3.-Capítulo 2 - Measuring - Underwriting - Profitability

sigma
No 3/2006 Measuring underwriting profitability

of the non-life insurance industry
3 Summary
5 Introduction
7 The conventional versus the

economic combined ratio
13 The accident year improves

the measurement of
underwriting profitability
18 Large catastrophic losses

distort underwriting profitability
21 Recognition of the time value

of money – discounting future
claims
25 Current underwriting profitability:

Economic combined ratio by
line of business
29 Appendix I:
Standardization of underwriting
and pre-tax results
31 Appendix II:
Definitions and sources
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Dr Thomas Holzheu
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Summary
Economic combined ratio is a better Sound technical underwriting has become the prerequisite for overall profitabil-
measure of underwriting profitability. ity in the current low-yield financial environment. As a result, the combined ratio
has received renewed attention as a key performance measure for the non-life
industry. However, the conventional combined ratio or other accounting-based
measures entail significant limitations for judging the underlying underwriting
profitability.
This sigma proposes the economic combined ratio as an alternative for measur-
ing underwriting profitability, addressing the question “How profitable is insur-
ance business written in each year?” It has the following characteristics:
 It is based on accident-year, not business-year data.
 It takes into account the time value of cash-flows, in particular by discounting
future claims payments.
 For the purpose of judging the quality of underwriting decisions, it also allevi-
ates distortions resulting from extraordinary catastrophe loss events.
It changes the view of insurance Using the economic combined ratio provides new insights for the understand-
price cycles. ing of insurance cycles, as the following observations on the 1994–2004 US
property/casualty industry demonstrate:
 Underwriting profitability deteriorated from a very high level in 1994 to aver-
age profitability in 1997, according to the economic combined ratio, though
the reported combined ratio improved,
 The trough of the cycle was 2000 according to the economic combined ratio,
rather than 2001, as reported by the peak in the conventional combined ratio,
 The accident years 1998 to 2001 were considerably worse than the conven-
tional combined ratio originally indicated.
 The profitability of 2003 and 2004 is comparable with 1994 and 1995,
despite a 5 percentage point lower reported combined ratio, because the
currently low interest rate environment reduces the impact of discounting for
Results for Canada, France, Germany, The picture for the business year results for Japan, Canada, France, Germany
Japan and the UK reveal a similar story. and the UK are broadly consistent with the US results. While the years 1994
to 1997 and 2002 to 2004 were profitable, though often only moderately, the
period from 1998 to 2001 exhibited dismal underwriting results. Substantial
improvements in underwriting results from 2001 to 2003 restored profitability
to the level of the 1994 to 1997 period.
Underwriting barely contributed to Ten-year-average underwriting margins before taxes were positive in all coun-
industry profits from 1994 to 2004. tries, implying a positive contribution to profits from the insurance activities.
However, the contribution was only about 1–2% in the US and Japan, 2–3% in
France, 5% in Canada and the UK, and 6% in Germany. These positive results
are a necessary but not a sufficient condition for creating shareholder value.
Profits must also cover tax and the insurers’ capital cost. Between 1994 and
2004, it was difficult for the industry to earn its underwriting cost of capital.
Swiss Re, sigma No 3/2006 3

Summary
Current profitability by lines of Across the board, business was profitable in 2004. Underwriting contributed
business is encouraging. between 6 and 9% of premiums to the overall profitability in the US, the UK,
Germany and France. Without huge typhoon claims, Japan’s results would have
been in the same range. Canada posted 15%. Particular long-tail lines like gen-
eral liability business were highly profitable.
However, in order to judge the ultimate profitability, further information is re-

quired, such as the amount and cost of capital needed to write the business.
Capital requirements and cost of capital depend on risk- and company-specific
factors as well as on the regulatory framework.
4 Swiss Re, sigma No 3/2006

