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INSURANCEMEGATRENDSWHAT’S DRIVING INSURANCE COSTS?

IN ASSOCIATION WITH:Foreword by STEVE FORBES, FORBES MEDIA

CONTENTS

Introduction ..............................................................................................................................................................2

Foreword by Steve Forbes .................................................................................................................................3

Executive summary ..............................................................................................................................................4

Key findings............................................................................................................................................................. 5

Observation one: U.S. casualty rates are now emerging from pre-9/11 lows .................................7

A rate cycle like no other ................................................................................................................................... 9

Observation two: Loss costs are increasing ..............................................................................................10

Rising regulatory demands .............................................................................................................................. 12

Observation three: Underwriting losses persist ....................................................................................... 13

Evaluating underwriting performance ......................................................................................................... 13

Observation four: Historically low interest rates contribute to low investment returns ...........15

Coping with suppressed interest rates ........................................................................................................18

Risk mitigation: customers will respond ......................................................................................................19

The surge in international activity .................................................................................................................19

Conclusion: Myriad forces are driving insurance rates higher ...........................................................20

INTRODUCTIONFive years after the !nancial crisis began, uncertainty continues to dominate economic discussions. On one hand, the Dow Jones Industrial Average is trading above 15,000, and the U.S. Economic Con!dence Index is hovering near its !ve-year high.

Meanwhile, former Reagan administration budget director David Stockman recently urged readers to “get out of the markets and hide out in cash” from the pages of the New York Times.

No matter which perspective better aligns with your own views, a deeper understanding of all the trends in"uencing the insurance market is critical for savvy buyers. To help explain these trends to indus-try participants, analysts and policymakers, AIG turned to the experts at Forbes Insights. This custom research practice is part of Forbes Media, which reaches nearly 50 million business leaders worldwide. Forbes Insights tapped its proprietary database of senior-level decision makers to poll ratings agencies, economists, investors and a former New York State Insurance Department Superintendent to gain a broad perspective on the trends shaping this market. The e#ort even reached to Steve Forbes himself.

The experts surveyed during the creation of this report sounded a number of common themes, includ-ing tepid macroeconomic conditions, record low interest rates and rising loss costs, to explain why pressure has been building for higher commercial property/casualty insurance rates. This report synthesizes those conversations and helps de!ne and explain the ongoing shift in the insurance industry’s mindset.

On behalf of my colleagues at AIG, I am proud to share their experience as re"ected in this report with you.

Russell M. Johnston President, Casualty, U.S. and Canada,AIG Property Casualty

2 | INSURANCE MEGATRENDS: WHAT’S DRIVING INSURANCE COSTS?

Three years into a tepid economic recovery, low interest rate policies continue to drag on the broader economy. In this report, we see what e#ect prolonged low interest rates and other macroeconomic factors can have on a critical sector of the American economy—insurance.

Overall, the current U.S. monetary policy enables the federal government to continue putting o# real, pro-growth reforms. While Washington ties itself in knots over spending cuts, every year American businesses and families spend more just to comply with all the rules embedded in our arcane tax code.

Once we get the "ow of capital moving again to small businesses and entrepreneurs, then we’ll !nally have the recovery for which we’re still waiting.

Many of these stories have been well documented, both in the pages of Forbes Magazine and elsewhere, even if their lessons have been ignored. This Forbes Insights report comes at the story from a di#erent angle, and it’s one of which most people aren’t aware: How arti!cially low interest rates are driving up the cost of commercial property and casualty insurance.

Insurance is a unique business and one that’s especially susceptible to unstable monetary policies. Unlike most businesses, where customers exchange money for immediate delivery of a product or service, insurance companies collect money up front but then don’t pay anything out until a claim is !led. In the case of commercial casualty insurance, this could be 10 or 15 years away, if not longer.

Most of the premium collected by insurers eventually gets paid back to cover losses, but in the meantime, insurers need to do something with those funds. They can’t just bury them in the backyard and dig them up when a big storm hits.

Insurers need safe, liquid investments, which is why most of those funds end up in highly regulated instru-ments like U.S. Treasury bonds. In a normal interest rate environment, these bonds properly account for the risk involved in a 10-year investment, so that companies can generate adequate returns.

What may surprise many, however, is that those returns don’t just go straight to the bottom line. Most of the time, the insurance market is well-functioning and competitive, which means insurers have to compete on price/risk. One way they do that is by applying those investment returns to help defray the cost of claims. This allows insurers to reduce the cost of insurance while still staying in the black. To remain pro!table, insurers use net investment income to o#set underwriting losses if premiums aren’t adequate.

Unfortunately, due to rock-bottom interest rates, these traditional safe investments are providing almost no return. No one truly believes, given the !nances of the U.S. government, that a 10-year Treasury bond should yield less than 2%. But in the current environment, that is exactly what you’re going to get.

The e#ect on insurers is clear. They are compelled to raise their own rates to ensure they have enough cash on hand to pay out future claims. Not only is the current spending environment making it almost impossible for companies to get !nancing for capital projects, once they can !nd the funding, they discover it costs them far more to insure whatever it is they’re building or operating. It’s a double “whammy,” and it’s one more factor in a long list of items that are holding this country back from the kind of growth needed to reduce unemployment and get incomes growing again.

