Major Industry Trends
Although the insurance sector has had at least one spectacular disaster during the current financial crisis, in the shape of the huge losses sustained by American International Group (AIG), it has, by and large, not been nearly as badly damaged by the crisis as the global banking sector.
In a considered paper on the impact on the sector of the crisis, Zurich Re author, Marian Bell, argues that although insurers and banks are both suppliers of financial services, and together constitute the bulk of the financial services industry, they remain very distinct businesses, with different regulatory regimes, and a different approach to risk. Thus, it is not surprising that the financial crisis has affected the two related businesses of banking and insurance differently.
The insurance sector has been exposed to the current financial crisis in several ways. It invests in equities, and, substantially, in banking stocks (which gives it exposure to bank losses through share price losses in its investment portfolio), and in corporate investment-grade bonds, about 60% of which come from the finance sector. Insurance companies have also, in recent years, become much more involved in the capital markets, with some insurance lines being securitized and sold to the capital markets.
However, this does not pose as great a risk as the banks investing in asset-backed securities, many of which turned toxic as the US subprime mortgage crisis developed. The International Association of Insurance Supervisors (IAIS), which represents insurance regulators and supervisors from some 190 jurisdictions around the world, has a clear view of the global insurance industry. In a communiqué issued on December 17, 2008, it said that the global reinsurance sector “remains resilient amid the financial crisis.”
The IAIS made the remarks in the context of publishing its fifth annual overview of the financial conditions of reinsurers, the Global Reinsurance Market Report 2008. The overview assessed the reinsurance market’s stability and interrelated risks, as well as the impact of the current turmoil on the sector’s ability to transact business. The point is that reinsurers, who can be thought of as the companies to which insurance organizations hand off some of their book risk, so as to dilute their own positions, play an important role in the functioning of efficient insurance markets across the world. They act like shock absorbers, particularly in providing disaster coverage.
The reinsurance business, as is true for the whole insurance sector, is very cyclical, with good years and bad years. Another cycle in the sector is that of hard pricing versus soft pricing. Hard pricing, basically, takes over after the sector has endured one or more particularly bad years, and the cost of insurance across a whole range of lines of business rises sharply. Normally, the capacity in the industry is enough to ensure that competition for business keeps prices on the low side. Any insurance company that tries to raise prices finds its customers going elsewhere, so no single organization has the power to “harden” prices. This can only happen when capacity is taken out of the industry, again, usually after companies have made losses through massive payouts on disasters.
The IAIS points out that, following record losses in 2005, particularly hurricane losses and flood damage, both 2006 and 2007 were profitable years for the reinsurance sector. This gave the sector a solid financial base to weather the challenges of the financial crisis, the IAIS says.
Zurich Re, in its report, quotes the IAIS as saying that no insurers have, so far, experienced “liquidity difficulties as a result of the recent market turmoil.” They have all remained open for business, and have been transacting business in a way that the banks clearly have not.
In all, the Zurich Re report says, insurers’ exposure to the toxic asset-backed securities market amounts to no more than 1% of assets in aggregate. In effect, the report says that the upturn in the insurance industry’s pricing cycle in 2008, with prices hardening in some lines of business, led insurers to start redeploying their capital away from potentially “dodgy” derivatives investments, and back into their core lines of business.
It is important to understand the difference between the types of risk run by the two sectors. As the Zurich Re report notes, the banking sector invested in products where the underlying risk is a financial or market risk (such as credit worthiness, price volatility, or exchange-rate volatility). Insurance-linked securities, on the other hand, are products where the underlying risk is a real event, such as a natural catastrophe, a fire, or a motor accident. The various types of financial risk can, in some circumstances, all turn out to be related, creating a “perfect storm.” With insurance risk, however, the events are fundamentally unrelated and uncorrelated. They are non-systemic, idiosyncratic risks. This means that in financial risks the risk can be aggregated in ways that prevent hedging strategies from working (all prices fall when markets collapse). “The risks cannot be diversified away by investing in other financial and market risks,” the report says. In contrast, insurance-linked securities offer the prospect of diversification and are not subject to the same degree of contagion as financial risk. Here again, this explains why the insurance sector has come out of the crash better than the banking sector.
Moreover, the sector has also benefited indirectly from the liquidity crisis. In normal times, when the capital markets are functioning efficiently, and when the insurance industry moves into a period of hard pricing (where they are able to raise premiums, often quite severely on some lines of business), new money is attracted into the sector. The capital markets fund new insurance start-ups, which compete on price, and, after a while, this competition transforms a hard cycle back into a soft cycle. In today’s market, however, existing insurance companies are capital-constrained in at least two ways: one, because prudence and the regulators are dictating that companies increase their capital reserves during difficult times, which leaves them less capital with which to write business, and two, because plunging markets have wiped 40% or more off their asset portfolios. As their assets are worth less, they have to increase their reserves to make up the difference, and that draws off capital that they could otherwise use to write business. At the same time, the capital markets are more or less illiquid right now, so potential new players cannot spring up to take advantage of gaps in the market. All this adds up to less capacity to write business, and less capacity means higher prices, by the iron law of supply and demand.