Introduction
The economic combined ratio is meant The goal of this sigma is to provide information for measuring the underwriting
to more accurately reflect underwriting profitability of insurance markets. For this purpose, the economic combined ratio
profitability.
is introduced as an alternative key performance indicator. Compared to the con-
ventionally published combined ratio, it reflects underwriting profitability more
accurately, based on the following characteristics:
 It is based on accident-year data, not business-year data.
 It takes into account the time value of cash-flows, in particular by discounting
 For the purpose of judging the quality of underwriting decisions, also distor-
tions resulting from extraordinary catastrophe loss events are alleviated.
The economic combined ratio is designed to measure underwriting profitability

accurately and without unusual factors distorting the results. A practical use of
the economic combined ratio concept is in comparing underwriting results be-
tween business lines and countries.
Six major markets are examined: US, UK, This study focuses on the underwriting profitability of six major non-life markets:
Germany, Japan, France, and Canada. the US, the UK, Germany, Japan, France, and Canada, providing comparable
figures for combined ratios for the past ten years. These markets represented
73% of the global non-life market in 2004 and are home to most of the globally
operating insurers. It also shows recent data on combined ratios in different
lines of business in these countries, with the combined ratio being adjusted for
the time value of liabilities. This sigma also gives insights into how the recent
insurance cycle can be interpreted and explains the background to the ongoing
profitability discussion.
The new ratio cannot be the sole guide This information can also be used in the broader context of steering an insurance
for strategy; an understanding of company’s business and for strategy purposes. However, a cautionary remark is
capital requirements is also needed.
necessary. While the economic combined ratio does give important information
about underlying underwriting profitability, decisions on steering and strategy
go beyond just interpreting profit generation. They also involve determining the
company’s specific capital cost. The amount of capital needed depends on how
certain kinds of business fit into the company’s insurance portfolio, on the rein-
surance policy the insurer follows, and – of course – also on country-specific
solvency requirements and rating considerations. The cost per unit of capital de-
pends on factors like the riskiness of the business and taxation. Issues regarding
capital requirements and cost of capital are beyond the scope of this sigma, but
some are covered in an earlier sigma.¹
¹ Some of these issues are discussed in an earlier sigma. See Swiss Re, sigma No 3/2005, “Insurers’ cost
of capital and economic value creation: principles and practical implications”.

Introduction
Structure of this sigma The study is divided into five sections. First, standardized definitions for the
measurement of underwriting profitability are discussed and the concept of the
economic combined ratio is introduced as a tool for resolving some major short-
comings of the conventional combined ratio. The next three sections explain
the key adjustments made to the conventional combined ratio to obtain the
economic combined ratio. The first section shows how using the accident year,
instead of the business year, can improve the measurement of underwriting
profitability. The second section illustrates how large catastrophes can distort
the understanding of underwriting profitability. The third section demonstrates
how discounting future claims can further clarify underwriting profitability. In
the final section, underwriting profitability is analyzed for major lines of business
in the US, the UK, Germany, France and Canada.

The conventional versus the economic combined ratio
In this section, the concept of the economic combined ratio is introduced. It is

derived from the conventional combined ratio by adjusting for reserves, excess
catastrophe losses and the time value of money.
Definition of the conventional combined ratio
The conventional combined ratio The combined ratio is the most common measure of underwriting profitability. It
is the most common measurement is utilized for comparing insurance business in different countries. Financial ana-
of underwriting profitability.
lysts rely on it for comparing the profitability of the insurance business of different
companies and for comparing different lines of business. Companies use it for
steering their business. What makes the combined ratio so suitable for compari-
sons is that it is not an absolute figure like the underwriting result, but a relative
figure that measures the cost of insurance as a percentage of premium income.
It is the sum of the claims, expense In formal terms, the combined ratio is defined as the sum of the claims ratio and
and policyholder dividend ratios. the expense ratio. A variant of the combined ratio also includes the policyholder
dividend ratio. A combined ratio of less than 100 indicates a positive underwriting
result, while a combined ratio above 100 means a negative underwriting result.
Figure 1
Combined ratio in US statutory versus US Statutory accounting US GAAP
GAAP accounting
Claims ratio Claims ratio
(Claims incurred/NPE) (Claims incurred/NPE)
+ Expense ratio + Expense ratio
(Expenses/NPW) (Expenses/NPE)
= Combined ratio = Combined ratio
+ Policyholder dividend ratio
(Policyholders’ dividend/NPE)
= Combined ratio after PHD
This study uses the statutory combined This study uses the definitions for the statutory combined ratio, since compre-
ratio as a starting point. hensive market statistics for these six countries (including mutuals) are based on
statutory accounting. The US GAAP combined ratio differs in some respects from
that used in US statutory accounting. Under GAAP accounting rules, acquisition
costs are deferred to match the duration of the insurance contracts, therefore
the GAAP expense ratio is calculated over net premiums earned (NPE) in the US,
and also in Canada and many European countries. Additionally, the technical
part of GAAP profit and loss accounts frequently does not include overhead or
corporate center costs.
GAAP accounting differs substantially Very often, insurance statistics provide the underwriting margin (underwriting
from statutory accounting. result as a percentage of premiums earned) as a similar measure for underwrit-
ing profitability. However, under various insurance accounting regimes, the
underwriting margin also includes allocated investment income and changes in
equalization reserves, thus limiting comparability between markets. In order to
obtain a common yardstick, a standardized underwriting result was calculated
for this study.²
² For a more detailed discussion of the adjustments, see Appendix I.

