Expert Commentary

Insurance Prices Are Up—So Why Aren't Underwriters Smiling?

The insurance industry is experiencing upward trends in pricing, but these pricing increases may not provide insurers with expected rates of return on capital. Learn what it will take for insurers and reinsurers to sustain successful results in the future.


March 2001

The insurance industry is experiencing upward trends in pricing and perceived relief from the declines in pricing that have occurred since the early 1990s. However, these pricing increases may not necessarily provide insurers/reinsurers with their expected rates of return on capital. In the past several years, operating results, driven by insured claims and operating costs, have exceeded premium income. The cumulative impact over time is producing questions about insurers' and reinsurers' product mix, volumes, and margins.

How can insurers and reinsurers sustain successful results in the future? As long as the insurance industry maintains excessive levels of underemployed capital, it will not achieve stable pricing that supports attractive rates of return.

Enterprise Goals

Today's premiums are trending upward, however, financial performance is still in question due to excessive amounts of capital held by the insurance industry not invested in underwriting clients' risks. A number of insurance enterprises have target rates of return that also need to be questioned. Are insurance companies competing in "capital auctions" where capital goes to the highest bidder or, rather, are they attracting capital based on risk-adjusted rates of return related to investors' needs to have balanced portfolios?

Investors are seeking diversification of risk and commensurate market rates of return. Otherwise, they would load up on high price/earnings (P/E) multiple stocks and be comfortable in riding out notable swings in the market. Of course, liquidating investments in an adverse market could result in significant losses. Generally, investors' asset allocation is balanced relative to their real and perceived risk profiles. Therefore, they desire a balance of higher and lower P/E stocks, high-to-medium credit quality fixed income investments with various maturity dates.

Buyers of insurance really want a stable and credit quality market, which provides them with a reasonable ability to forecast and budget related costs. Otherwise, what is the point of buying insurance as a short-term financing/hedging vehicle? Also, insureds want their claims to be paid promptly. The alternative is dealing with insolvent insurers and government guarantee schemes that cause delays and the possibility of deep discounts in funds recovered.

Insurers want to deliver their products to the market and earn competitive risk adjusted rates of return. However, there is a need for the insurance industry to focus more on their product offerings, risks, and expected returns relative to the total capital market. P/E ratios are one measure of risk-adjusted rates of return, which suggests the degree of risk as well as the expectation of earnings and cash flows in the near term. Historically, insurance enterprises have traded at a P/E of 12 to 15 with some short-term peaks for "hard" market insurance prices.

Insurance Fundamentals

Risks assumed by insurance companies involve the unexpected or fortuitous causes of loss defined in the policies. Policies also define certain benefits involving consequential loss impacts associated with the defined event, such as continuing business interruption, subject to time and dollar limits, or necessary discovery and defense costs for third parties' legal actions. This does not imply underwriting the ultimate success or failure of clients' businesses, as faced by security underwriters.

On a portfolio basis, underwriting firms focus on matching assets and liabilities while maintaining a reasonable degree of liquidity in order to pay claims. Given their fiduciary responsibility to policyholders, combined with their investment philosophy of maintaining safe high-credit quality (lower yields) fixed income investments, they are likely to have rates of returns on total capital near the lower end of the 6 to 10 percent range, or below.

We need to remember that investors are looking for a balance of risks and, hence, an array of returns. Capital market firms talk about the high returns in the market, but if that were all they had to sell, their own portfolios would have large inventories of higher risk investments. Think about the impact of the recent 40 to 50 percent downward correction that occurred within the high-tech business sector. Businesses heavily invested in high-tech stocks are adjusting their book values to the lower of cost or market as required by generally accepted accounting principals (GAAP).

Insurers are limited by regulation as to the degree to which they can hold stocks in their investment portfolios. To the degree permitted by regulators, insurers and reinsurers holding high-tech stocks experienced an investment "hit" to overall results in addition to adverse loss experience relative to premium income.

Calibrating Expectations

Different industries generally have different P/E ratios due to their inherent risks and recent historical performance, as well as near-term future expected rates of returns. High technology, biotech, and pharmaceuticals firms generally have higher P/E ratios as compared to the manufacturing and service industry sectors, such as automobiles, banking, insurance, and hospitality.

The size, maturity, and growth rate of any particular firm affect its P/E ratio. Higher growth and higher margin businesses enjoy higher P/E ratios, but also have higher risk factors. What does it take to stay on top? High tech and selected segments of a few other business sectors enjoy P/E ratios in the range of 20 to 30 or more, and the service sectors in the range of 10 to 20.

It is unusual for any individual firm to sustain P/E ratios uncharacteristic of its industry sector without a recognized fundamental change within its business. Furthermore, the insurance industry generally has a P/E of around 12. It is unlikely that a firm can maintain a higher P/E without having consistent and sustainable earnings performance well above its peers within the industry. If an enterprise is seeking high returns and higher P/E ratios, it will need to seek new lines of business with higher degrees of risk and, hopefully, higher returns.

