Economic factors have a strong effect on demand for insurance but not for reinsurance. Seán Mooney explains what drives demand for reinsurance.

There has been relatively little work published on the relationship between the demand for reinsurance and macroeconomic factors, such as growth in gross domestic product (GDP), inflation, and interest rates. This is not surprising since, as we discuss further on, there are relatively weak correlations between economic factors and reinsurance markets.

Perhaps the most frequent use of economic statistics in reinsurance is not to determine relationships, but to benchmark. So let's see what benchmarking can tell us about the global reinsurance industry. On a global basis, is it a growing, mature or contracting business?

If we look at data for the current decade, the global reinsurance industry appears to be mature, that is growing at about the same rate as the world economy.According to Swiss Re, global reinsurance premiums increased by 49.3% in the 1990s, practically equal to the growth in world GDP of 51.7 % for the same period. However, this simple result probably conceals more than it reveals. It tells us nothing about countries or regions where reinsurance is growing faster than GDP, nor does it say much about individual companies, many of which have more rapid growth than the industry average.

For the United States, Guy Carpenter has assembled data on professional reinsurance companies on a consistent basis for a number of years, as shown in Chart 2.

From 1984 to 1997, reinsurance premiums increased by 251%, substantially faster than the growth in United States GDP of 107 % over the same period. This contrasts with the earlier observation on world reinsurance demand in the 1990s.

However, it would be wrong to place too broad an interpretation on this result. It is obvious that forces other than the macroeconomy are at work. The liability crisis of the mid 1980s and the property crisis following Hurricane Andrew in 1992 explain the rapid increase in premiums in the mid-1980s and early 1990s, respectively, while competitive forces resulted in the flat or declining markets of the late 1980s and currently. These observations are in line with the basic premise of a weak relationship between broad economic trends and the reinsurance market.

A second area for benchmarking is cross-sectional, comparing data from country to country, adjusted for economic size. In Chart 3 we show the relative penetration of reinsurance, adjusted for GDP, around the globe.

First, a word on the data. The reinsurance data by country used in this chart were collected and published by St. Paul Re. In a pioneering study, analysts at St. Paul went to great lengths to collect data on a country of origin basis. They wanted a clear answer to the question of how much reinsurance is ceded from each region of the world. In economic terms, they wanted to determine the sources of demand.

Most analysis of reinsurance markets is in supply terms, meaning those who assume reinsurance. This is mainly because this is how the data are reported: reinsurance companies report on their total reinsurance premiums and normally do not identify the source countries of their business.

Chart 3 shows that there is a wide range between regions in the demand for reinsurance, even after the data are adjusted for economic size. Australia has the highest use of reinsurance, almost 2.5 times the global level. At the other end of the scale, Japan makes the least use of reinsurance, at about one tenth of the global level. As expected, North America and Western Europe show similar levels of use of reinsurance. The use of reinsurance in Latin America is relatively high, but a substantial portion of cessions in this region currently go to quasi-governmental agencies. In sum, this cross-sectional analysis indicates that factors other than GDP are very important determinants of reinsurance demand.

Theoretical relationships
Turning now to a review of more theoretical influences of macroeconomic factors on reinsurance markets, three major economic factors are considered: interest rates, inflation and economic growth.

Interest rates: Interest rates can impact the asset side of reinsurers' balance sheets. As interest rates rise, the market values of bond portfolios decline. In addition, increases in interest rates are frequently accompanied by stock market declines. This is particularly true during periods of severely tight credit, when fears of recession accentuate the move away from equities.

In general, because of the strong capital position of most reinsurers, we have experienced relatively few instances when high interest rates have a severe impact on insurance assets. In fact, we need to go back to the 1970s to witness a period when asset prices declined to a point where there was a marked impact on insurers and reinsurers.

Interest rates can and do impact on underwriting decisions, particularly by casualty reinsurers, where typically there is a period of many years between the cash inflow from premiums and the cash outflow for claim payments, resulting in a period of significant inflow of investment income. As an example, the relatively high interest rates of the early 1980s encouraged insurers and reinsurers to reduce prices drastically for casualty insurance in a spate of cash flow underwriting. By way of contrast, the current relatively low level interest rates do not seem to be leading to increases in prices in either insurance and reinsurance casualty markets.

Inflation: A stable inflation rate does not normally affect insurance markets. If insurers and reinsurers know that prices are increasing at a constant rate of, say, 5%, they can factor this increase into their premium calculations.

On the other hand, unexpected increases in inflation are typically bad for both insurers and reinsurers. This is because increases in claim payments are higher than anticipated. The converse also holds. An unexpected reduction in inflation has a favourable impact on insurers and reinsurers because claims come in a lower level than anticipated in the setting of premiums. Relatively low inflation has been a major factor in the recent strong performance of the US auto insurance market.

Economic growth: Over the short term, economic growth has little impact on reinsurance markets. However, over the longer term there can be significant effects, particularly in terms of developing economies. Looking first at primary insurance, we can observe three phases of development. The first involves the early stages of economic development. In this stage, insurance is typically needed to support international trade and infrastructure investments. The second phase is when per capita income and wealth increase and individuals turn to life insurance products, both as a protection for family income and as a savings mechanism. Finally, the third phase occurs when individual assets increase and the driving population expands, leading to the demand for property and auto insurance.

When we turn to reinsurance, we find, in general, that the reinsurance market does not expand in tandem with the primary market. Frequently, the government in emerging economies controls the reinsurance market and holds this control through the many different phases of economic development.

This means that the defining factor for growth in the reinsurance market is the liberalisation of financial markets. Such liberalisation typically comes in the later stages of economic development. This is one of the key reasons why we see very little relationship between long term economic growth and reinsurance.Looking to the future, the outlook for the reinsurance market in most countries is most likely to be affected by industry specific factors, rather than by broad changes in the economy. Reinsurers can not ignore economic changes, but the impact of such changes is more likely to affect long term strategy, rather than shorter term tactical decisions.

Seán Mooney, Ph.D, is economist and research director for Guy Carpenter & Company, New York. Tel: 1 212 323 1345; fax: 1 212 313 4550; e-mail: smooney@guycarp.e-mail.com