The major part of the combined ratio Table 1 shows the breakdown of the combined ratio into its components. The
is the claims ratio. figures show that the largest part goes toward compensating insurance clients
for their losses: 61%–81% of premiums are spent on insurance claims, while
another 23%–39% are distribution and administration costs. Policyholders’ divi-
dends account for only a very small portion (about 1% or less).
Table 1
Components of the combined ratio, and
profitability breakdown of major non-life
markets
United States Canada UK Germany France Japan

In % of net premiums 1994–2004 1994–2004 1994–2004 1994–2004 1995–2004 1996–2004
Claims ratio 78.7% 73.3% 73.0% 71.3% 80.8% 61.2%
Expense ratio 26.4% 29.8% 31.2% 27.5% 23.3% 38.1%
Policyholder dividend ratio 1.1% n.m. n.m. 1.0% 1.1% 0.1%
Combined ratio 106.2% 103.1% 104.2% 99.9% 105.2% 99.4%
Standardized underwriting result¹ –6.9% –3.7% –4.7% –2.4% –6.1% 0.4%
Net investment result 16.2% 13.8% 16.8% 15.4% 13.4% 4.7%
Other expenses/earnings 0.0% 0.4% –0.5% –0.3% –0.3% –0.8%
Profit margins (pre tax) 9.2% 10.4% 12.8% 12.7% 7.0% 4.4%
¹ Includes other technical income and charges
Source: Swiss Re Economic Research & Consulting
Over the past decade, four of Four of the six countries under review reported average combined ratios of over
the six countries reported 100% and hence negative underwriting results during the last decade. While
average underwriting losses.
the combined ratios for the US, Canada, the UK, and France were between
104% and 106%, Germany and Japan achieved essentially a break-even under-
writing result. Investment results, including realized capital gains, added the
equivalent of between 13% and 17% of premium income to the overall results,
except for Japan with 4.4%, which had very low bond yields and a declining
stock market since the mid-1990s. Investment results offset underwriting
losses, which led to overall pre-tax profit margins being positive in all six coun-
tries. The pre-tax overall profit margin was in the 9–10% range in the US and
Canada, around 13% in the UK and Germany, and significantly lower in France
and Japan. Japan’s low profit margin is a result of the very low investment
income, while France’s low profit margin results from a combination of a rela-
tively high combined ratio and fairly low investment results.
The conventional combined ratio does A major conclusion to be drawn from the summary table is that the scaling of
not give clear guidance on underwriting the conventional combined ratio does not provide clear guidance for assessing
profitability...
underwriting profitability. Underwriting results – frequently negative – need to
be analyzed in conjunction with investment income. However, the interaction of
underwriting profitability and investment income is complex, since it changes
over time and differs across lines of business.

From the conventional to the economic combined ratio
…due to major drawbacks: undiscounted In order to address the question “How profitable is the insurance business writ-
future claims, reserve adjustments and ten in each year?”, the conventional combined ratio, which is geared towards
unexpected cat claims.
data from financial accounting, suffers from three major drawbacks:
 It does not take the time value of cash-flows into account. At the time business
is written, the economic value of future payments is always less than its nomi-
nal value, due to the discount effect. This is in particular of significance for the
claims ratio which relates nominal future claims payments to current premium
revenues. Hence, the interpretation of the conventional accounting claims ratio
depends on interest-rate levels and claims payment patterns, ie the duration of
claims reserves, which vary across lines of business.
 Accounting data do not necessarily reflect the profitability of the business writ-
ten at a certain point of time due to the impact of changes in reserves on the
“claims incurred”. Strengthening or releasing claims reserves for previous acci-
dent years is not related to the underwriting conditions of current business and
hence can substantially distort the data.
 The incidence of extraordinary catastrophe losses, which are by definition
rare and severe at the same time, can create changes in claims ratios which
do not reflect actual changes in pricing or loss trends of the vast majority of
the business. This can lead to serious misinterpretation of loss trends of the
underlying business.
The economic combined ratio adjusts The economic combined ratio as an alternative concept for calculating under-
for these drawbacks. writing profitability addresses these drawbacks:
 It takes into account the time value of cash-flows.
 It is based on underwriting-year or accident-year data and not on business-
year data.
 It attempts to eliminate distortions resulting from extraordinary loss events,
in particular large natural catastrophes.
Definition of the economic combined ratio