If I had enough space to write a book, I could list all the reasons it’s time to return to a stable monetary policy that lets interest rates function as a reliable pricing mechanism. Since I don’t, I’ll close by saying that after reading this report, you’ll understand the impact that historically low interest rates—and other macroeconomic factors—have on property/casualty insurance rates.

Steve ForbesChairman and Editor-in-ChiefForbes Media

FOREWORD BY STEVE FORBES

COPYRIGHT © 2013 FORBES INSIGHTS | 3

In today’s relatively weak global economy, industry-wide property/casualty rates in the U.S. are just now emerging from pre-9/11 lows. At the same time, the last decade has experienced a rise in healthcare and other loss costs. Pair these facts with lower than expected insurance rates and the result is a sharp deterioration in the industry’s combined ratios—a key measure and driver of underwriting performance (see Evaluating Underwriting Performance, page 13).

Meanwhile, typically, when in"ation is on the rise, so too are investment yields. This is particularly true for !xed-income investments like U.S. Treasury bonds and notes, essential investments for highly regulated insurance com-panies. But in today’s markets, the relationship between loss cost in"ation and investment yields is being short-circuited. The two should move in tandem. But owing to various stimu-lus initiatives such as the U.S. Federal Reserve’s zero interest rate policy (ZIRP) and quantitative easing (QE), investment yields are being arti!cially reduced, resulting in low bond and note yields. The consequence: book yields, an expression of net investment income as a percentage of average net invested assets, are on a decline similar to that of insurance rates.

As these macroeconomic forces take hold, to maintain an adequate return on investment, insurers are compelled to begin increasing their rates.

At the same time, these fundamentals are creating opportunities and incentives for U.S. companies to expand internationally either by increasing exports, growing o#-shore operations, or both. This is great news for insurers able to provide advice and expertise in foreign property/ casualty insurance.

Generally speaking, there are four forces at work, all of which are pointing to higher domestic U.S. insurance premiums. These include:

from pre-9/11 lows

creating upward pressure on rates

urging underwriters to “return to the basics”

requiring insurers to earn more of their keep through their underwrit-ing results

The report that follows provides greater detail around each of these core observations.

EXECUTIVE SUMMARYFor commercial casualty insurers operating in the United States, business simply cannot go

on as usual. Traditionally, underwriters could count on two fundamental sources of income:

premiums and investment income. However, because of a series of macroeconomic condi-

tions—all of which are outside of any one company’s or insurer’s control—both streams are

now under duress.

Generally speaking, there are four forces at work, all

of which are pointing to higher domestic U.S.

insurance premiums.


KEY FINDINGSIndustry-wide commercial casualty insurance rates in the U.S. are now emerging from their pre-9/11 lows but need

to continue to improve.

Healthcare cost inflation is influencing casualty loss costs.

Investment yields are at historic lows—reducing what had become a critical source of income for insurers.

Markets are beginning to firm—but long-term firming is essential to improve the return on equity (ROE) being

produced by the industry.

The same forces leading to higher insurance rates in the U.S. are driving American companies to either export or

expand to international markets.


THE PANELISTS

James Auden, Managing Director, Fitch Ratings

Tracy Dolin-Benguigui, Director, Standard & Poor’s

J. Patrick Gallagher, Jr., Chairman, President and CEO, Arthur J. Gallagher & Co.

Robert P. Hartwig, Ph.D., CPCU, President and Economist, Insurance Information Institute

Thomas Hettinger, Americas Property/Casualty Practice Leader, Towers Watson

Karin Landry, Managing Partner, Spring Consulting Group

Howard Mills, Director and Chief Advisor, Insurance Industry Group, Deloitte, LLP; former Superintendent, New York State Insurance Department

Richard Sega, Chief Investment O!cer, Conning

John Ward, CEO, Cincinnatus Partners

Both Forbes Insights and AIG are grateful for the contributions of these executives to this report.

The accompanying report on macroeconomic trends impacting the commercial casualty insurance market in the U.S. was developed by Forbes Insights in conjunction with AIG. Its conclusions are based on independent economic research and conversations with over a dozen industry experts, analysts and participants. Quoted and named sources include:


OBSERVATION ONE: U.S. CASUALTY RATES ARE NOW EMERGING FROM PRE-9/11 LOWS

And yet, in the casualty insurance market, says Standard & Poor’s (S&P) Director Tracy Dolin-Benguigui, “rates are on the rise.” Speci!cally, says Dolin-Benguigui, “insur-ers are achieving better rates, particularly in the smaller commercial lines.” That is, Dolin-Benguigui explains, many larger clients may be seeing rate hikes in the low single digits, whereas smaller accounts are experiencing mid to high single digit increases. As for the di#erence between the two, says Dolin-Benguigui, “it’s easier for insurers to get a larger percentage increase in a $5,000 policy than for a $50,000 policy.”

Dolin-Benguigui o#ers further context, saying that S&P believes 2011 represented the trough of a rate cycle. As for price increases, they vary by business line. Moreover, rate hikes are proving most evident where rate is needed the most, particularly following any multi-year periods of underpricing.

