Raising the bar

The most intense monetary policy tightening since the 1980s is profoundly affecting non-life insurance. Almost 95% of central banks have hiked policy interest rates since 2021 due to high inflation post-pandemic. This is generating strongly higher investment yields for invested assets, but has raised the cost of equity capital for the non-life industry to the highest level for more than a decade.

Our research indicates that the benefit of higher interest rates on insurers' investment results far outpaces the increased cost of capital that accompanies it. Insurers' cost of capital has increased in all major regions since the start of the tightening cycle, with European insurers seeing the largest jump in risk-free rates.

Comparison of insurance sector ROEs with cost of capital

Yet since the average non-life investment portfolio is generally 2.5 times net premiums earned, an additional 100 basis points (bps) of investment yield is roughly equivalent to 250bps improvement in the combined ratio. Even with a likely deterioration in combined ratio between 2021 and 2023, higher interest rates improve the profitability of new business with respect to cost of capital, incentivising stronger growth in 2023.

Cost of capital estimates and 10-year US Treasury yield

In contrast, the low-interest-rate years after the global financial crisis caused profitability headwinds for insurers. Non-life insurers' returns on equity (ROE) did not meet their cost of equity capital globally in either the post-financial crisis era (2010-19) or pandemic period (2020-22). 

Interest rate sensitivity of US P&C insurance, 2021 and 2023

Higher interest rates transform the economics of insurance and put insurers on a more financially sustainable long-term path. Still, to narrow protection gaps, industry resources would need to grow in line with the growth in demand from evolving risks, such as catastrophes. For example, we estimate that US Property & Casualty (P&C) industry capital has grown by 5% annually on average for the past 10 years, two percentage points less than the 7% estimated growth in the natural catastrophe protection need each year. To narrow this protection gap will require higher growth in capacity, in the form of industry capital.

In 2023 we expect improving profitability for most non-life business, as underwriting measures adjust to claims trends and higher portfolio yields boost net investment income. For new business, higher yields contribute an estimated 630bps improvement to the non-life industry operating ratio, exceeding the 190bps increase in the cost of equity capital. Our analysis suggests that in 2023 non-life insurers will narrow the underwriting gap by six points on average from 2022, but still miss their CoC targets, by about four points of combined ratio on average. Despite this, we see the global profitability level as still too low and so supportive of more rate hardening. The cautious return of investors to the Alternative Capital (AC) market, despite higher returns on catastrophe bonds, reinforces our view that hard market conditions may persist into 2024. 

Underwriting profitability gap in share of net premiums earned in eight key markets, and their total

Non-life insurers' available risk capital and capacity deployed are constrained in many lines, despite the stronger profitability of new business at current higher interest rates and investment returns. This is driven by heightened risks including economic and social inflation, the war in Ukraine, and uncertainty around claims trends, reserves and other risks. Capacity restraints are also partly driven by model uncertainty after years of above-average natural catastrophe losses. With investors hesitant and return expectations rising, issuing new equity is also less attractive.

Economic drivers of the non-life pricing cycle

Given the competing demands of higher demand and risk, and limited capacity, on non-life insurers, more efficient use of capital becomes key. Reinsurance can function as a flexible and efficient capital substitute to ease these pressures. Reinsurers can offer insurers access to their balance sheet at costs below insurers' capital costs because their portfolio is diversified across a broader range of geographies and risks. Reinsurance can help insurers by improving their capital efficiency (higher returns, enhanced solvency), providing certainty for legacy liabilities, and supporting the growth of new business.

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