Risk Management

Why Low Interest Rates Boost Insurance Prices

A steady drop in insurance companies’ investment income is prodding them to charge you more.
David KatzMarch 31, 2014

If you’re wondering why you’re paying more for casualty insurance and why your insurers are asking so many questions about your company, look no further than rock-bottom interest rates, according to Robert Schimek, the current chief executive of AIG’s property-casualty operations in the Americas and its former CFO.

Low interest rates mean that insurers aren’t making much money by investing their hordes of cash. And that, in turn, means that they have to work harder to make sure that they’re covering their cost of goods sold, says Schimek, who still relishes speaking in the language of finance.

“To be a long-term, reliable, sustainable provider of coverage, we’ve got to be able to cover our cost of goods sold,” he said last week at a casualty insurance conference sponsored by Advisen, a risk management research firm. “And the cost of goods sold includes our cost of capital. And you’re not getting a lot of help covering your cost of capital in this industry of mine.”

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For an insurance company, COGS comprises insured losses, expenses and cost of capital. Assuming that its revenues will more than cover its losses and expenses, AIG also wants “to have a return on equity that’s greater than our cost of capital,” said Schimek.

But that’s easier said than done.  Today, a company that’s breaking even on its underwriting business, for example, can earn a return on equity of about 7 percent. In 1990, that company could have earned an ROE of 16 percent, he noted, contending that the insurance industry has absorbed 16 straight years of falling investment income resulting from declining interest rates.

The inability to make a decent return in the capital markets has put pressure on insurers to make good choices on the risks they take and on the prices they charge companies for assuming those risks. “If you made an underwriting mistake in 1990, you had a lot of help from investment income to cover that up and still end up with an acceptable ROE,” explained Schimek.

But if an insurer makes underwriting mistake today, “you’re not going to get a whole lot of help from investment income,” he added. “And you better work hard to make sure that you’re making the best underwriting decisions.”

Insurers feel most of that heat on the casualty side of the business rather than on the property side. Property insurance poses relatively little difficulty for underwriters, who often simply multiply their assessment of the value of a property by a standard rate to arrive at their price.

Such coverage “has a duration between when we received the premium and when we pay out the claim that’s pretty short,” Schimek explained. “In general, we are not counting on investment income very much when we write a property line of business.”

In contrast, the industry has traditionally counted a great deal on its investment income to provide a buffer for losses it sustains in such lines as general; auto; product and directors and officers liability; and workers’ compensation. One reason for that need is that the duration between when an insurance company collects a premium for casualty and when it ultimately pays out a claim is usually something close to four years — six years for workers’ comp, according to Schimek.

Further, assessing risk in casualty insurance, which is essentially financial protection for a company against lawsuits, is tougher because of the shifting nature of litigation trends and the fact that the risk tends to vary a great deal by industry.

That means that there’s a greater chance to make underwriting errors and a greater necessity for investment income to protect the insurer against resulting losses. “It’s a different profile than the property profile, and it counts on the importance of investment income a lot differently than the property business,” said Schimek.

At the same time, such “long tail” business has more time to exacerbate the effect of the steady annual decline in interest rates. In turn, that decline has “really gotten us to focus on [making] sure we’re getting that underwriting correct,” Schimek said, noting that AIG has recently invested heavily invested in risk analytics and underwriting talent.

The result for buyers? Expect a grilling the next time you renew your casualty insurance policies — and, more than likely, higher premiums.

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