Looking Beyond the Obvious
3 reasons why your client's rates may be moving despite a spotless claims history
Your first thought is that there must have been a large number of construction losses that hit the market in the last year. But after a bit of research you don’t find any evidence to support that. The truth is the soft market has finally caught up to insurers. Insurers are feeling the effects of offering rock bottom rates for too long. Rates are on the rise for all lines of insurance. The most obvious conclusion is that the market has suffered adverse loss experience, but this may not be the only reason. In fact, there are a number of other factors that can contribute just as much, “if not more so, to a hardening market. We’re going to examine a few of these factors.”
1) Interest Rates:
As interest rates drop, premiums increase to offset lost investment income.
The events of the 2008 financial crisis forced central banks to lower lending rates in an attempt to spur the economy. Because of this we’ve seen government bonds and GICs that were once yielding over 5% drop to under 2%. For most people in the workforce, employment income far outweighs investment income, so we rely a lot less on high investment returns to pay for day-to-day expenses. The negative impact of a drop in interest rates is therefore relatively minimal. For insurance companies, the situation is just the opposite.
We can separate an insurance company’s profit into two categories: underwriting profit from insurance operations and investment income. Underwriting profit is the amount that premiums charged for a policy exceed the undiscounted cost of claims, overhead and claims handling expenses and brokerage. The investment income category includes, for the most part, the investment returns earned on capital and on reserves set aside to pay future claims. Insurers rely heavily on this component to achieve their target return on equity (ROE). The extent to which they rely is dependent on the “tail” of the business (i.e. how long it takes to pay out claims after the receipt of premiums). For short tail lines like property, investments play a lesser role. However, for most casualty lines of business, the investment returns exceed the underwriting profit priced into an insurance policy. In some situations, policies are even priced to an underwriting loss with the understanding that investment returns will make up the shortfall. Since government bonds typically make up a large share of insurers’ investment portfolios, interest rate cuts can have a meaningful impact on rates.
Consider the following example: let’s assume it is 2005 and a relatively risk free investment earns 5% interest. Your insured buys a policy for $10,000 that costs the insurer $9,500 (loss costs of $6,500; overhead and underwriting costs of $1,500 and retail brokerage of $1,500), which means the expected underwriting profit is $500. If the insurer has to hold capital at a ratio of 2:1 then the profit of $500 on $20,000 in capital equates to a 2.5% return, well short of the typical 15% target ROE of most insurers. The remainder of the return is actually generated through investment returns on the capital and loss reserves. If it takes on average 4.5 years to pay losses, the insurer will have reserves on hand equal to about $29,000 (4.5 years x $6,500 of expected loss costs). Reserves and capital combined total about $49,000 and generate a return of $2,500 at a 5% interest rate. This means that investment income alone generates a return of 12.5% on $20,000 of capital, bringing the combined ROE to 15% (2.5% + 12.5%).
We make a number of simplifying assumptions to illustrate the point, but the example is not unreasonable. With interest rates at 5%, the return generated by investment income is five times the underwriting profit priced into the policy. Now, what happens if the interest drops 1% to 4%? The $49,000 investment will now generate roughly $2,000, instead of $2,500. The $500 investment shortfall must be now be recovered by increasing the premiums charged to the insured. We can see that in this situation, a 1% reduction in investment return requires a 5% increase to insurance premiums. Table 1 shows the impact of more significant interest rate changes.
2) Capital Requirement and Catastrophes
As insurers are forced to hold more capital to support the business, premiums must increase to generate the same rate of return.
Insurers have a fiduciary responsibility to ensure that capital levels are sufficient to handle all potential risks. This can be impacted by a number of issues, from the risk of reserve deficiency to reinsurance credit risk to inflation risk. For a mature insurer, we expect most of these risks will not change significantly from one year to the next. One area that is prone to dramatic changes, however, is the capital required to support the exposure to catastrophes, like earthquakes and hurricanes.
