There’s an irony in the term “perfect storm” that insurers understand better than anyone. Not only do we help policyholders recover from them, but we may be in for one of our own. Like shifting winds and plummeting temperatures, the warning signs are too prominent to ignore:

  1. Interest rates remain low pressuring investment yields.
  2. Shrinking reserves may fail to hold up to increasing loss costs.
  3. While we’ve had a prolonged period of peace and quiet, history and models suggest that we need to expect much higher levels of nat-cat activity.
Bill Donnell, Swiss Re
Bill Donnell, Swiss Re
“Higher retentions imply more vulnerability to cat risks,” Donnell says. “More leveraged, deteriorating underwriting results can compromise an insurer’s ability to pay claims in the event of a severe cat year or adverse development in a casualty book.”

Despite vigilance and good intentions, it’s easy to fall into a trap of unintended complacency. In good times, our clients may increase their retentions while at the same time seriously looking at new casualty lines or even entertaining plans to jump into cover emerging risks like cyber.

But when we see the clouds on the horizon we are reminded of the value of reinsurance. We are here to give our clients balance sheet protection if and when their experience outpaces their models and expectations.

The “perfect storm” we face is not signaled by atmospheric or meteorological markers, but by economic trend lines:

1. Interest rates are low and any increase in insurers’ portfolio yields will be gradual.

We’re stuck with low interest rates, which impact investment portfolios. Yields will continue to suffer so long as rates are kept low to stimulate the economy. Through the first three quarters of 2014 the US P/C industry saw virtually no change in net investment income even though there was a 4.2 percent year-on-year increase in cash and invested assets. Total investment yield dropped a few ticks, to 3.1 percent from 3.3 percent the previous year. Including capital gains, net investment results declined 8.4 percent, Swiss Re’s Economic Research & Consulting group reported in the U.S. Property & Casualty Quarterly Review published in late January.

The capital markets are also feeling the pinch and looking for better returns elsewhere. Insurance risk transfer is looking more attractive by the day.

2. Casualty loss reserves are drying up.

According to A.M. Best, “inadequate loss reserves were the leading cause of past insurer insolvencies.”

For many years now, reserves have been redundant on average, fueling reserves releases that were surprisingly persistent. Lately, we see signs of change.

Insurers are releasing fewer reserves and those releases having less impact on the bottom line. In the first nine months of 2014, P/C insurers released $3.8 billion less in claims reserves compared to the same period in the prior year. The $8.4 billion release did improve the calendar year combined ratio by 2.3 points, but that’s down from a 3.5-point improvement in the previous year. Commercial lines saw an even bigger impact, where the contribution from reserve releases declined to 0.9 points from 2.3 points, Swiss Re Economic Research & Consulting reported.

While general inflation remains low, the cost of claims began to trend upward. Economists have noted an uptick in health care, prescription drugs and auto repair costs. Bodily injury claims trends, which are still benign, are likely to rise with a stronger economy—pushing up medical and wage inflation.

Claims-related expenses rose faster than net written premiums in the first nine months of 2014 over the same period in 2013. As a result, the industry’s combined ratio rose 1.9 points to 97.7 during the first three quarters of 2014 compared to 95.8 in the comparable 2013 period, Swiss Re, Economic Research & Consulting reported.

3. We are in a phase of below average natural catastrophe activity and this will normalize.

Underwriting got a big boost from another benign cat year. Global natural catastrophe losses last year were less than half the average of the prior decade.While Florida hasn’t had a named hurricane since 2005, the combination of coastal development and climate change exacerbates the vulnerability to more severe events. As we put more valuable assets in harm’s way, we stand to lose much more when an event hits. Swiss Re’s Cat Perils team continues to produce staggering estimates of what major historical events would cost in today’s world. For example, the 1821 Northeast hurricane today would cause $100 billion in damage (wind and storm surge) and have a total economic impact of $150 billion. (Source: “The big one: The East Coast’s USD100 billion event,” Swiss Re, 2014)

4. Insurers are retaining more risk because it is profitable. But sooner rather than later the tables are likely to turn.

When underwriting results are rosy, higher retentions seem like a good idea since it produces more underwriting income, more cash flow and more underwriting leverage. However, there are risks.

First, all these positive factors turn negative once the underwriting profitability turns negative. Second, higher retentions imply more vulnerability to cat risks. Both risks are correlated since more leveraged, deteriorating underwriting results can compromise an insurer’s ability to pay claims in the event of a severe cat year or adverse development in a casualty book. We have seen this happen time and again when major catastrophes occur, eroding profitability and driving some insurance companies out of the market.

Reading the Storm Indicators

In the coming years insurers can expect shrinking profits, vanishing reserve redundancies and declining return on capital. It’s precisely during this moment of crisis when reinsurance excels. Dollar for dollar, reinsurance remains a viable source of risk transfer and balance sheet protection for insurers, especially in today’s unpredictable and turbulent world.

The current abundance of capacity is causing commoditization among smaller capacity providers and driving a flight to quality. Larger reinsurers have an advantage through size, scale, diversification, agility and an appetite for new and high-growth markets. . When faced with complex risks, these reinsurers tailor solutions to create most value for their clients and help them achieve their goals. In addition to providing capital, global reinsurers can provide a wider perspective on long-term and emerging risks. We collaborate with our clients to develop this knowledge and foresight—what we at Swiss Re call “smarter together.”

As a class, reinsurers have generated a consistent profit and increased capital for three successive years. The reinsurance industry delivered another strong underwriting result in 2014 with an 88 combined ratio, unchanged from 2013 and down from 90 in 2012. However, the result was supported by two strong factors: First, reserve releases continued at a large scale in 2014.Second, the reinsurance industry benefited from very low cat losses globally in 2014. If we adjust for these factors, average profitability was weaker last year and some companies will not have earned their cost of capital.

Just as insurers assist their policyholders in times of need, so too do reinsurers support primary carriers when their own adverse circumstances strike. As warning signs indicate darkening skies ahead for insurers’ balance sheets, the diversification and strong capitalization of global reinsurers will help ensure stability for the industry as it navigates its own “perfect storm.”