Challenges of Over-Capitalization

Managing in an over-capitalized position is difficult. Senior management will be disappointed with the firm's return on capital, and retaining their best accounts will be a challenge for underwriters. Returns on total capital, underwriting risk combined with excess capital invested in the high-quality financial assets, will likely result in lower yields than a portfolio fully invested in underwriting risks. If insurers cannot earn a rate of return within their business that is greater than being invested in financial assets, they should liquidate.

Enhancing returns will require developing new products with higher margins. Insurers' and reinsures' stated targeted hurdle rates or returns on capital range from 12 to 20 percent. Some of the best Fortune 500 firms in the world, with solid investment grade credit ratings, who are invested in businesses with greater profit margins than the insurance industry, have P/E ratios in the lower end of the 12 to 20 percent range.

Insurers currently remain in an over-capitalized position with operating losses. Increasing premiums will absorb some of the surplus capital, however, it is unlikely to eliminate the total surplus position. Investment income has reduced the deficit, but operating margins have been affected by account or risk selection and market pricing levels. Pricing has been impacted by over-capitalization and the basic laws of economic supply and demand. Excess capital positions need to be reduced by investing in higher yielding lines of business and/or returning excess capital to shareholders.

Directions for Greater Success

The first step, when underwriting firms are dealing with operating and/or combined experience (operating + investment income), is focusing on risk selection for improved loss ratios, reductions to operating expenses, and "forced" upward changes to insureds' risk retentions.

Next, insurers and reinsurers need to extend their reach into new products beyond their traditional lines of business without necessarily being able to apply their technical underwriting metrics and their actuarial history. Perhaps the insurance industry needs to consider new product development by providing a capital allocation of 95 percent/5 percent, traditional versus new products, respectively.

New products refer to products that have not been offered to customers in the past. Additionally, truly new product development needs to be free from organizational structure and normal political processes in order to have the greatest chance of success.

Without taking on risk and allowing for groups of employees to have organizational autonomy, this world, for example, would not have "Post Its" from 3M, "Walkman" and "Mini Discs" from Sony, or MP3 technology. These firms allocate capital and freedom for small groups of employees to chase their ideas and dreams.

New product development does not always result in a successful product, but without trying, there is a 100 percent probability of the status quo. Even if the defined goals were not met, businesses should focus on what was learned in the process and turn it into a competitive advantage.

Currently, most reinsurers and insurers are emphasizing high-expected returns on capital without material increases in risk or investment in business opportunities. Capital is an important resource for the insurance industry and will continue to be the ultimate driver in determining market premiums. However, the market remains in an over-capitalized position, which requires several actions, otherwise, it is likely that current premium increases will be short-lived.

Over-capitalization needs to be modified through re-deploying capital in lines of business driven by clients' needs and higher returns on capital. As previously stated, the alternative for insurance enterprises is to return unneeded capital to the shareholders/owners.

Credit quality differentiation has not been rewarded in the traditional insurance markets as it is in the financial markets. The insurance product pricing differences are nonexistent for firms having an AAA versus AA versus A credit rating. The opportunity cost in terms of profitability may not be worth maintaining a higher credit rating.

Insurers who leverage their balance sheets by using reinsurance expand their ability to underwrite business with less capital than if they were to purchase less or no reinsurance. Hence, insurers' performance will be improved having less capital and more income produced by ceding commissions. Obviously, too much leverage in terms of reinsurance can migrate control from the insurers to reinsurers and may result in a lack of confidence in an insurers' ability to underwriter business.

If selected insurance enterprises choose to re-deploy capital into financial services, such as swaps, credit enhancement, etc., it will require more capital, and less reinsurance will be permitted, which should produce higher product pricing, risk, and returns on capital.

Summary

Direction for change to the targeted risk adjusted rates of return or "hurdle rates" has to come from the very top of insurance enterprises. Current upward pricing trends are being driven by the enterprises' expected returns on capital. The drag on overall capital yields resulting from excess capital invested in high-quality, liquid, and short-term financial assets with lower yields, needs to be addressed sooner rather than later.

Underwriters have to play the hand they are dealt. They are only the messengers. The books of business that they are responsible for need to reflect the corporate goals. Some accounts may get a bit more favorable treatment, but then, some other accounts will pay a greater proportional share.

In the short-term, clients can emphasize what is important to them and seek out financial service/insurance firms that are looking for clients to work with them on new product development. The only other option is to wait for insurers' leadership groups to achieve improved rates of return through new investments, adjustments to their targeted rates of return, and/or the return excess capital to shareholders. Alternatively, market forces will adjust premiums/prices to total capital held by insurance enterprises.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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