sigma No 4/2018: Non-life profitability - Economic drivers and cyclical trends

Thomas Holzheu, Kulli Tamm, Roman Lechner, Irina Fan, 08 Sep 2018

The global non-life insurance sector is currently at a weak phase of the profitability cycle. Sector profitability declined in 2017, with return on equity (ROE) slipping to 6% from 7% in 2016, well below the roughly 9% achieved annually between 2013 and 2015. Last year's result was driven by three main factors:

  • Soft underwriting conditions. Following a modest improvement in commercial insurance prices in 2012, rates fell for 18 consecutive quarters. In 2017, the global market index was at just 89% of its 2012 value;
  • Low investment yields. Investment returns for non-life insurers remain under pressure. Average yields have stalled due to the ongoing low interest rate environment. The contribution of investment returns to profitability in 2017 remained at the post-crisis low level of 9-10% of net premiums earned; and
  • Large natural catastrophe losses in the US.

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Underwriting margins fall 5 to 9 percentage points short of profitability targets

We believe that non-life insurance markets are in a transition period, between a prolonged soft and a hardening market. Commercial lines and reinsurance premium rates started to rise at the end of 2017. Additionally, prices in personal lines have hardened moderately in key markets for a few years, but are still trending down in other markets. It remains to be seen how strong and sustainable the firming market is.

In spite of the modest premium rate hardening, the sigma shows that more work to improve underwriting performance needs to be done if current shortfalls in profitability are to be redressed. We estimate that underwriting margins need to improve by at least 5 to 9 percentage points in the major western markets and Japan, and by 1 point in China, if insurers are to deliver acceptable returns to investors in the future. The assumed target ROE ranges from 10% for mature western markets to 15% for China, partly reflecting differences in interest rates and past performance.

Estimate of the profitability gap, as a percent of net premiums earned

Source: Swiss Re Institute

Separating the cyclical downturn from the long-term performance

In its analysis of the profitability cycle, this sigma shows that over the long run, insurance companies have delivered a level of profitability comparable with firms in other sectors. In line with these profit trends, a two-decade comparison of non-life insurers' stock market performance suggests at par or even above-par valuation. Furthermore, insurance stocks demonstrate low correlation of price returns with other industry sectors and thus offer value to investors in the form of diversification benefits.

20-year average stock market performance of US stock companies, 2008–2017

Source: Bloomberg, Swiss Re Institute

Underwriting cycles have become more synchronised across countries

Underlying trends indicate that underwriting cycles are strongly integrated globally and across lines of business. The analysis in the sigma identifies a general cyclical pattern, but also some idiosyncratic variations due to natural catastrophe losses and a degree of country- and line-specific pricing trends. Hence, writing non-life business across lines and countries brings diversification benefits to an insurer's underwriting portfolio. Another finding is that the average duration of the cycle seems to have lengthened since the early 1980s, when central banks changed their policy focus toward fighting inflation and large parts of the financial services industry were deregulated.

Calendar-year combined ratios of major markets

Source: Swiss Re Institute. The blue band shows the 3-year rolling average of one standard deviation from the average

Interest rates and non-life insurers' underwriting results are interrelated in the long run. In the past, during periods of higher interest rates, stronger investment returns were offset by larger underwriting losses. By contrast, underwriting results in the current cycle have deteriorated without the benefit of compensating rising yields, as the slow post-crisis recovery has led to a prolonged backdrop of low interest rates. Changes in interest rates are not a meaningful driver of the cycle in a short-term context though.

What drives the underwriting cycle?

(1) The strongest factor seems to be non-catastrophic claims trends – also called attritional losses. A rise in expected losses and higher parameter uncertainty about the loss expectation can lead to reduced capacity, even if the overall amount of capital remains the same. Insurers must hold additional capital for these unexpected losses, thus removing capacity from the market. The most severe hard market was the US liability crisis of the mid-1980s, which was triggered by a strong increase in liability claims frequency and severity. Also, Hurricanes Andrew (1992) and Katrina (2005), and the WTC loss (2001) revealed unrecognised or un-modelled risks which caused capacity shortages and rate hardening in the property cat segment, with far-reaching repercussions into the primary insurance market. The events of the 2017 cat season fell more within the range of expected model outcomes.

(2) Investment yields are also an important external factor determining re/insurance prices. In the past, high investment returns have encouraged cash flow underwriting and fueled soft markets, most notably from 1997 to 2000. However, the low-yield environment of the last decade has largely discouraged this strategy. Instead, the market has been softening even with low yields, due to excess capacity and benign claims trends.