Seeing similar activity, James Auden, managing direc-tor at Fitch Ratings, calls rate conditions “surprisingly positive for insurers—and given the state of the economy, much better than we anticipated.” Elaborating, Auden says, “we look at a wide range of indicators and sources, at analyst reports and company commentary on earnings calls.” And from what the executive can gather, “there’s a good deal of positive momentum building. It’s a climate where insurance prices appear to be !rming.”

To Dr. Robert Hartwig, president and economist at the Insurance Information Institute (III), none of this comes as a surprise, as to his mind, “for some time now insurance prices have had almost nowhere to go but up.” There can be no doubt, says Hartwig, that there has been a de!nite hardening over the past year to 18 months across a broad spectrum of markets, though rates remain well below their peaks of nearly a decade ago (Figure 1).

The global economy at large remains tepid.

FIGURE 1: CUMULATIVE QUARTERLY P/C COMMERCIAL RATE CHANGES, BY ACCOUNT SIZE

Chart prepared by Barclays Research

NOTE: CIAB data cited here are based on a survey. Rate changes earned by individual insurers can and do vary, potentially substantially

SOURCE: Insurance Information Institute (III)

4Q99

1Q00

2Q00

3Q00

4Q

001Q

012Q

013Q

01

4Q01

1Q02

2Q02

3Q02

4Q

021Q

032Q

033Q

03

4Q03

1Q04

2Q04

3Q04

4Q

041Q

052Q

053Q

05

4Q05

1Q06

2Q06

3Q06

4Q

061Q

072Q

073Q

07

4Q07

1Q08

2Q08

3Q08

4Q

081Q

092Q

093Q

09

4Q09

1Q10

2Q10

3Q10

4Q

101Q

112Q

113Q

11

4Q11

1Q12

2Q12

3Q12

4Q

12

Small Accounts Medium Accounts Large Accounts

165

155

145

135

125

115

100

95

1999:Q4=100


As Hartwig explains, “certainly in the seven and a half years from 2004 through the middle of 2011, buyers of insurance saw rates trend downward to signi!cantly lower than they need to be given current trends in claim fre-quency and severity and the Fed’s pledge to keep interest rates low for years.”

So in spite of recent “modest” increases in premiums, says Hartwig, “the typical commercial or even consumer buyer is paying far less than they were a few years ago.” Overall, says Hartwig, “it would actually be unreasonable to believe that prices could stay as soft as they had been. They simply could not remain that low in the current eco-nomic and claim-cost driver environment.”

So pressure is clearly building for higher rates. John Ward, CEO of Cincinnatus Partners, an insurance-focused private equity investor, agrees that prices today are at rela-tive historical lows. However, he adds, “it’s always been the case in insurance pricing that the premiums tend to move in cycles.” Today, says Ward, “the market is begin-ning to harden, the cycle is shifting to !rmer.” Speci!cally, “we’re moving from the soft or "at market of the past few years towards some increases in casualty rates in the range of the low to mid single digit increases.”

Thomas Hettinger is property/casualty practice leader for the Americas at global professional services com-pany Towers Watson. Hettinger’s team executes ongoing research contributing to his !rm’s quarterly Commercial

marked the seventh consecutive quarter that aggregate

prices for all commercial lines rose.” But at the same time, “we’re also seeing a decrease in

general overall in"ation,” which given the current low interest rate policy and other variables, “is a bit of a sur-prise, as you’d expect some in"ation” alongside a loose !scal policy and relatively higher energy prices. What this means for future insurance pricing increases, Hettinger says, “we’ll have to see.”

Hettinger, like most other interviewees for this report, says his group is always guarded in terms of making for-ward statements. “Our role is more to report and advise,” rather than predict the future, he explains. But pressed to make some sort of call on future rates, Hettinger says, “what I can tell you is that the U.S. seems to be on a path that is very likely to lead to in"ation: as the econ-omy gains steam, which it now is showing signs of doing, a tightening of money supply and a reduction in federal spending will need to happen to avoid an in"ationary spi-ral. Whether in"ation will pick up or not will depend on how quickly those actions are taken and how e#ective they are.” With all of this in mind, instead of a forecast, he o#ers this advice: “Pay attention to in"ation—depending on where that goes, we’ll know a lot more about whether insurers will need to take even more rate or not.” Speaking of future in"ation, Dolin-Benguigui of Standard & Poor’s has this to o#er: “We’re seeing current evidence that insurers are reserving against higher in"ation. Certainly, the leading insurers, especially for the longer tail lines, are preparing for signi!cant in"ation.”


What is your perception of the current rate environment? This will be my fourth major cycle. If you think about the recoveries in insurance rates, in 1975-76, 1984-85, and then 2001-03, there are four things that have to be present for rates to spike. One, there has to be a sustained period of underwriting losses. Next, there has to be a material decline in capacity. Three, there needs to be a tighter reinsurance market, and finally, all of a sudden, you need a return to stricter underwriting pricing discipline. Well, in this environment, we’re largely missing the first three.

So what you have in the first time in my career, is an income-statement-driven response by senior manage-ment. And the thing is, these manag-ers really understand their numbers at a level they’ve never had before. Because of technology, take a chief executive (at a major insurance com-pany) and today, he knows where he’s making money, every moment, every line, every geography.

