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Insights 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 Copyright 2011 Barrie & Hibbert Limited. All rights reserved. Reproduction in whole or in part is prohibited except by prior written permission of Barrie & Hibbert Limited (SC157210) registered in Scotland at 7 Exchange Crescent, Conference Square, Edinburgh EH3 8RD. The information in this document is believed to be correct but cannot be guaranteed. All 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). This document is intended for information purposes only and is not intended as an offer or recommendation to buy or sell securities. The Barrie & Hibbert group excludes all liability howsoever arising (other than liability which may not be limited or excluded at law) to any party for any loss resulting from any action taken as a result of the information provided in this document. The Barrie & Hibbert group, its clients and officers may have a position or engage in transactions in any of the securities mentioned. Barrie & Hibbert Inc. and Barrie & Hibbert Asia Limited (company number 1240846) are both wholly owned subsidiaries of Barrie & Hibbert Limited. www.barrhibb.com