Providing advice on contending with a changing market
Being able to deal effectively with volatility is essential for a healthy (re)insurance market. While consistent change provides many challenges for market participants, it also provides opportunities for stakeholders that are prepared to act strategically within changing market cycles. In this episode of Fo[RE]sight, Jay Dhru, Global Head of Business Intelligence, and Richard Hewitt, Head of Business Intelligence, EMEA, discuss factors that contribute to global volatility, mitigation steps to help contend with the effects, which lines of insurance are particularly influenced by volatility and how volatility might affect capacity in the reinsurance market.
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Transcript
I’m Eric Stenson with Guy Carpenter. Welcome to this episode of Fo[RE]sight: a Guy Carpenter podcast series, bringing you unmatched insights on trending challenges and our solutions delivered by Guy Carpenter experts on the vanguard of thought leadership in the reinsurance industry. Today, I’m pleased to be joined by Jay Dhru, Global Head of Business Intelligence, and Richard Hewitt, Head of Business Intelligence EMEA, who will discuss macroeconomic forces that contribute to global volatility, regulatory and geopolitical concerns, and steps reinsurers could take to help insulate themselves from the negative influences of volatility. Thank you very much for being with us, gentlemen.
Richard Hewitt
Thank you, Eric. It’s a pleasure to join you today.
Jay Dhru
Thank you, Eric. Yes, looking forward to the discussion.
Eric Stenson
I'd like to start with Richard. As we know, economic conditions around the world contribute to global volatility. What do you think are the biggest macroeconomic factors that drive volatility? Would inflation still be a major factor?
Richard Hewitt
Yes, Eric. Insurance and reinsurance industries are second- and third-order factors in the macroeconomy. So, economic volatility is very important for the sector in terms, really specifically, in 4 areas: interest rates, economic growth, inflation, and regulatory changes.
So, interest rates first: these impact investment income investment values, directly bonds, but also, through correlated securities such as equities, real estate, and pretty much anything else that is in the risk area). It can also impact prices in real terms. The valuation of liabilities, and, of course, capital—both traditional and alternative.
Secondly, for economic growth over the long term, economic growth positively influences the demand for insurance, and eventually, reinsurance. Broadly speaking, over the longer term, the insurance industry’s growth is similar to economic growth, developing in emerging economies, probably a bit more; developed economies a bit less. Now, during periods of growth, businesses and individuals are more likely to purchase more insurance products, while economic downturns can lead to reduced demand and increased claims, both in property and casualty insurance.
Thirdly, inflation. And, inflation is very pernicious for the industry and creates a lot of volatility for both profitability and capital. This is especially the case as we have seen recently when it is unexpected and increases rapidly. Rising inflation can increase the cost of claims. Insurers and reinsurers can adjust premiums, terms and conditions to keep pace with rising costs. But this is easier on short-tail business and much harder for long-tail business, where inflation can challenge prior years’ reserves and be difficult to reprice for.
Inflation also impinges on capital. This describes economic inflation—what we’ve just been talking about—but we shouldn't forget social inflation, which can also have a big impact.
And lastly, regulatory changes. New regulations can create uncertainty and require adjustments in business practices, leading to potential volatility. We should also include here changes to fiscal and monetary policy that also have an influence on the previous 3 factors as well.
And certainly, recent changes in governments are the periods when we would expect to see most regulatory changes appear and impact in the industry. And other macroeconomic factors that I could mention would include exchange rates, debt levels, credit conditions, and all of them can have an influence on the insurance industry.
Now, all of these factors, Eric, are interlinked through various transmission mechanisms. And in periods of uncertainty, for example, after economic or financial market shocks, volatility and its effects can significantly increase, especially around future expectations and their quantification. Now, turning to the question on inflation of whether it is still here and a major factor. Now, despite inflation falling back, the peaks as we saw around 10% in 2022 to about 2% targets in most major economies today, it is still very much there as a tail risk and could come back again, as we saw in the 1970s, and even settle above the 2% target longer term. Catalysts for this could include surging economic growth, geopolitical events that restrict supply chains, tight employment markets and government policy changes.
Eric Stenson
Thanks, Richard. It's great to get a nuanced perspective on inflation's impact. For Jay, geopolitical uncertainty would also seem to be a significant factor in driving global volatility. Are there particular circumstances you think would be especially influential in pushing volatility?