What does that do for rates?

They know there’s no return in the in-vestment world. When you have no return whatsoever, driving for a combined ratio of 100% doesn’t get you anywhere near your cost of capital. With interest rates so low, insurers have to earn their money through pre-miums. And what underwriters are saying to us, and this began around the second quarter of 2011, is ‘Look, I need an increase. And if I can’t get an increase, I’m underpricing and that’s just not sustainable.’

What sorts of increases are you seeing?

It started with increases of 2% or 3% and then 5% or 6%. Today, it’s hovering in the 3% to 5% range. And there’s at least one insurance line that is in real trouble. The combined ratio for [workers’ compensation] is, depend-ing on whom you listen to, anywhere from 115% to 125%. Remember, to get a decent return on equity, you need to be running this business at a combined ratio of 92%.

But here you are at 110%. It’s not going to hold up in the long run.

Where we are is that carriers understand that not only are they not getting their investment income, their loss costs are rising substantially. Recognize, back in 1979, a combined ratio of 100% would give you a 16% return on equity. In 2012, you’re deep in the hole.

What about excess capacity in the industry?

There was a case where one of the reasons rates were so low is that there was so much capital in surplus chas-ing premium that just keeps pushing prices down, down and down. But all of a sudden, essentially at around the same time, the industry is waking up to realize, “hey, we’re heading for trouble financially.”

So now we’re seeing that there is no appetite for slashing prices. I was just at [a major insurance industry event] and not one time did I hear anyone talking about going after market share. Every single CEO says they’re urging their people to wise risk under-

writing. If an account deserves a 15% reduction because of the risk profile or the way they’re running their busi-ness? Let them have it. But if someone else is running around 100% combined and they’re demanding a flat renewal rate to keep the account? The answer is to let them go, because a flat renewal rate is actually losing ground to inflation.

So what would you advise a corporate risk manager?

I would ask them, are you better o" getting another 5% o" today but then in a year or two you’re going to walk into that veritable hard market where there’s no cover-age to be had? Scrambling for cover can jolt your P&L. It’s better to work with your insurers to give them what conditions dictate. It’s a partnership over time, and what you give now will be worth it in costs and risks avoided going forward.

A RATE CYCLE LIKE NO OTHERQ&A: J. PATRICK GALLAGHER, JR. Chairman, President and Chief Executive O!cer, Arthur J. Gallagher & Co.

“Not only are [carriers] not getting investment

income, their loss costs are rising.”

—J. PATRICK GALLAGHER, JR. Chairman and CEO,

Arthur J. Gallagher & Co.


OBSERVATION TWO: LOSS COSTS ARE INCREASING

Consider healthcare. U.S. medical spending almost dou-bled in the last decade, reaching $2.6 trillion in 2010. Over the past 20 years, the cost of medical care has exploded rel-ative to the broader basket of items composing the U.S. Consumer Pricing Index (CPI). The cost of medical care has risen 383% since 1981, more than 2.5 times the rate of growth in the broader CPI. Note that should highly in"a-tionary healthcare and related costs be removed from the base CPI !gure, the relative slope of emphatic healthcare costs—its rate of incline above core CPI—would trend even more steeply.

It is worth highlighting, says Hartwig, that the steep increase in healthcare costs is not necessarily a bad thing for society at large: “Higher costs are often the price we pay for new technologies, new drugs and new treatments.”

In addition, there are also costs associated with training more and more medical professionals amid ever more tech-nical and specialized disciplines. Such costs, says Hartwig, are societal investments in “extending lives and improving the quality of life.”

The more insidious side of healthcare in"ation, explains a senior insurance industry executive requesting anonymity, “is the enormous expansion of government regulation and involvement in medicine.” Add to this “an aging work force, the rise of obesity and diabetes, and new rules that require providing coverage for existing condi-tions” and the stage is set, says the executive, “for pricing private insurers right out of the market.”

With the rise in healthcare costs outpacing growth estimates, it’s small wonder underwriting performance is

Rising medical costs, tort defense and settlement costs have at times exceeded even the best

underwriting forecasts.

FIGURE 2: U.S. TORT COSTS RELATIVE TO POPULATION

SOURCE: Towers Watson

U.S. Population (millions) Tort Costs ($ billions) Tort Cost Per Capita ($)

1980 1990 2000 2010

900

800

700

600

500

400

300

200

100

0


so lackluster. But next, consider the exponential growth in tort costs and matters could worsen. Since 1950, direct tort costs have risen 9% on average, exceeding commensu-rate U.S. GDP growth by approximately 2% per annum. Since 1980, tort costs per capita—the cost allocated to each individual citizen—have grown !ve-fold (Figure 2). More recently, relative to 2009, tort costs increased by 5.1% to $246 billion annually, far exceeding both the CPI and GDP growth. Translated into a per capita share, each U.S. citizen’s share of tort costs reached $857 in 2010, up from $820 in 2009.

Today the U.S. ranks highest in the world in direct tort costs. And there are no signs of relief. In 2011, the average cost of the top 10 jury verdicts climbed 17%, from $157 million to $184 million—this following increases of 3.7%

in 2010 and 12% in 2009. The disproportionate rise in the cost of such litigation and settlements exacts a signi!cant toll not only on individual wallets, but also on the com-bined ratios of the insurance industry.