The next two forces are the ones that we actually hear most about: capital and catastrophes

(3) The supply of non-life insurance is driven by capital. In the long-run, most capital growth is organic and comes from within the industry through retained earnings and capital gains on invested assets. Capital can increase more (or less) if underwriting losses are lower (or higher) than expected. New capital enters the insurance industry through start-ups, often based offshore, and through capital injections into incumbent insurance carriers. In addition, alternative risk transfer vehicles such as captives, risk retention groups, and ILS were developed which complement and compete with the traditional supply of insurance companies. Exits of capital generally take the form of net losses, dividends to shareholders and share buybacks.

The amount of non-life insurance capital in our sample of nine major markets grew from below USD 900 billion by the end of 2007 to around USD 1 090 billion 10 years later. The average growth over that decade was 2.3%, approximately in line with the rate of average annual premium growth. The period included the global financial crisis in 2008/09, the high cat losses of 2011 and 2017, and a more active capital management strategy by many insurance companies to avoid massive overcapacity. Over the latest four years, non-life capitalisation has remained roughly stable.

(4) The effect of cat losses is smaller than often assumed, especially for primary insurance. Large catastrophes or asset shocks have triggered market turns in the past, but there is no guarantee that they will always do so. For example, other economic forces offset the impact of the Northridge earthquake (1994) or of hurricane Sandy (2012). Lost capital is easily replenished, increasingly so with alternative capital.

(5) A final important market force is momentum. Premium rate trends change only gradually and depend strongly on the prior-year dynamics, a factor that is institutional in markets where rates require regulatory approval. The time period from when claims trends materialise, to the filing for rate changes based on these trends to implementation of new rates post approval, can be long. This is more an issue for personal than for commercial lines, which are mostly deregulated. Decision biases which are rooted in insurers' difficulty predicting the true cost of a policy also play into the momentum trend. In long-tail business especially, claims trend factors materialise with a lag. Insurers therefore set rate targets based on a combination of actuarial science and external market signals, including the previous year’s price and average market trends. Brokers play an important role in framing the perceptions of the market trends and add to a process of collective adaptive learning. Lastly, insurers look at their current profitability to set rate targets, which also adds a lag.

Economic developments alone will not close the profitability gap

Underlying economic growth improved strongly in 2017 and 2018, putting upward pressure on inflation and interest rates. Central banks in many countries are already withdrawing monetary stimulus to ward off overheating. This signals a changing operating environment for non-life insurers. Under the current stronger economic conditions, we expect interest rates in mature markets to continue to rise moderately, which should benefit insurers' earnings through higher investment returns. However, macroeconomic developments alone are unlikely to generate sustained improvement in profitability of the non-life sector. For one, the increase in long-term interest rates that we foresee is not substantial. Moreover, tighter labour markets are projected to push up general and claims inflation, creating an offsetting effect on underwriting results. The accelerating claims inflation will also have an impact of eroding the adequacy of claims reserves – ie, for claims which already incurred but are not settled or paid yet - and further affirms that, in order to achieve sustainable improvement in sector profitability, insurance premium rate increases in excess of rising claims trends will be needed.


Though the underwriting cycle seems to have reached an inflection point and non-life insurance prices are hardening modestly in the major markets, our analysis shows more work needs to be done if insurers are to close the existing profitability gap. To deliver target returns to investors, underwriting margins need to improve by at least 5 to 9 points in the major western markets and Japan.

Over the longer-term, insurance has remained an attractive investment opportunity, having delivered profitability and stock market returns comparable with other sectors, and also offering diversification benefits.

Underwriting cycles are increasingly integrated globally and across lines of business. Cycles are inter-related with interest rates in the long-run and have become longer since the 1980s.

The evolution of the global economy into a later-stage of the business cycle will benefit future profitability through (moderately) higher interest rates and investment returns in mature markets, but tighter labour markets are also expected to push up general and claims inflation at the same time. More rate increases in excess of claims trends will be needed to achieve a sustainable improvement in profitability.

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Thomas Holzheu

Chief Economist Americas, Swiss Re Institute

Kulli Tamm

Senior Economist, Swiss Re Institute, New York

Roman Lechner

Senior Economist, Swiss Re Institute, Zurich

Irina Fan

Senior Economist, Swiss Re Institute, Hong Kong