Jay Dhru
Well, Eric, we certainly live in interesting times. The last couple of years are littered with examples of how geopolitical uncertainty has increased volatility for claims costs and capital. Claims costs have increased through inflation, and capital volatility has come through the investment markets.
I would highlight 5 factors causing this volatility. First, is the global health crises. Events like pandemics can lead to widespread claims in health insurance and business interruption insurance. The uncertainty surrounding such events and how policymakers deal with them can create geopolitical uncertainty and volatility in markets. As we saw with COVID-19, this volatility can last for many years, and manifest in higher inflation and interest rates, tight labor markets, demand surge, broken supply chains and de-globalization.
The second is wars and its security threats. Now, it’s not surprising that these always have a detrimental impact on volatility. Of course, they impact the countries involved. But in our interconnected world, the shockwaves are felt globally through disruption in supply chains and increase in energy and commodity prices. The Russia-Ukraine conflict, for instance, is a recent example of this volatility in action. Further back, some of our listeners would remember the 1970s energy crises brought on by conflict in the Middle East.
Third is trade wars and tariffs. Trade disputes can also disrupt supply chains and increase costs for businesses, leading to higher claims in insurance. Tariffs also affect the pricing of goods, impacting the overall economic growth outlook, employment and competitive efficiency.
Number 4 is climate change and environmental policies. Geopolitical decisions regarding climate change policies can and do impact the insurance industry, particularly in areas prone to natural disasters. Regulations and their interpretation by courts may lead to increased costs and claims.
And finally, migration and refugee crises. Large-scale migrations due to conflict or economic hardship can create new risks for insurers, particularly in health and property insurance, as populations shift and demand for services change. So, Eric, these are the 5 different ways that geopolitical volatility can impact the insurance sector.
Eric Stenson
Thanks, Jay. There certainly are a lot of factors to consider when preparing for volatility. For Richard, what steps would you suggest insurers should keep in mind to mitigate the impact of global volatility?
Richard Hewitt
Sure, Eric, the pervading macroeconomic and geopolitical environments can certainly lead to additional volatility challenges for the insurance industry and its clients, as we have discussed. Now here's what they can do about it. First is diversification. It’s a classic defense, but this can help spread risk and reduce exposure to any single event or market, and reinsurance can certainly assist with this.
Then there’s rigorous risk assessment. This considers geopolitical, economic and other factors that can help insurers identify potential vulnerabilities and adjust accordingly. We noticed that during the recent bout of inflation, it was a lot more work that was required of some insurers. Dynamic pricing and analytics, advanced analytics, machine learning and AI can be used to develop dynamic pricing models to help insurers respond more effectively to changing market conditions and risks, ensuring that premiums reflect current realities, and also proactively respond and manage volatility.
And fourthly, investment strategy. Insurers should have an investment strategy that allows for nimble adjustments in response to changing interest rates, economic conditions, and market volatility. This includes consideration of asset liability management, liquidity, and diversification in their investments.
Fifth: scenario planning and crisis response. Engaging in scenario-planning exercises can help insurers prepare for various potential future states, allowing them to develop strategies for different geopolitical and economic scenarios. As part of this, they should also develop and maintain key relationships that would be helpful for them in the event of a scenario. In other words, don't just rely on the desktop. There's too many best-placed plans are dropped once a crisis hits.
And finally, capital modeling. Over-arching all of these, insurers must establish rigorous capital models and know-how. This is to ensure that they will always have sufficient capital both to meet the ongoing expectations of clients and investors, but also regulators and rating agencies. In addition to the overall level, it should also give consideration to the composition, efficiency, use of reinsurance, sensitivity, transferability and fungibility, as well as the headroom to raise more if needed, even in extreme circumstances. As well as the volatility challenges and associated mitigating strategies we’ve been discussing, we should remember that volatility reminds us of fundamental value of insurance and therefore the potential to develop new opportunities and also growth areas. And finally, Eric, I would add that Guy Carpenter and the other businesses of Marsh McLennan are well-placed to assist insurers in developing tools to mitigate the impacts of volatility and uncertainty.