It does bear mention, says Hartwig, that owing to numerous state and federal e#orts to curb tort costs, the overall pace of increases is slowing. But overall, “what we’ve been able to do so far is bend the cost curve. We haven’t stopped the growth of tort costs.” And that’s unfor-tunate, “because that makes us less productive as a nation. We have the highest tort costs in the world, and that’s a heavy tax on businesses and consumers.”


What, to your mind, are the biggest challenges ahead for the insurance industry?

One is getting past the soft rate climate. With the eco-nomic downturn, not only are interest rates low, which harms investment returns, but insurers are seeing less business overall. Outside of mandated coverages like auto insurance, there’s less activity in building, in manu-facturing, in new home construction. And all that leads to less business in casualty, property, workers’ compen-sation and other coverages. But there’s another, poten-tially even larger set of challenges, longer term in nature, having to do with regulation that the industry hasn’t quite yet come to grips with.

What regulations should be of concern?

There is a tremendous amount of uncertainty surround-ing a number of regulatory initiatives. For example, we’re two years into the Dodd Frank legislation and the establishment of the Federal Insurance O!ce (FIO). And two years after the arrival of this FIO, we still don’t know what they’re going to do. They’re almost a year late with a report that was mandated to be delivered to Congress in January 2012. This is the first time the federal govern-ment has gotten this deep into insurance regulation, so there’s a great deal of concern.

What is the FIO?

The FIO is going to be a watchdog. And no one knows for certain everything they’re going to do. But one thing that will likely be a certainty, we’re already seeing it, are demands for stricter capital standards. Owing to the economic crisis, state regulators are looking for higher capital reserves. The thing is, no one wants to see in-surance companies fail, so they want greater reserving against insolvency.

So insurers are already seeing increased scrutiny by state regulators, and now there’s high potential for overlap-ping supervision by the federal government. All this means that compliance is going to be a much more re-source-intensive, time-consuming and expensive propo-sition. And it all means more rules, more interaction and more opportunities to get into regulatory trouble.

Are there other sources of regulatory concern?

Very much so. Another initiative is the need to develop and file an Own Risk and Solvency Assessment, or ORSA. This is a requirement largely coming out of the European Union’s Solvency II Directive. What it means is that every

insurer in the U.S. with over $500 million in direct written premium will need to develop and file a very personal-ized risk assessment with their state regulator.

The challenge here is that this is like enterprise risk management on steroids. It’s every risk you face, along with how each and every risk could com-bine to threaten solvency. They want each in-surer to identify, define, catalog, model and show plans to remediate every conceivable risk scenario. Moreover, and this is intentional, they’re o"ering no templates, guidelines or checklists. They’re leaving it up to the companies to be very thoughtful and independent and come up with something highly personalized for their company. And when they’re done, they’ll file with their state regulator, who along with the rating agencies and maybe the feds, will give them a close look.

What could happen?

It raises the stakes, because the more you reveal, the more others will want to get involved and regulate what you’re doing. One of the greatest risks is dual regulation. You al-ready know about the FIO, which has the ability to make all manner of data requests and demands from the industry. But there’s also this whole alphabet soup of groups that have been created by the federal government or that are just forming, like the O!ce of Financial Research (OFR) or the Consumer Financial Protection Bureau (CFPB). And there’s another big one, the Financial Stability Over-sight Council (FSOC), where if they take an interest, you could be overwhelmed with regulation. If somehow you are deemed to be a systemically important financial institution (SIFI), those companies will be in a whole new world of intensive, dual regulation and review.

Why so much scrutiny?

Financial services companies and insurers in particular, they’re being cast as the bad guys in today’s economy. And it’s also the rating agencies, the investment com-munity and the states who want absolute certainty. In general, it’s an era with higher regulatory risk, greater compliance costs and an attendant reputational risk and risk of brand damage.

What does it all mean for insurers?

More regulation, closer scrutiny and higher compli-ance costs. Insurers will have to find a way to recover these costs.

RISING REGULATORY DEMANDS

Q&A: HOWARD MILLS, Directer and Chief Advisor, Insurance Industry Group, Deloitte


EVALUATING UNDERWRITING PERFORMANCE

OBSERVATION THREE: UNDERWRITING LOSSES PERSIST

Figure 3 shows that the U.S. property/casualty industry has experienced pro!t from its underwriting activity in only !ve of the last 37 years. Moreover, when all the data is in, underwriting losses in 2011 are expected to be the largest since 2001, the year the 9/11 tragedy drove losses demonstrably higher.

One of the most useful means of gauging the indus-try’s performance in underwriting is to look at what are known as combined ratios. Combined ratios are calculated

by adding operating costs to actual losses incurred, then dividing this sum by the associated collected premiums for the period being examined (see sidebar, Evaluating under-writing performance). A combined ratio less than 1 means that the premiums exceed operating costs and losses, resulting in an underwriting pro!t. A ratio of 1 or greater shows operating costs and losses in excess of premiums, resulting in an underwriting loss.

Another key factor driving the industry toward higher insurance rates is the degree to which the

industry continues to post underwriting losses, and in general, says Fitch’s Auden, “the industry

has shown some pretty weak underwriting performance.”

