The cost of using investor capital by property-casualty insurers has dropped from 15 percent in the 1980s to between 7- and 8 percent, according an analysis by Swiss Re.
The Zurich-based company said in its latest sigma study that the decline in costs was due to significantly lower risk-free interest rates, equity risk premium and percentage of equity invested assets.
Veronica Scotti, who wrote the study, said that the analysis also concluded that insurers who want to keep their share prices up should focus on good underwriting results and premium volume as opposed to investment gains.
Ms. Scotti said one reason for the drop in cost of capital for the U.S. insurance sector is the reduction in the interest rate on government bonds.
She also noted that equity risk premium "has come down significantly. It was 6-to-7 percent and we're now talking 2-to-4 percent."
Ms. Scotti observed that when an insurer pairs good premium growth with profitable underwriting, "investors will be very happy with it, and the share price will go up. If a company were to focus on investing in financial markets, this strategy will not play out in a higher price for the shares."
The sigma study offers insights as to how the cost of capital relates to shareholder value in insurance companies both in theory and practice.
Swiss Re said its study analyzed the historical statutory accounts and market capitalization data of 27 U.S. p-c insurers.
Given such a small sample, Swiss Re said the results should be taken as indicative only, but its main findings are still of interest. Among the highlights cited by the carrier:
o Companies with the highest economic price/book ratios achieved a combination of high underwriting profit margins, premium growth and scale of operations.
The results, the reinsurer said, indicate investors will assign a higher value to companies that can simultaneously achieve profitability and growth, but are unwilling to pay for growth at the expense of profitability.
Swiss Re found that empirical analysis suggested investors may favor investing in larger companies that may be better positioned to secure long-term profitability and achieve the economies of scale vital in the industry.
o Investment strategy differences were found to have a neutral effect on the price/book ratio.
It is difficult for insurers to earn excess returns through investment strategies that simply involve taking on more market risk. There remain, however, strong liquidity and tax arguments for insurers to invest in corporate bonds and shares, according to the study.
o Higher investment income produced solely by taking more financial market risk may help insurers meet return on equity targets, but is unlikely to increase their price/book ratio, Swiss Re said
Increasing investment risk cannot compensate for poor underwriting, the company advised.
The study is available on Swiss Re's Web site at www.swissre.com/sigma and print editions can be ordered.
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