In Canada, OSFI currently mandates that insurers have sufficient capital to safely withstand a 1-in-400 year earthquake event (increasing to a 1-in-500 event over the next 10 years). To determine their exposure and assign a dollar figure to such an event, insurers often depend on third-party catastrophe models. But like any model, assumptions and methodology must be updated as new information becomes available, and this can produce drastic increases to the modeled results. This was precisely the case last year when Risk Management Solutions (RMS) released Version 11 of their catastrophe model, with significant changes to the Atlantic Hurricane module. The changes resulted in substantial increases to many insurers’ 1-in-250 modeled hurricane loss. As insurers adopt the new estimates, they are forced to hold more capital in support of catastrophe exposure or write less business. This lowers their total return on capital, unless they can make up for it by increasing premiums.
Let’s look at a property insurance company with $100 million in capital and a target return on capital of 15%. The company limits their premium writings based on a maximum 1-in-250 year earthquake event of $50 million (i.e. in this scenario they elect to hold twice as much capital required to remain solvent in the event of a 1-250 year loss). Using current catastrophe models, the company reaches their maximum allowable earthquake exposure after writing $40 million in premium. Now assume the catastrophe model is updated and earthquake exposure estimates have increased by 50% (increases much larger than this have been known to occur). Using the new model, the company can only write about $26 million in premium before the maximum earthquake exposure is reached, but they have the same capital and target return. The company has therefore forgone roughly $4 million in lost profits on the $14 million worth of policies that can no longer be written, and will have to make it up by increasing rates by 15% on the $26 million of retained business ($4 million lost profits / $26 million premium written = 15.3% rate increase required).
In actual fact, most property insurers purchase reinsurance to control exposure levels. Rather than write less business, the company may elect to purchase more reinsurance. Nevertheless, this will ultimately have the same effect as rates will need to be increased to offset the costs of additional reinsurance.
3) Cost of Reinsurance
Increasing costs of reinsurance are borne by primary policyholders.
As mentioned previously, insurance companies are faced with many risks that could threaten the solvency of the company. They must evaluate, monitor and control these to ensure that they are not overly exposed in any one area. One such way they do this is by purchasing reinsurance. Most, if not all, P&C insurance companies purchase reinsurance in one form or another, whether it be proportional treaties, excess of loss treaties, property catastrophe covers or whole account aggregate protections, thus the availability and cost of reinsurance plays an important role in the pricing of underlying policies.
Reinsurers are generally global entities, and as such, losses suffered in one region will likely affect reinsurance markets throughout the world. In 2011, earthquakes and other natural catastrophes cost over $100 billion, a significant portion of which was paid by reinsurers. As reinsurers seek to recover lost profits and lost capital, they are forced to increase rates in all regions of the world. To make matters worse, the Canadian reinsurance market suffered significant losses due to a number of domestic catastrophes, including the Slave Lake wildfires (estimated in excess of $700 million) and the Goderich tornado (estimated at over $75 million). Because of the above events, we have already seen evidence of increased prices in Canada for all property reinsurance programs, in particular non-proportional treaties and catastrophe covers. As treaties are renewed, the increased cost of reinsurance erodes insurers’ bottom lines and insurers are forced to pass along rate increases to their policyholders.
Like any successful company, an insurance company must achieve a reasonable rate of return in exchange for the risk of doing business. To accomplish this, insurers will adjust insurance rates up or down depending on the situation. A major driver of insurance rates is insurance losses, be it catastrophe or other, but they aren’t the only contributing factor; interest rates, capital requirements and reinsurance costs are three considerations that aren’t as obvious and can have a significant impact on insurance prices. So the next time insurers don’t cooperate when you push for lower premiums on a clean loss record, you may have a better understanding of why that is. But that doesn’t mean you shouldn’t try.
Matt Wolfe is managing director for Canada and Jeff Turner, ACAS, is vice president of reinsurance brokerage beach and Associates.
Copyright 2012 Rogers Publishing Ltd. This article first appeared in the April 2012 edition of Canadian Insurance Top Broker magazine.