The “combined ratio” is a widely used measure of industry performance in underwriting. It is calculated as:

Combined ratio = incurred losses + operating expenses

Premium

FIGURE 3: UNDERWRITING GAIN (LOSS)

NOTE: Includes Mortgage and Financial Guaranty Insurers in all years SOURCE: Insurance Information Institute from A.M. Best and ISO data

$35

$25

$15

$5

-$5

-$15

-$25

-$35

-$45

-$55

($ billions)

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 0 01 02 03 04 05 06 07 08 09 10 11 12:12:Q3


So how is the industry performing in this climate? Not well, according to Auden. In fact, in 2011, says Auden, “the combined ratio for the industry was 108%,” meaning losses and costs exceeded premiums by 8%.

An array of factors can have a positive or negative impact on the combined ratio. Deconstructing 2011 performance, Auden says that to varying degrees, members of the industry are encountering:

the rise. For example, “while in"ation overall is very low,” says Auden, “that’s not the case in healthcare, where medical costs are surging.” Higher medical costs are also impacting workers’ compensation claims, as well as bodily injury claims in consumer auto insurance segments.

to Auden, “a weak economy means that people will tend to press or stay on a claim a lot longer than they might when there are other opportunities.” This raises litigation costs for insurers and potentially eventual settlements as well.

in"ation, fraud and litigation are on the rise is equally evi-dent to all participants in the marketplace. And yet, so many insurers continue to write policies without commensurate price increases. What drives behavior like this, says Auden, “is competition for customers and market share.” Essentially, says Auden, “there’s just too much capital chasing the business, and that’s pushing premiums down and combined ratios up.”

The combined ratios in Figure 4 show that in 2001, insurers were paying out $1.16 in losses and operating expenses for every dollar of premium collected. In 2006, insurers were paying only 93% in losses and operating expenses for each dollar collected from insurance rates (Figure 5).

Following a single year of the industry’s posting a reasonably favorable combined ratio, matters worsen. In the past f ive years from 2007 onward, industry underwriting performance as measured by its ratios again deteriorated. As earlier mentioned, by 2011, losses plus expenses exceeded premiums achieved by 8%.

FIGURE 4: P/C INSURANCE INDUSTRY COMBINED RATIOS

NOTE: *Excludes Mortgage and Financial Guaranty Insurers 2008—2012. Including M&FG, 2008=105.1, 2009=100.7, 2010=102.4, 2011=108.2; 2012:Q3=100.0. SOURCE: Insurance Information Institute from A.M. Best and ISO data

NOTE: *2008-2012 figures are return on average surplus and exclude Mortgage and Financial Guaranty Insurers 2012:Q3 combined ratio including M&FG insurers is 100.9 2011: combined ratio including M&FG insurers is 108.2, ROAS = 3.5% SOURCE: Insurance Information Institute from A.M. Best and ISO data

FIGURE 5: INVESTMENT IMPACT ON RETURN ON EQUITY (ROE)

ROE*Combined Ratio

Combined Ratio/ROE

97.5

92.7

95.799.5

97.5

92.7

95.799.5

1978 1979 2003 2005 2006 2007 2008 2009 2010 2011 2012E

110

105

100

95

90

85

80

18%

15%

12%

9%

6%

3%

0%

95.7

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* 2012:Q3

120

110

100

90


OBSERVATION FOUR: HISTORICALLY LOW INTEREST RATES CONTRIBUTE TO LOW INVESTMENT RETURNS

When people think about what creates value in the insur-ance industry, says the executive, “they generally assume insurers are making their money in underwriting.” And pro!ting from risk, “is a good thing for the economy, because you need those companies that are absorbing risk in the system to be pro!table and secure—that’s what underpins the economy.” But in practice, he explains, “since the 1970s, a signi!cant, if not the greatest contrib-utor to insurance industry pro!tability—and thus health and viability—has been investment income.” With inter-est rates at historic lows, “there’s no subsidy available, and that means insurers are today losing money on their core operations. They’re underpricing risk, expecting to make up the di#erence in interest income, but there’s none to be had.”

John Ward of Cincinnatus Partners says that in today’s low interest rate environment, insurers are missing out on a crucial component of their income. “Insurers take in premiums and they take on risks,” says Ward. “And during the period where they’re liable for those risks, they hold on

to premium, investing for return.” However, insurers are signi!cantly limited in the types of investments they can pursue. As Ward explains, “they need to be low risk, and they need to be liquid enough for that capital to be avail-able to cover losses incurred.” What this means, says Ward, is that insurers are largely limited to investments in top-rated, !xed-income assets “like U.S. Treasuries.”

Unfortunately, Treasury yields are today near 50-year lows. As III’s Hartwig explains, “over the past 35 years, when rates were high, insurers could generate substantial returns from their portfolios.” But in the current mar-ket, “you’ve got the [U.S. Federal Reserve] announcing not only a third round of quantitative easing, but also a plan to maintain a low interest rate policy until the unem-ployment rate drops below 6.5%, which could take years.” Overlaying the trend in U.S. Treasury yields against the industry’s weak performance in combined ratios highlights yet another driver of why insurers must go to their clients in search of higher underwriting premiums.

