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The prime interest rate and insurance pricing changes.

While natural catastrophes, problems with real estate portfolios and losses from workers' compensation insurance are pressuring for higher insurance product prices, a less obvious force is working again as it has over the last 20 years. Interest rates influence the pricing of insurance products and insurance industry underwriting results. The graph indicates that the drop in the average prime rate to 6 percent will result in heavy pressure to improve underwriting and pricing of insurance products, implying higher prices for insurance in the future.

Two separate lines on the graph show the relationship of underwriting results to the average prime rate. The underwriting combined ratio for all U.S. property/casualty companies is graphed over time based on the scale on the left margin and axis. The average annual prime rate over time is graphed based on the scale indicated to the right. The line for 100 percent combined ratio is also the line for 6 percent average prime rate, and 5 percent change in underwriting ratio on the left vertical scale is equal in magnitude to 2 percent change in the average prime rate on the right vertical scale.

As the prime interest rate increases, investment income increases. This creates a larger return on an insurer's invested assets, and allows the company to continue or improve net operating results with less contribution from the underwriting of insurance. This reduces the pressure on underwriting and allows more competitive pricing.

When interest rates go high enough, as they did in the mid-1970s and early 1980s, there is an extra pressure placed on insurers to produce premiums that can be invested at these higher interest rates. This increase in interest rates leads to a decrease in insurance pricing and an increase in the underwriting combined ratio. This is not a new phenomenon. As the graph shows, there is evidence that this correlation began in the 1950s and has continued through today.

Note that the red and green line that indicates underwriting combined ratio (green for profit and red for loss) generally lags or follows the average prime rate graphed in blue. The reason for this is twofold. First, pricing is slightly delayed in response to changes in the interest rate. Second, there is generally a delay of more than one year from the time of pricing actions to the time of underwriting results.

Clearly, the average prime rate is not the only independent variable that influences underwriting combined ratios. The insurance marketplace has an abundance of capacity to write casualty risks, partially due to an influx of foreign capital. At the same time, huge losses due to catastrophes during 1992 increase pressure on underwriting and pricing. Given the external pressures from catastrophe losses and real estate defaults, perhaps the influx of new capital into the U.S. insurance market and the strong stock market are only temporarily delaying significant price adjustments in casualty lines of insurance. The strong one-year-lag correlation indicates there may soon be a change in commercial lines pricing. The potential becomes even stronger if the prime would continue to fall below 6 percent.- Gregory N. Alff, senior vice president and senior actuary at Willis Corroon Advanced Risk Management Services in Nashville, TN.
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Author:Alff, Gregory N.
Publication:Risk Management
Date:Jul 1, 1993
Words:533
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