Major Industry Trends
In January 2011 the insurance sector was awash with capital as new money poured into the sector and insurance premiums on a wide range of protection products softened. This is known as the soft phase of the insurance cycle and is a normal feature of this highly cyclical industry. As a rule, after a year in which the sector has to pay out huge sums on a series of major disasters the industry raises premiums, in effect passing the cost on to clients, while it also benefits from the fact that disasters heighten awareness of the need for insurance. “Smart money” then pours into the sector to take advantage of increased risk premiums.
With that as background, by July 2011, the sector was reeling from the impact of one enormous disaster after another, and was looking at the highest payout year on record, eclipsing the previous record payout year of 2005. A series of natural disasters, including the Japanese earthquake and tsunami in March, combined with flooding on a biblical scale in Australia and Asia-Pacific, the New Zealand earthquake, tornados in the eastern United States, and political unrest in the Middle East, have racked up claim costs enormously. On August 1, 2011, the Guardian reported that insurer Lloyd’s of London was reporting pre-tax losses for the first half of year of £85.6 million (US$139.5 million) and other insurers were also reporting steep losses. In all, the sector is facing losses of more than US$50 billion. In response, US catastrophe reinsurance rates went up by 10% while premiums in the areas most affected by catastrophes have risen in some instances by 50%.
Accountants PricewaterhouseCoopers (PwC) and the Centre for the Study of Financial Innovation produced a study in 2011 analyzing the risks run by the insurance sector across the life, non-life reinsurance, and London market sectors. Interestingly, in a year of major catastrophes, the risk that insurers themselves most prioritize is the risk posed to their business models by regulatory changes. Without doubt, this reflects the global industry’s dissatisfaction with Solvency II, the major regulatory form being faced by the sector as regulators seek to prevent another meltdown such as the US$188 billion loss suffered by American International Group (AIG), which had to be bailed out by the US taxpayer, and was one of the first casualties of the 2008 financial crash.
In general, though, the insurance sector was not 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 argued that, although insurers and banks were both suppliers of financial services, and together constituted the bulk of the financial services industry, they remained very distinct businesses, with different regulatory regimes, and a different approach to risk. Thus, it is not surprising that the financial crisis affected the two related businesses of banking and insurance differently.
The insurance sector was exposed to the global financial crisis in several ways. It invests in equities, and, substantially, in banking stocks (which gave 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 did 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 in December 2009, it said that the global reinsurance sector “has demonstrated robustness and resilience despite the combined challenges of sustained catastrophic losses and the historically low investment environment that manifested in 2008.”
The IAIS made the remarks in the context of publishing its sixth annual overview of the financial conditions of reinsurers, the Global Reinsurance Market Report 2009. 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, in spite of 2008’s challenging environment, reinsurers returned an overall positive result, indicating industry strength and contributing to both the stability of the global insurance markets, as well as ultimately the security of individual insurance customers. It added that reinsurers continued to focus on diversified risk taking, drawing on the fundamentals of the reinsurance business in order to navigate a particularly turbulent year for the economy in general, and the financial sector in particular.
Zurich Re, in its 2009 annual report, said that although the global insurance industry suffered sharp declines in asset values in 2008 and the first half of 2009, it recouped large parts of its unrealized assets by the end of 2009.
In its 2008 annual report, Zurich Re said that “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 Zurich Re notes, the banking sector invested in products where the underlying risk is a financial or market risk (such as creditworthiness, 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 finance, 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.
We have already seen the enormous impact on the sector of a concatenation of catastrophic events around the world through 2011, with the implications this has for the sector moving to the “price hardening” phase of the cycle. 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 will be 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 by investing in particular catastrophe-bond instruments. However, in 2010, this development was reported to still be “years away.”
Swiss Re said that growth resumed in the industry loss warranties (ILW) sectors. 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 said that in the property and casualty sector, primary non-life claims showed little growth. Commercial lines suffered a double impact from the recession, according to Swiss Re. Demand decreased significantly, yet competition remained strong. However, natural catastrophe claims were low. Meanwhile, premiums for life insurance fell by around 3% in 2009. However, life reinsurance premiums continued to grow through the crisis, despite the drop in demand for primary life products.
According to Swiss Re, three key factors will drive the business in 2010. They are:
The growth of non-life premiums in emerging markets. Swiss Re says that increased government spending on infrastructure projects, particularly in Asia, should support property and engineering reinsurance demand;
Traditional Life insurance demand will remain strong. Swiss Re says that life insurers recapitalization efforts will continue in 2010;
Insurance-linked securities activity will gain momentum.
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