A holistic approach to managing insurance risk and capital 

Insurance companies in the property and casualty (P&C) sector have been facing a ‘perfect storm’ of challenges that stress both the asset and liability sides of their balance sheets. Ongoing macroeconomic uncertainty and volatile business performance are putting further pressure on their ability to weather such ‘storms’ or rebuild efficiently before another ‘storm’ strikes.

The inflationary environment, shifting frequency of losses, lagging rate approvals, higher reinsurance costs and increased retention levels have contributed to underwriting pricing volatility. Meanwhile, greater uncertainty in markets over monetary policy, capital loss on equities and negative real yields for bonds are putting investment performance under pressure. In addition, credit agencies are becoming more stringent in how they calculate ratings; in this challenging operating environment insurers are prioritizing stability and growth of earnings above simple capital protection.

Such conditions are even forcing some P&C insurers to pull out of some geographic markets or withdraw some types of coverage.  Given this environment, others are looking to build scale through M&A to diversify business lines and strengthen the balance sheet. 

Many industry participants consider the current situation to be a watershed. Until a few years ago it was far easier to hedge risks. Since then, many reinsurers have pulled back from the space and are asking insurers to take more risk on their balance sheets. This dynamic has prompted many insurers to  undertake a more holistic approach to risk and capital management given a limited risk and capital budget.

Historically, using cheap reinsurance capital, P&C insurers were able to target greater returns with less volatility than they realistically can in the current environment.

While insurance rate increases may be the first stop to manage profitability, ongoing and significant rate action may create rate fatigue with regulators who may start to delay or deny rates from rising commensurately, which would increase margin volatility and therefore the underlying performance of insurers. Couple this with increased scrutiny around non-renewal of business and insurers are exposed to greater underwriting uncertainty.

There is also an emerging challenge from climate change, which is likely to result in catastrophic events becoming more frequent, yet remaining unpredictable, and emerging in new geographies. Insurers are not only facing the ‘big cats’ of hurricanes and earthquakes but also more frequent ‘kitty cats’, the smaller catastrophes of severe winter storms and wildfires that will need to be managed more carefully should reinsurance retentions be required to stay at the current levels of expected attachment.

In this broad context, while new capital may well come into the reinsurance market, the trends of the past few years are unlikely to disappear quickly and higher retentions, in particular, are likely to feature for some time. This is where a more holistic approach can benefit P&C insurers.

A holistic approach to balance sheet management, which simultaneously addresses underwriting and pricing uncertainty and investment risk, should result in better-optimized enterprise value. We believe the best way to implement a holistic approach is by embracing flexibility and developing a strategy that caters to each insurer’s specific requirements.

Insurers are increasingly considering how to put the right capital structures in place to support their liabilities while ensuring they have the right investment strategy.

For instance, the upward shift in interest rates – due to central banks around the world raising interest rates to combat inflation – has allowed insurers to revisit their investment approach. Here, risk appetite, or at least risk tolerance, plays an important role.

Some insurers may seek to de-risk their investment portfolios by cutting equity exposure and replacing it with a greater proportion of fixed income assets. This is likely to reduce volatility and improve yields, boosting investment income.

Others may be willing to take on a bit more risk and aim to take advantage of specific opportunities, investing in areas such as multi-asset credit strategies that include higher-yielding assets. Meanwhile, more risk-averse insurers are focusing on making sure they have the liquidity to withstand challenging environments by building a cash buffer.

Aligning underwriting and investment risk through an enterprise view can help improve stability and grow company value over time. Finding the right balance is a unique process given each company’s risk appetite and current pressures, and escalating costs of capital and a shift in reinsurers’ appetites require a thoughtful approach to limit exposing the company when it is already under significant pressures to perform.

The combined resources of Mercer and Guy Carpenter provide insurers with a huge range of integrated solutions to optimize balance sheet management objectives – aimed at reducing volatility and enhancing risk/return, capital and liquidity profiles – by linking underwriting, investment and capital strategy, and we believe that this requirement is only going to grow in the coming years.