Part 1: The increasing importance of investment returns
By Marius Strydom
Rising interest rates and yields are reintroducing the importance of investment returns to UK P&C insurers
Property and casualty (P&C) insurance companies make money in two key ways: underwriting risk and making a margin by delivering a combined ratio of less than 100% (an underwriting profit or margin); and generating investment returns on the regulatory capital they hold as well as on the assets backing their substantial insurance reserves (often referred to as the free float). Investors like Warren Buffett’s Berkshire Hathaway have traditionally been attracted to P&C insurance companies because of this return on the free float, which helps such companies to deliver operating margins well ahead of their underwriting margins and to achieve superior net asset value (NAV) returns (return on free float adding to the return from underwriting margin and investment return on capital).
Since 2009, interest rates in developed economies, and in the UK in particular, have been at historically low levels and declined to close to zero when the COVID-19 pandemic hit. The wider insurance market, including P&C companies, has also adopted more conservative approaches to solvency, with most participants choosing to hold higher levels of capital than in the decade leading up to 2009. Over the past decade, the average solvency level for UK motor P&C insurers Direct Line, Admiral, Sabre and Hastings was c 180% of regulatory capital, where levels of 160% (on a Solvency II basis) were more common before.
Higher solvency levels resulted in higher levels of investments held (relative to premiums) from which to generate investment returns to boost operating margins. However, this benefit was meaningfully offset by low interest rates and yields. In addition, the higher solvency levels had a dilutionary impact on return on tangible NAV/equity (ROTE).
The net result of higher solvency and lower rates was therefore negative, with operating margins suffering from a lower return on the free float and low returns on additional capital, while ROTE suffered from lower returns on higher levels of capital.
Over the past decade, average investment return on assets for the peer group above was only c 1.5%, rarely contributing more than 10% to earnings over the period.
However, over the past year there has been a dramatic change in global and UK interest rates, with three-month Libor rising from close to zero to more than 3%, while the UK 10-year gilt yield increased from 0.9% to 3.5% after reaching 4.5% in September 2022 (both have been very volatile). This is a huge development for the UK P&C motor industry, and is expected to have a very positive impact on margins and returns.
Negative investment portfolio impact is temporary and should be followed by a strong uplift in investment returns
Published UK P&C company financial results for the first half of 2022 have been less than stellar, affected by high claims inflation and sticky premium rates, especially for UK motor insurers. We expect a marked turnaround in combined ratios, driven by strong premium re-ratings into 2023, which we will explore later in this series.
Earnings and returns during the first half of 2022 were further affected by higher yields on fixed interest portfolios. Capital losses on investment portfolios, which are not included in headline earnings but in total comprehensive income (TCI), were a feature for all the operators, pushing Hastings, Sabre and Direct Line into negative TCI territory and leaving Admiral with close to zero TCI. Annualised ROTE remained positive but dipped to five-year or more lows for all the companies. While we expect the underwriting performance for the sector to improve in the second half of 2022, we also anticipate the sharp rise in yields since June 2022 to continue, negatively affecting TCI and returns for the full year.
We expect these unrealised investment losses to turn around sharply in 2023 as yields normalise and bond and gilt portfolios approach maturity. With higher yields and interest rates, investment return is set to become a much more important contributor to earnings and returns.
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