to follow falls in
stock markets. A brainstorming exercise can identify many other direct and indirect links
for the particular type of business you write.
Not all economic links have a detrimental effect on underwriting returns in times of
economic hardship, though. For example, in Marine Cargo insurance, lower economic
activity leads to a fall in shipping activity, which has a downward effect on claims levels. In
Workers‟ Compensation insurance, the average experience of the workforce increases
during recessions, as inexperienced staff tend to be laid off or not taken on at all; this can
reduce accident rates in the workplace and lead to lower claims frequency. Also, low
inflation can reduce settlement costs for claims. The overall effect is likely to be the result
of several competing factors at play.
Claims inflation
In the delay between writing a policy and settling a claim, the cost of the claim (e.g.,
repairing or replacing an insured item; medical costs of treating an injured party; or lost
wages paid to a claimant) may have increased above that had the claim occurred at the
time of writing the policy. This is claims (severity) inflation, and although an anticipated
level of claims inflation can be factored into the pricing of the policy, the risk remains that
realised claims inflation is above expectations.
Claims inflation is often difficult to isolate in data investigations, as there tend to be so
many other „moving parts‟. Claims inflation may be caused by non-economic factors, such
as court award inflation and changes in statutory awards and limits. For many classes of
business, however, it is possible to identify the various components of a claim, and
envisage a link to an appropriate observable price index. Consumer prices, wage growth,
medical care inflation or a commodity price are examples of this.
P&C insurers writing long-tailed excess-of-loss reinsurance can be particularly exposed to
unexpected increases in claims inflation. This is because of the gearing effect of the
excess, as illustrated in Figure 2. In the „base case‟, a $500,000 excess is applied to a
ground-up claim of $550,000, leading to a loss to the layer of $50,000. After an increase in
the ground-up claim cost by 5 per cent, due to claims inflation, the ground-up claim is
$577,500 and the loss to the layer is $77,500. The loss to the reinsurer has increased by 55
per cent.
Figure 2: Gearing
effect of inflation on
excess of loss
reinsurance.
600,000
575,000
550,000
525,000
Loss to Layer
Retention
500,000
475,000
450,000
Base Case
5% Increase in Inflation
Even if there was no „basis risk‟ – i.e. ground-up claims inflation risk could be removed
through investing in inflation-linked bonds – the gearing effect and non-linearity in
inflation sensitivity of an excess-of-loss claim will reduce the effectiveness of inflation
hedging. Non-linear inflation derivatives, such as inflation swaptions, may therefore be
more effective in such circumstances.
Financial markets and catastrophes
What about major disasters such as natural catastrophes? Although one would not imagine
the occurrence of such disasters to be affected by the economy, major disasters do have
an impact on the economy and financial markets. Disasters cause destruction of capital
assets and infrastructure which reduces economic output. Equity markets may fall in value
and increase in volatility reflecting the loss of output and heightened uncertainty.
Conversely, there may be positive effects on the economy, at least for certain sectors. For
example, the increase in demand for construction services and materials often stimulates
higher growth and prices in this sector. The “demand surge” effect on claim costs is well
known, but there is also an impact on investment asset returns for the construction-related
sectors.
Barrie & Hibbert have examined the financial markets in the 30 days after the 20 largest
insurance losses since 1970. While broad equity markets in the affected country fell on
average 2 per cent over the period, construction-related stocks outperformed the market
on average by nearly 5 per cent. Further, the events with larger insured losses tend to be
associated with larger out-performance of the construction sector.
These results suggests that a catastrophe exposed P&C insurer could potentially reduce its
overall risk position, and simultaneously increase expected return, by increasing
investment exposures to selected industry sectors, rather than a diversified market
portfolio. By investing in sectors which respond positively to catastrophe shocks,
catastrophe claims can be partially mitigated by the rise in asset values post-event.
Although we have illustrated this with equity indices, other investment assets, such as
corporate bonds, may also be impacted at the sector level.
