July 31st, 2008

Bag Profits Early: Investment Gains Under Pressure

Posted at 2:06 PM ET

Christopher Klein, Global Head of Business Intelligence

Asset-driven losses have put pressure on earnings. Investment gains comprise an important part of carriers’ long-term profits, and financial markets have shown just how volatile this source can be. With net income off 60 percent from the first half of 2007 to the first half of 2008, carrier profitability will become increasingly reliant on technical earnings.

Investment Performance Squeezes Earnings

Several years of relative calm have led to strong earnings growth, but the rate of growth has begun to slow. While there have not been any mega-catastrophes, disasters around the world have impacted (re)insurer profits. There have been market-shifting insured losses in 2008, though distributed across several events on different continents. At the same time, capital markets have had to adapt to the effects of the subprime mortgage market collapse. Equity values, consequently, have been pushed lower. Both investment and underwriting gains have been squeezed, putting (re)insurer earnings at risk.

A study of several prominent risk-bearers suggests that investment gains are down profoundly across the (re)insurance industry significant. Investment gains for this group reached an aggregate USD98 million for the first half of 2007. For the same period in 2008, though, the group showed an aggregate investment loss of USD566.2 million, and the majority has been realized. Net income is down 60 percent year-over-year.

Capital markets are still trying to find solid ground. Equity values are depressed both generally and for the (re)insurance industry specifically. The FTSE 100 and S&P 500 indices are down approximately 15 percent year-over-year (measured from 2007H1 to 2008H1). The Dow Jones Euro STOXX 50’s decline of 25 percent is more precipitous, but it is not as severe as the 34 percent plunge of the Dow Jones Insurance STOXX 600.










As investment gains have become less reliable, catastrophe losses have increased, particularly in the United States. The second quarter of 2008 was the second costliest second quarter of the past decade. The increase in insured losses was offset, at least in part, by reserve releases. The emerging environment may be more challenging than it appears. Since reserve releases represent a finite resource for the support and stabilization of earnings, the continuation of catastrophe losses at the current pace could have an even greater impact on profitability.

Impact for (Re)Insurance
To maximize profitability in the coming months, risk-bearers may need to adjust their risk management strategies, as investment gains are unlikely to provide the buffer on which they have relied over the past few years. A large catastrophe loss this year could erode many companies’ earnings and capital bases.

Further, Market risk sensitivity in dynamic financial analysis (DFA) and Enterprise Risk Management (ERM) models could also become a factor. Large losses from different sources could call the efficacy of ERM into question. Assessments could be jeopardized in the event of a large catastrophe loss following the significant asset-side write-downs experienced so far in 2008.

For this reason, carriers may consider protecting underwriting earnings booked year-to-date. Reinsurance cover in the form of a “stop-loss” can lock in underwriting profits against potential future catastrophe losses. Unlike excess of loss reinsurance, which is related to single loss amounts, stop-loss covers relate to the total claims incurred in a given underwriting year.

The impact of selecting risks judiciously can be enhanced through increased risk transfer. By locking in underwriting gains now – and reducing retentions – carriers can mitigate the effects of capital market turmoil and protect their bottom lines.

Additional Contributors:

  • Sean Mooney, Chief Economist
  • David Flandro, Senior Vice President
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