Swiss Re’s chief economist, Thomas Hess, has great faith in the insurance sector’s survival instincts. As he tells Ellen Bennett, there is reason for cautious optimism among the gloom
“If governments and the central banks didn’t respond as they did, I think you would have seen people queuing in the streets,” says Swiss Re chief economist Thomas Hess, gesturing out of the window of the reinsurer’s landmark building at 30 St Mary Axe, aka ‘the Gherkin’. He is talking to Global Reinsurance about the economic collapse after Swiss Re’s annual review of the year. And what a year it has been. Hess reckons this has been the worse crisis since the Wall Street Crash and the Great Depression of the 1930s, but the insurance industry has pulled through it with flying colours.
Like many of his colleagues in insurance and reinsurance, Hess is keen to emphasise that this recession was caused by a banking failure and its solutions should focus on the banks. He praises policymakers’ responses, but warns that they must not over-regulate. Looking ahead to next year, he outlines continued slow recovery and gradual improvements in balance sheets. He also has a few intriguing predictions for the market in the months ahead.
But first, if this is the worst economic crisis since the 1930s, why hasn’t that been reflected in the real economy? Sure, it’s been pretty bad – but nothing like the haunting scenes of America in the dark days of Depression.
“There is more wealth in the economy now and more social insurance systems,” Hess says. “The policy response was much better this time – central banks stepped in very forcefully and in quite a co-ordinated way, and governments developed substantial fiscal programmes. But the initial drop in the real economy was extremely sharp – that was not so different.”
Hess, an amiable man with the air of an academic, laughs. “This was a run of banks on banks, so perhaps they were queuing up inside their computers.”
Hess acknowledges the recovery has been slow. “The global economy grew in the second half of 2009, but the recovery is fragile,” he says. “Growth will generally be below trend in the major economies in 2010, but will accelerate modestly in 2011.
“Monetary policy will shift to tightening in late 2010 at the earliest, and reductions in fiscal stimulus will follow shortly afterwards. As a consequence, growth and inflation are subdued.”
By 2011, Swiss Re expects real GDP growth in OECD countries to be about 2% to 2.5%, while in emerging markets it will be substantially higher at 6%. Oil prices are expected to remain fairly close to current levels, rising slightly in 2011 and 2012, when economic activity accelerates. A reduction in monetary easing will push up yields on government bonds, particularly in 2011.
Against this backdrop, there will be an improvement in balance sheets for primary insurers, continuing the trend in the second half of 2009. By November capital was almost back at 2007 levels. Meanwhile, demand for life and non-life insurance is expected to improve with the economy and capital markets in 2010.
This is good news for reinsurers, which remained robust throughout the crisis. Swiss Re predicts slightly improved top-line growth in 2010. Profits will improve or remain stable, it says, and improved investment returns will compensate for slightly lower underwriting.
So is there any sign of a hard market returning in the January renewals? Hess shakes his head. “It will be very tough,” he says. “There is a lot of competition, and companies still have reserves to release from prior years.”
This means they can afford to keep rates low; the soft market will linger until reinsurers run out of cash and are left with no option but to raise rates. Over the course of the year, though, low asset returns will put increasing pressure on reinsurers to underwrite for profit (see box, below).
Regulation is another headache, though Hess is quick to draw attention to the insurance industry’s underlying strength. “The crisis was proof of the resilience of the global insurance industry,” he says. “Insurance and reinsurance functioned routinely throughout, even at the peak of this extremely severe financial situation, meeting their claims obligations fully and without delay. Taxpayer support, as far as insurers were concerned, was confined to very few companies, and was almost entirely due to the banking-type operations of these companies.
“Even the financial guarantee insurers devastated by the crisis received no government assistance. The non-life and life and health (re)insurance operations remained well capitalised.”
But do policymakers and regulators understand this? The banking system’s excessive leverage and capital reserves that were too low for the risks assumed were not insurance industry problems. Therefore, the regulatory response should be different for the two industries.
While it is agreed that banking needs higher capital requirements, it may prove counterproductive for insurance. In particular, it may push life insurers into even more conservative investments. Hess warns: “This could lead to old age provisions being financed by low-risk assets only, such as government bonds. With life insurers and pension funds being prevented from taking risk, an essential source of financing for the real economy will fall away.”
Despite such dire warnings, Hess seems cautiously upbeat about the year ahead. He even has one final prediction up his sleeve. “As the markets recovers, you will see more acquisitions,” he says.
You heard it here first. And this time next year, Hess will be back to tell us all about them.
Ellen Bennett is executive editor of Global Reinsurance
Continued trend towards increasing natural catastrophe losses
Matt Weber, a member of Swiss Re’s executive board and head of the property and specialty division, expects continued growth in the natural catastrophe insurance business.
“Despite an unusually low hurricane season this year, overall natural catastrophe losses have increased significantly over the past decades and are expected to grow further,” he says. “Europe has seen above-average losses in 2009, and the impact of climate change is likely to cause more frequent and more severe storms and floods around the globe in the future.”
According to Swiss Re, by the end of this century, once-in-a-millennium storm surges could be striking northern Europe on average once every 30 years.
Worldwide average insured natural catastrophe losses between 1970 and 1989 were $5.1bn per annum; these losses increased to $27.1bn per annum between 1990 and 2009. “As a result, we see increasing demand for natural catastrophe cover,” Weber says.
“In this environment, and in combination with potential catastrophe events, both intelligent cycle and sound risk management remain crucial elements of Swiss Re’s business approach. To ensure this, we are continuously optimising our own natural catastrophe models for relevant markets and perils.”
Low asset returns in 2010
While the corporate bond market and equity markets are expected to continue improving in 2010, insurers’ investment income will continue to suffer from the low interest rate environment, Swiss Re predicts.
Insurance and reinsurance companies mostly invest in high-quality fixed income assets and yields, particularly on government bonds. Rates on these assets are very low by historical standards. Unlike banks, insurance companies do not tend to have very high leverage ratios. But even property and casualty (P&C) insurers have asset leverage, and this magnifies the impact of declines in investment yields on return on equity (ROE).
For example, P&C insurers in the US had asset leverage – assets as a percent of equity – of 278% in 2008. To maintain the same ROE after a 1% point drop in investment yields requires about a three percentage point improvement in the combined ratio.
“The implication is clear,” says Swiss Re chief economist Thomas Hess. “Low investment yields will force (re)insurers to focus on underwriting profitability. This will give companies with a strong combined ratio history a competitive advantage.”