Of course, this strategy is not without its own risks. The construction sector is more volatile
than the market as whole. Figure 3 below shows construction sector stock indices relative
to the market in the days after each disaster in our sample. Just after Hurricane Ike had
ravaged Texas in September 2008, the world financial markets were in melt-down
following the bankruptcy of Lehman Brothers. The construction sector underperformed
the market by 9 per cent and was down 29 per cent in total over the 30 day period. This
highlights that catastrophe event risk cannot be hedged through this route, and residual
risks will always remain: an insurer should not bank on an imperfect hedge to save them in
the event of disaster. However, the analysis suggests that construction sector equities may
be relatively more attractive than other sectors, and might just provide a smart insurer with
an edge over their peers.
1.25
Hurricane Katrina
1.20
Japanese Eq
Hurricane Andrew
1.15
Construction Sector Relative to Local Market
Figure 3: Local
construction sector
index relative to local
total market index
post natural disaster.
WTC
Northridge EQ
1.10
Hurricane Ike
Hurricane Ivan
1.05
Hurricane Wilma
Hurricane Rita
1.00
New Zealand Eq (II)
Hurricane Charley
0.95
Typhoon Mireille
Hurricane Hugo
0.90
WS Daria
Chilean Eq
0.85
WS Lothar
WS Kyrill
European Storms 87
0.80
Hurricane Frances
WS Vivian
0.75
0
5
10
15
20
25
30
Market Perform
Days After Event
Holistic investment strategy
A P&C company which views asset allocation and risk management in relation to its
underwriting can be stronger, more competitive and more profitable than one which
manages their investments in isolation.
Viewing assets and liabilities together, a company which invests in the “safest” assets is
not the safest company overall. Taking an appropriate amount of investment risk has the
potential to reduce the risk of insolvency, free up capital, and increase profitability.
We illustrate this with a hypothetical P&C insurance company, Smart Ins., which writes a
broad range of business including long-tailed liability and is exposed to natural
catastrophes through direct property insurance.
Smart Ins. has historically managed investment risk using an asset-only approach. Their
assets are only invested in high quality short-term fixed income bonds. However, since
the 2008 financial crisis they have seen profit margins squeezed by falling premium
income coupled with unusually high claims. Investment returns have also fallen
significantly because of the low interest rate environment. They are now concerned
about the economic outlook, particularly with regard to the uncertainty around interest
rates and inflation, and are looking to gain understanding of the key economic scenarios
which might affect their results over the next year. They wish to set their investment
strategy accordingly.
They identify that the key economic drivers to their underwriting returns are interest
rates, GDP, unemployment and inflation, and estimate the sensitivity of exposure,
premium rates and claim amounts to each of these factors for each line of business.
Several alternative inflation indices are identified which influence claims inflation for
specific lines.
Smart Ins. sets about creating an integrated stochastic model of their investments and
underwriting, driven by Barrie & Hibbert‟s Economic Scenario Generator (ESG), from
which they can calculate economic capital requirements and other risk measures.
Starting from the portfolio which minimises their economic capital requirement, they trial
thousands of asset portfolios and compare their risks and returns at an enterprise level.
Once candidate portfolios are identified, they are then put through their paces. With the
help of the ESG‟s VisualAnalytics, they are able to identify downside scenarios for their
enterprise-level profit and „drill-down‟ to see which factors are contributing to the loss.
Using this, they can construct an appropriate asset allocation to ensure their risks are
controlled while still generating returns.
Figure 4:
VisualAnalytics enables
you to identify the impact
of changing asset
allocations on the risk and
return characteristics
ofyour business....
Figure 5:
... then identify the
scenarios which impact
enterprise-level results.
Figure 6: Through
understanding
market risks on both
asset and liability
sides, you can set
asset allocations to
improve risk-adjusted
returns at an entity
level.
Summary
The economic and financial environment affects P&C insurers in several ways
through the price and amount of insurance business they can write, their claims
experience and their investment assets. The natural way to control these risks is
through an appropriate investment strategy which takes into account both sides
of the balance sheet. Barrie & Hibbert‟s Economic Scenario Generator provides
the economic and financial market scenarios that you need to assess risk and
reward of market risk across your organisation.
Disclaimer
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Edinburgh EH3 8RD.
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opinions and estimates included in this document constitute our judgment as of the date
indicated and are subject to change without notice. Any opinions expressed do not
constitute any form of advice (including legal, tax and/or investment advice).
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