Insurance premiums are a function of these factors: The perception of future risks, recent catastrophic claims and the return available on investment. Huge fires and other disasters factor in, such as the Colorado Springs blazes earlier this year and other natural disasters have also forced large payouts. Even the devastating Japanese earthquake and tsunami from 2010 affects insurance premiums in the United States, since insurance companies routinely purchase re-insurance coverage from very large companies. And these reinsurance companies, such as General Re, have been increasing their rates. In addition, jury awards and settlement costs in a variety of commercial fields have put pressure on insurance company reserve funds.
Yes, insurance companies are just like you: They assess the risks they can cover, and then buy insurance themselves to protect themselves against very large but unlikely events that would overwhelm their reserves.
We saw a similar tightening of the property and casualty insurance world across the board, in 2001, following the 9/11 attacks on the World Trade Center. The direct costs themselves were significant, but reinsurance companies also increased their rates then, in order to cover their own risks and ensure clients were protected in case of acts of war, nuclear strikes, chemical strikes, etc.
Fortunately, their worst fears weren’t realized, but prudent insurers are in business to cover the worst case scenario, and so they had to plan and set premiums accordingly.
Fast forward to today, though, and we have a different phenomenon at work. Reinsurers had just started to climb out of the substantial capital shocks of 2008 and 2009 when they got hit with the Japan tsunami, which put pressure on capital pools. But as they work to replenish their reserves, all insurers, all over the world, have been forced to reckon with a new reality: Low interest rates.
Insurance companies make money in two ways: Bringing in premiums, and investing the “float.” Normally, insurers break even or even run a slight loss on premiums. This keeps premiums affordable, but is only possible because they can invest their accumulated reserves at a profit.
Ten years ago, an insurance company could get 5 or 6 percent on a portfolio of Treasuries. Now that same insurer struggles to get 2 or 3 percent on a AA-rated bond portfolio, and U.S. Treasuries – the traditional mainstay of conservatively-run insurance companies, may well be generating a negative real return after inflation.
Something has to give.
That’s what we’re seeing now: Actuaries have no choice but to increase premiums to cover anticipated payouts in light of the new lower interest rate environment. To do otherwise risks insolvency, which does no service to the insured at all, and even defeats the purpose of insurance.
The tightening of the reinsurance market, combined with adjustments to account for the lower returns on assets, is now making its presence felt on Main Street: Aggregate commercial insurance ratios increased for the fifth consecutive quarter, and by 5 percent in the first quarter of 2012 alone. That’s the biggest increase we’ve seen since 2004 (remember those summer hurricanes in Florida that year?)
The two lines responsible for the largest increases, according to a Towers Watson survey, were the two segments most vulnerable to jury award and medical cost increases (workers compensation), and increased reinsurance costs from megadisasters and lower interest rates (commercial property insurance), respectively.
Insurance markets tend to cycle along with other industries. As reinsurance pools of capital get replenished, or as interest rates rise, allowing carriers to generate more revenue from the “float” rather than rely so much on point-blank premium collection, rate increases tend to moderate, and new carriers spring up to compete for business.
So if you are seeing rates increase, it’s more a matter of prudence in the face of risk and low returns on capital, which affect all carriers everywhere. As a result rates increase to make sure there are enough in reserves to cover future claims . No one is exempt, and it’s a bigger issue than any single insurance agency, carrier, or insurance line.