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Insurance Markets Best Practice

Insurance—Bruised, Not Crushed

by Robert P. Hartwig

Table of contents

Executive Summary

  • Compared with the banking sector, the insurance industry has been able to continue business as usual through the crash thanks to some crucial differences between the two sectors.

  • The sector faces some specific challenges posed by “long-tailed” business in the downturn as it seeks to match assets against liabilities.

  • Low returns in an era of near zero interest rates will push up premium prices.

  • The sector has a number of anxieties concerning potential regulatory responses to the crash.

  • Risk appraisal is a key differences between banks and insurance companies.


There is no doubt that, compared with the banks and the investment banks, the insurance sector has come through the crash in relatively good order. The sector has not escaped entirely. AIG, the world’s biggest insurer, needed a US$85 billion bailout from the Federal Reserve to help the company unwind its credit default swap (CDS) positions “in an orderly manner,” without precipitating one of the biggest insolvencies ever in US insurance history. However, it is important to realize that AIG was a very unusual insurance company, and a leader in the CDS market, which went sour when the liquidity crunch set in. AIG’s business model and profile of operations have no real parallel in the rest of the sector.

The vast majority of what the United States calls property and casualty insurers, and Europe terms general insurers, are working through the current deep recession with the fundamental business of insurance operating normally, with the transfer of risk from client to insurer and from insurer to re-insurer continuing as normal, and with no shortage of capacity.

None of this is true of the banking market, and this is where the fundamental difference between these two components of the financial services sector manifests itself most strikingly. In the banking sector, of course, loan activity has been greatly reduced, and, by early 2009, there was really very little that could be termed “normal” about many of the world’s major banks.

Of course, the insurance sector as a whole is not immune to a general economic downturn, and particularly not to a full-blown, deep, global recession. The sector is less sensitive to fluctuations in the economy than most industries, as in many instances insurance is not an option but a necessity. However, to the extent that economies are not growing, the sector cannot advance.

A Risk-Averse Market

We have a more general challenge, however, in the sector, and this has to do with the fact that many insurance risks are “long-tailed;” they run for many years into the future. In an ideal world, you would look to match your liabilities with your assets. Today, however, there is very little yield available on long-term instruments, and we even had the bizarre situation on December 4, 2008, when long-dated Treasury bills slipped into nominal negative returns. This kind of position shows a tremendous level of risk aversion in the market, with short-term fear outweighing long-term needs. It created a bubble in the price of Treasuries that leads to unsustainable programs.

What all this means is that insurers are not going to tie up their investment money in a 20-year yield at these very low rates, as, if the rates went up in a few years’ time, these instruments would sustain a significant loss. This, in turn, means that investment income will decline in the medium term for insurers, as short-term investments are likely to provide very meagre rates of return.

A “Soft Market”

For the insurance sector, there are only two possible sources of income. These are investment income premiums on business written, and low investment returns have a very direct impact on premium prices, which will almost certainly rise. There is very little option about this for the industry. The sector’s anticipated losses are not going to be any the less because investment yields are down. Natural catastrophes happen every year, and they cost a great deal, whatever the investment climate.

This, then, creates a fear that insurance prices will become too high for the market to bear. We are currently in a period of declining prices for insurance premiums; what the industry calls a “soft market.” Prices have been declining for four straight years, and the price of many types of insurance in the United States today are below where they were in 2004. This is one of the features of the sector. Insurance is nothing if not cyclical, and every player in the sector knows this very well.

However, even if rising prices cause the insurance sector to “flip flop” from a declining price market to a rising price market, the cost of premiums, despite the current difficult economic circumstances, is highly unlikely to become an onerous burden on an individual’s or a company’s budget. The last “hard market,” when the industry was able to charge high prices because the market in general was pricing high, was in the period 2000–2003, and we could be seeing a return to that period.

To understand how pricing affects the industry, it is worth pointing out, perhaps, that the hard pricing of 2000–2003 brought the industry through the 9/11 period with its massive payouts, and, when insurers experienced record catastrophe losses in 2004 and 2005, the industry had to build up sufficient capital to come through in good shape. At the same time, 2006 and 2007 were low loss years as far as natural disasters were concerned. That all turned around in 2008, where we had poor investment returns and high catastrophe payouts.

It is probably too soon, at the time of writing in February 2009, to say that insurance markets are definitely heading back to a hard market, with a rapid and sustained price rise ahead. The industry globally needs to take a very severe hit before that happens, and we are possibly not there yet.

Despite the adverse features of 2008 for the industry, the underwriting performance was not that bad, and was consistent with four years of a soft pricing market. The problem the sector has is that, with the economic downturn, asset categories that were thought of as safe have lost significant amounts of value, and the sector has to invest its premium income to generate returns.

To sum up then, the industry went into the financial crisis extremely well capitalized. However, much of that surplus capital has been eroded through the underwriting and investment losses 2008. So now, instead of being extremely well capitalized, the industry is merely adequately capitalized.

One of the common misconceptions about the challenges facing the industry is that global warming, and the more energetic and extreme weather events that are predicted to follow from this, will be too much for the sector to handle. In actual fact, extreme weather conditions are nothing new for the sector. It has been dealing with the consequences of extreme weather events for centuries. The key here, as elsewhere, is to be able to price the business appropriately. The increased risk has to be priced into the cost of insurance.

The insurance sector has been extremely strong in Europe and, more recently, in the United States, in voicing its concerns about global warming and the need for concerted action. However, it is undoubtedly true that the current crisis has somewhat overwhelmed environmental concerns.

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