Eric Stenson
Thanks, Richard. I think it's very important to discuss analytics and pricing, as well as ways modeling can help provide guidance. Jay—in the reinsurance sphere, are there specific lines that you’d expect to experience the most volatility? Which would feature more prominently, casualty or property lines?
Jay Dhru
Well, Eric, all lines are impacted by economic and geopolitical volatility, but the effect can differ significantly in terms of magnitude and duration. So, claims inflation is the main economic factor impacting property and shorter-tail lines volatility. This is particularly the case for building material prices in areas that are prone to natural disasters, which could also be further impacted by supply-chain disruptions and scarcity of resources post events.
Furthermore, capital dedicated to property may be impaired or restricted due to inflation and other changes in economic conditions. This can be sudden and significant, but manageable relatively quickly through pricing and changes in terms and conditions. Economic-related volatility factors that impact casualty and longer-tail lines of business are more varied than property, and they often take longer to fully manifest themselves and can be far more significant.
Economic downturns can lead to increased claims, including more lawsuits and claims related to employment practices, workers compensation, financial lines and general liability. Economic inflation weighs on prior-year reserves that may turn out to be deficient, and that can be much harder to mitigate against with pricing alone. Real interest rates, present and future, also affect pricing and the value of claims reserves, and therefore capital.
Reinsurance becomes an important mechanism to assist here through loss-portfolio transfers and other structured products. This allows companies to free up capital deployed in older, possibly underpriced business into newer, better-priced business. Considering the industry’s track record over the decades, we can observe that economic induced volatility in property can create short- term spikes, some extremely unpleasant—but volatility for casualty could be a more profound or even systemic-type impact, such as that experienced in the late 1990s and early 2000s that required a widespread recapitalization of the industry.
Fortunately, Eric, insurers are built tough to withstand this volatility and have a proven history of managing through complex economic and geopolitical risks.
Eric Stenson
Thanks, Jay, it’s definitely interesting to see how different lines are affected. Richard, a final question: How has volatility been affecting market capacity?
Richard Hewitt
Significantly, I should say. And as we know, and do well not to forget, the reinsurance industry is also a cyclical one. If we look back to the past few years, up to around 2021, the underwriting cycle had been threatening to harden as average returns on capital had been approximately 6% over the previous 5 years and well below the cost of capital of approximately 9%.
The seeds were sown and the stage was set, as it were. However, dedicated reinsurance capital had remained more than adequate, assisted by low interest rates among other factors, and reached a then-record high of 571 billion US dollars at the end of 2021. So, the cycle didn't harden, as some might have expected (or reinsurers may have hoped) but this all changed in 2022.
Rising inflation turned into a crisis. Central banks, alarmed at what they saw, increased interest rates rapidly, tightened monetary policy, and financial markets went into a tailspin. The US Treasury 10-year yield doubled, unprecedented in the past 40 years, and the S&P 500 dropped by 20% in the year. As a consequence, the industry’s dedicated capital dropped by some 40 billion US dollars, and reinsurers’ risk appetite also reduced, with the willingness to deploy capital even more restrained.
There was a risk-off moment, as it were, a dislocation between supply and demand.
As a result, prices, terms and conditions reacted violently in favor of reinsurers, such that by 2023, the reinsurance industry had bounced back from a return on capital of just 5.7% in 2022 to a record 22% in 2023, plus the prospect of high mid-teen returns for the following years. In 2024, as inflation slowly but surely came under control and interest rates have started to be pulled back, volatility has also subsided, dedicated capital and the willingness to deploy it has also increased. Renewals have become more orderly, and healthy competition has returned to the market.
Eric Stenson
Thank you very much, Jay and Richard, for sharing your insights with our audience about what causes global volatility, how insurers and reinsurers can best prepare for its impact, and how volatility can influence reinsurance capacity.
Jay Dhru
Thank you, Eric, this was a lot of fun.
Richard Hewitt
It’s been a pleasure, Eric. Thank you.
Eric Stenson
Well, thank you again. And anyone wanting to learn more or who would like to engage with a Guy Carpenter expert directly should visit Guycarp.com and click on Explore Solutions.
Please look for the next episodes in our series as we address additional themes connected with the reinsurance environment. And, thank you to our audience for joining us on Fo[RE]sight: a Guy Carpenter podcast series.