Premiums are low, loss costs are increasing, and as a result, underwriting performance is weak.

So, says, one executive, “what else could possibly go wrong?” The answer: “the economy could

enter a sustained interval of artificially low interest rates.”

FIGURE 6: P/C INSURANCE INDUSTRY COMBINED RATIOS VS. U.S. TREASURY YIELD

NOTE: *Excludes Mortgage and Financial Guaranty Insurers 2008—2012. Including M&FG 2008=105.1, 2009=100.7, 2010=102.4, 2011=108.2; 2012:Q3=100.0. SOURCE: Insurance Information Institute from A.M. Best and ISO data; U.S. Federal Reserve 10-Year U.S. Treasury YieldCombined Ratio

95.7

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* 2012:Q3

120

110

100

90

7%

6%

5%

4%

3%

2%

1%


According to the unnamed executive above, “this is essentially a shift back to the basics” for the insurance indus-try. “From the 1930s through the 1970s, that’s the way insurers used to make their pro!t—through underwriting and not through investing,” says the executive. But as interest rates climbed, insurers began generating signi!cant returns from their investment portfolios. Eventually, owing to the competitive nature of the marketplace, “various insurers began factoring their positive interest rate income into their pricing—meaning they could charge less and grow market share.” Eventually, “investment income went from being something on top of underwriting returns and instead in many years became the primary generator of income for the industry.”

In short, says Hartwig, higher insurance premiums are essential for the industry to make up for today’s declines in bond yields. “If you’re earning a million (U.S. dollars) less on your investments than before, that’s the mathematical equivalent to sustaining $1 million more in claims.” What

this means for today, says Hartwig, “is that the insurance industry needs to return to its roots, charging for risk and earning its returns through underwriting.”

According to Conning Chief Investment O$cer Richard Sega, lower interest rates are “decimating” investment returns for insurers. The impact is especially harmful for writers of longer-tail business such as workers’ compen-sation or medical malpractice, because, as Sega explains, “investment income comprises a greater portion of their overall return.”

One way to view these losses is to examine book yields. A book yield for a property/casualty insurer is an expression of the net investment income as a percentage of average net invested assets. As Figures 7 and 8 illustrate, book yields in the industry have fallen from 5.7% in 1997 to 3.7% in 2011. Such reductions are driven by today’s low interest rate climate, “and are very painful for insurers.”

FIGURE 7: P/C HISTORICAL BOOK YIELD

The impact of reduced investment income may actually be greater depending on circumstances, as relative to premium income, investment income is taxed at the lower capital gains rate.

Calculations based on net investment income divided by net investable assets ANALYSIS AND FORCAST: Conning

SOURCE: ©A.M. Best Company - used by permission

7.5%

6.5%

5.5%

4.5%

3.5%

1997 1999 2001 2003 2005 2007 2009 2011E


But interest rates “can’t stay low forever,” says Sega, and in fact, Conning predicts they could begin to rise again starting in 2013—as illustrated by the medium blue line in Figure 8. But even so, any recovery in book yields will be slow in materializing due to a rollover e#ect. That is, explains Sega, “insurers won’t be able to immediately rein-vest at higher rates, but rather, will only be able to realize rate gains gradually,” as old business matures and new busi-ness is underwritten. As such, improvement in investment returns for insurers, even in a higher interest rate environ-ment, will recover relatively slowly (as illustrated by the dark blue line in the graph).

Note also that should interest rates remain "at, the state of book yields will actually deteriorate, as illustrated by the light blue line in the graph. In this instance, as older Treasury bills yielding higher interest mature, they must be replaced at a lower interest rate, resulting in further declines in book yield. All of this, says Sega, “creates pressure on insurance company pro!tability.”

FIGURE 8: P/C FORECAST BOOK YIELD RATES

SOURCE: Conning, company statutory filings, AFFIRM™ analysis assuming cash flow rebalancing of investments

5%

4%

3%

2%

1%

0%

2012 2013 2014 2015

Yields Stay Flat Yields Revert Market Rate


COPING WITH SUPPRESSED INTEREST RATES

How important are interest rates to the insurance industry?

They’ve become an absolutely essential component of re-turn. Without investment income, insurance profitability is stressed. And so this period of low interest rates is really hurting the industry.

What’s keeping interest rates low right now?

First and foremost, it’s the actions of the world’s central banks, particularly in Europe and the U.S. On the one hand, they’re trying to keep interests rates down, thinking that will somehow spawn real economic growth—though there’s been little success to date in that regard. But in addition, they’re so debt-riddled, low interest rates are the means to decreasing government funding costs. Plus, I guess if you can’t repudiate your debt, another way around it is to inflate your way out of it.

So the actions you’re seeing, such as the third round of quantitative easing, es-sentially mean that the Fed is printing money. In addition, there’s also the zero interest rate policy (ZIRP), where the Fed is making money available to banks at almost no cost. The Fed, in fact, has been clear in say-ing they’re extending that into the second half of 2015, so we’re in for several years of very low interest rates. Then in Europe you have the long-term refinancing operations (LTRO), which is where the central banks lend money to Eurozone banks, again, at almost no cost.