Market Analysis
Another key development in the market today is the way the industry is approaching the threat of global warming. Insurance is about covering future risk, rather than funding recovery from disasters that are certain. If sea levels start to rise beyond question, as a result of global warming and the melting of polar ice, then people on very low-lying coastal properties will not be able to buy insurance, as it is certain that their properties will suffer damage, and possible destruction. The industry is already exploring various kinds of partnering arrangements with government, which would see government stepping in where the sector cannot. It is a fact that some of the world’s most valuable real estate lies on very low-lying coastal ground, or on active fault lines (California springs to mind on the latter count, Florida on the former). The sector has been very active in trying to get committed global action to mitigate the risks posed by global warming. The weather is already unpredictable enough for the industry’s taste. An increase in the frequency of natural disasters would simply increase its losses, perhaps out of all proportion to the opportunities such an increase creates for the sector to write business.
However, the insurance industry has been very innovative over the years, including in relation to natural catastrophes. The instrument of this innovation is catastrophe bonds, a major branch of insurance-linked securities. In a report published on January 22, 2007, Swiss Re, one of the world’s largest reinsurance companies, advocated the setting up of a European loss index based on industry-wide data. The idea is that if potential investors have access to a database that shows them a picture of the entire European claims data, they will be able to form a view of how much risk they are taking on in investing in particular catastrophe-bond instruments.
Swiss Re pointed out in the report that the issuance of European catastrophe bonds increased by 130% in 2006, bringing the total value of outstanding catastrophe bonds to US$8.1 billion. One of the drivers of this growth was the availability of US market-loss indexes for US risk. Another insurance industry derivative, industry loss warranties (ILWs) achieved US$4 billion of sales. ILWs are a product where the buyer of a US$50 million limit on an ILW at US$10 billion pays a premium, and in return, receives US$50 million if total losses to the whole insurance industry from a single event, for example a hurricane, exceed US$10 billion. It should be clear that ILWs and catastrophe bonds attract liquidity to the industry, and help it to offset losses from major disasters. At the same time, they provide money-market investors with the opportunity to make significant returns, if they call the risks correctly. Hence, better risk information makes it much easier for potential investors to decide to commit to these instruments. (The alternative way for capital markets to commit to the insurance industry, as we have seen, is to invest in new insurance start-ups after a major disaster has taken capacity out of the market). However, derivative products such as ILWs and catastrophe bonds are much more liquid, and much more specific. In essence, catastrophe bonds allow investors to enjoy premium income while taking on the risk of having to pay out specific sums, if the risk envisaged in the bond comes to pass. ILWs allow the investor to take a bet on the magnitude of an event. If it happens, but is less severe than the limit in the bond, they get nothing.
Looking at the growth of the insurance business worldwide, Swiss Re, which produces the authoritative “sigma study”1, showed that premium incomes are growing far faster in emerging markets than mature markets—not a surprising result when one remembers that emerging markets start from a lower base, and have higher GDP growth. According to the Swiss Re study, world insurance premium income grew 3.3% in real terms in 2007, to US$4,061 billion. The growth was primarily driven by life-insurance business in both industrialized and emerging markets, and to a lesser extent by non-life business in emerging markets.
Life insurance premium growth increased by 5.4% over the figures for 2006. Non-life business in emerging markets grew even faster, at in excess of 10%, but sales actually contracted fractionally in developed markets (0.3%), according to Swiss Re.
Commenting on the report, Daniel Staib, one of the study’s authors, said: “Despite a macroeconomic environment characterized by marginally slower economic growth and rising inflation, life insurance continued to expand in 2007, with world life insurance premiums increasing by 5.4% to US$2,393 billion.” Sales of retirement and other wealth accumulation products spurred premium growth in the industrialized economies.
A key driver of growth in the life business is an ageing population in developed countries, where pensions and annuities business remains strong, particularly in the face of an evident pullback by governments from providing comfortable retirement safety nets for their populations. In emerging markets with relatively young populations all lines of business, from protection insurance to motor insurance and life, are seeing strong sales.
According to Swiss Re, the outlook for the coming year is for growth in life-insurance premiums to become more moderate, as capital markets and stock-market turmoil dampen demand still further. Once the upturn begins and some stability returns, life insurance is projected to resume its strong performance, Swiss Re concludes.
Note
1 Sigma provides comprehensive information on the international insurance markets and analyses of economic trends and strategic issues in reinsurance and financial services, covering life and non life businesses.
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