Mr Patrice Conxicoeur of HSBC Global Asset Management shares the results of an experiment they conducted to illustrate the impact of financial and business scenarios on the profitability of insurers.
With insurance combined ratios which are seldom very far from 100%, insurers depend on investment returns, and hence interest rates, for a large proportion of their earnings. We built a financial model to illustrate the impact of financial and business scenarios on the profitability of insurance companies.
What started as a simple, spreadsheet-based model quickly turned into a major research endeavour, which is on-going. We share here a few findings.
Comparison of “average” and “aggressive” companies
Our first idea was to observe different insurance companies subjected to the same interest rate scenario, but with three “levers” on which insurance managers can act: business parameters, asset-liability profile and strategic asset allocation.
For this we had to create fictional insurance companies, namely “average” and “aggressive” companies: “average” companies are calibrated to display key parameters in line with their industry, Life or Property/Casualty (P&C), while “aggressive” companies display behavioural traits allowing them to grow faster, but with higher costs and risks.
Both types of companies were further differentiated with Asset-liability Management (ALM) scenarios (eg durations of asset and liabilities matched or not, and if not asset durations longer or shorter than for liabilities) and Strategic Asset Allocation (SAA) choices between fixed income and equity. The tables on the next page show initial parameters.
To simplify, our companies invest in bonds and equities, purchased at prevailing market price and yields, and keep them till maturity, save in cases of policy surrenders, claims or other cash needs. Our tests were done comparing two sets of interest rate projections over 15 years.
In one of the sets, the overnight rate is expected to converge towards 4% along a random path. In another set, it will be oscillating around 0%. We have further assumed a company will go bankrupt if its debt to equity ratio exceeds a pre-set level.
Results were in line with expectation
Results are in line with our intuition: companies are less profitable and more vulnerable if interest rates stay low. Term premium is a key driver of performance particularly with low rates. Allocating to equities seems to serve well as an alternative to holding long dated bond, especially for P&C insurers who generally do not invest much in long-dated assets.
“Aggressive” insurers capture more market share but their shareholders seem to fare less well than “average” companies regardless of interest rate scenario and choice of ALM or SAA.
Business choices trump ALM and SAA choices
This simplified view of the insurance industry allowed us to document a few more facts. First of all, it seems business choices trumped ALM and SAA choices most of the time.
In other words, how the company fares (in terms of Return on Equity) relative to peers is more likely to be dictated by business appetite for aggressive behaviour, or lack thereof, than whether assets and liabilities are closely matched.
Undoubtedly, this reflects our choice of parameters and interest rate scenarios, however it is interesting to note that small differences in choices lead to strikingly different financial results.
“Aggressive” companies are more leveraged: there is no reinsurance in our model and thus higher growth leads directly to higher leverage. This is compounded by the lower profitability of “aggressive” insurers, which in turn leads to lower retained earnings, less capital than “average” competitors and higher risk of insolvency.
Ingredients for a prosperous insurance company
The inertia of book yields is clearly shown by the study. This makes any attempt at timing the interest rate cycle not only futile but also potentially counterproductive. Yet, given the diverse behaviours of equity and bonds in different interest rate regimes, it does not reduce the opportunities brought by making calculated decisions on SAA and ALM. Some diversification to equities pays off most of the time.
At this stage of our work, we have mostly re-created a model which confirms what seasoned insurance professionals would know: a prosperous insurance company combines strong risk management, disciplined investments, and tight product design. Together, they give flexibility to the company under different economic or financial scenarios.
Mr Patrice Conxicoeur is Managing Director, Global Head of Insurance Coverage, at HSBC Global Asset Management