How will this play out?

These governments seem to feel they can revive their econ-omies, reduce unemployment and stimulate housing. But I don’t believe that high interest rates were ever the prob-lem in the economy. The problems are regulations and high taxes. So pushing interest rates down to artificial levels, it’s doing more harm than good.

The truth is, I don’t believe anyone can overcome market forces in the long run. In particular, there should be real concern about long-term inflation. Of course, some of the impact on currency values is being muted because everyone is doing the same things at the same time. But if you look at the cost of real goods, of commodities and gold prices, you get an idea of what’s coming. All of this stimulus, all this currency that’s being printed, in the long run, that’s going to have a slingshot impact on interest rates.

When might interest rates revert?

That’s hard to predict. We’d love a nice, gradual return to normalcy. But markets never do that, they instead always work to defeat most people most of the time. So when the cycle reverts, it’s not going to be steady or gradual, it’s going to be traumatic.

Q&A: RICH SEGA, Chief Investment O!cer, Conning

“The truth is, I don’t believe

anyone can overcome

market forces in the long run.”

—RICH SEGA

Conning


RISK MITIGATION: CUSTOMERS WILL RESPOND

There is no doubt that higher insurance rates are here today—and here to stay. Even so, numerous factors are also at work that will, at least to some degree, provide a cushion to higher rates for many insurance buyers.

One, says Karin Landry, managing partner at Spring Consulting Group, is the “accelerating pace of information flows.” She cites the tsunami in Japan as an example where significant investment capital came flowing into the insurance markets right after the event. Investors, says Landry, “entered the markets quickly in anticipation of rising casualty insurance rates from that point on.”

In addition, says Landry, companies themselves, “the buyers of coverages,” will move quickly to “reduce their dependence on the pure insurance marketplace.” Faced with rising rates, “they will take steps to improve their risk management and likely loss characteristics” to appear as better risks for insurers. They will also, says Landry, “do more in terms of captive insurance funding and self-insurance.”

“Companies will take steps to improve their

risk management.”

—KARIN LANDRY Managing Partner, Spring

Consulting Group

THE SURGE IN INTERNATIONAL ACTIVITY The same macroeconomic forces driving !rmer insurance rates are having another e#ect on the market: creating incentives for U.S. companies to expand internationally, export, or both. A relatively weak U.S. dollar, for exam-ple, fueled by slow growth, low interest rate policies and quantitative easing, is making this nation’s goods and ser-vices signi!cantly more competitive overseas. And with third-quarter 2012 GDP growth of a mere 2% at home, U.S. businesses are understandably turning their focus to high-growth developing markets.

Demand from emerging markets is growing faster than demand from mature markets. GDP growth among the G7 nations from 2009-2010 averaged 1.4%. Compare this with the same period of GDP growth for the G20 of 2.5% and it’s small wonder U.S. businesses are turning their focus to high-growth developing markets.

The G20 has eclipsed the G7 as the driver for global growth. Ten years ago, countries making up the G7, the world’s richest nations, composed 50% of global GDP. Today the !gure is less than 40%. As the proportion of revenues from overseas markets grows larger than revenues at home,

many companies expand internationally to meet demand. In fact, companies that make up the S&P 500 currently gener-ate about 45% of their revenue outside the U.S.

to soften the U.S. dollar. This in turn is making American-made goods more competitive and is helping to fuel recovery, so much so that half of the U.S. economic growth since the end of the latest recession was driven by exports. Today U.S. exports are growing at an annual pace of 16%, one nominal percentage point higher than necessary to meet the White House’s goal of doubling exports to $3.1 trillion by 2015.

As U.S. exports rise, and as more U.S. businesses seek to establish or expand o#shore, the nature of their risk pro-!le necessarily shifts. U.S. businesses often underestimate both the complexity of international business and the levels of insurable risks they face.

All told, this rise in international activity is altering the risk pro!le of an already large and growing number of U.S. companies. The question for senior management and the board: do we have a full appreciation for the scope of our expanding and evolving international liabilities—along-side a rational and optimized approach to insurable risks?


CONCLUSION: MYRIAD FORCES ARE DRIVING INSURANCE RATES HIGHER Rates emerging from pre-9/11 lows as a starting point. Rising healthcare costs. Underwriting losses. Historically low interest rates. These conditions cannot persist without a commensurate increase in commercial casualty insurance rates in the U.S. Insurers are waking up to these facts, and making moves to protect their balance sheets. The result is a gradual !rming of insurance rates across a range of essential commercial coverages.

Going forward, in the U.S., buyers of casualty insurance can expect a continued !rming in insurance prices. And rather than staunchly resisting these trends, a more prudent approach is to view such increases as a rational and essential adjustment based on today’s economic realities. Insurance is a long-term proposition, designed to transfer and reduce risk. Buyers of insurance should of course conduct a degree of comparison shopping, but they must do so with eyes wide open, recognizing that ultimately, their fates are entwined with the health of the insurance industry.

Finally, with the boom in exports and international investment, U.S. companies need to take a fresh look at their o#shore exposures. The same drivers of !rming insurance rates at home are leading to a growing array of export and investment opportunities in international markets. Savvy risk managers understand that growth opportunities often carry di#erent risks.


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