Economic combined ratio
= Economic claims ratio
(Net present value of claims incurred in the accident year, adjusted for random
catastrophe losses/Net present value of premiums earned)
+ Economic expense ratio
(Net present value of expenses/Net present value of premiums written)
+ Economic policyholder dividend ratio
(Net present value of policyholders’ dividend/Net present value of premium earned)
There are many advantages to the Here are some key advantages of the economic combined ratio compared to
economic combined ratio. the conventional combined ratio:
 This calibration aligns underwriting results to the accident year.
 An economic combined ratio below 100% indicates that underwriting creates
profit for the accident year.
 By discounting future claims payments, the calibration puts long-tail and
short-tail lines of business on an equal footing.
 All changes in the economic combined ratio are due to changes in market
conditions (prices, expenses, and claims trends) and not due to the event risk
of catastrophe claims.

To create value, the underwriting profit A necessary condition for value creation through writing insurance is that the
still needs to exceed the underwriting economic underwriting profit must exceed the underwriting cost of capital. These
cost of capital.
concepts are discussed in sigma No 3/2005, “Insurers’ cost of capital and eco-
nomic value creation: principles and practical implications”. The present sigma
sticks with the adjusted economic combined ratio and uses it to analyze the
markets.
The main differences between the two In the following course of the study, a simplification of the economic combined
ratios originate in the claims ratio, ratio is introduced. The concept of the economic combined ratio would also re-
defined here.
quire discounting premiums, expenses, and policyholder dividends. However,
the discount effect on these payments is very small, on average, since most of
premium revenues and payments for acquisition costs fall at the beginning of
the year in which the risks are covered. Therefore, only discounting of claims
payments is pursued further in this sigma.
Additionally, due to constraints on the availability of data, we rely on accident-

year data, not on underwriting-year data. As the difference is basically is only
relevant only for a small number of multi-year contracts, this deviation appears
justified.
All differences from the conventional combined ratio data relate to the claims
ratio. The economic loss ratio can be derived from the conventional accounting
data as follows:
Business-year claims ratio (Claims incurred in the business year/NPE)

+ Reserve adjustment
([– change in claims incurred of prior years + change in claims incurred of the
accident year] / NPE)³
= Accident-year claims ratio
(Claims incurred in the accident year/NPE)
+ Catastrophe adjustment⁴
([– actual catastrophe claims + average catastrophe claims] / NPE)
= Catastrophe-adjusted accident-year claims ratio
(Expected claims incurred in the accident year / NPE)
+ Discount eﬀect
([Nominal value of accident-year claims payments incurred – net present value of
accident-year claims payments] / NPE)
= Economic claims ratio
³ A reduction in prior years’ claims reserves due to claims payments does not affect the profitability as
long as the estimate of the total ultimate claims payment remains unchanged.
⁴ The catastrophe adjustment of actual losses serves as an approximation of the expected losses at the
time of underwriting. Most other deviations of actual losses from the expected losses diversify over an
industry-wide portfolio. One important exception is unexpected claims inflation, which is correlated
across large numbers of risks. Unexpected claims inflation causes adverse development, which will be
allocated to the loss ratios of the original accident years.

Reserve and cat adjustments can be posi- The reserve adjustment and the catastrophe adjustment can be positive or
tive or negative, but the discount effect is negative. Over time, the catastrophe adjustment is espected to add up to zero.
always negative.
The reserve adjustment does not follow any pattern for a given number of years
such as 1994 to 2004, but would add up to zero over a suffi-cient number of
years. The discount effect is always negative, since it discounts future claims
payments by a positive interest rate. Also, the higher the interest rate is, the lar-
ger the discount.
Table 2
Example US: From the published combined
ratio to the economic combined ratio
Average
in % of net premiums 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 1994–2004
Claims ratio 81.1% 78.9% 78.4% 72.8% 76.5% 78.8% 81.5% 88.5% 81.6% 74.9% 72.8% 78.7%
Expense ratio 26.1% 26.3% 26.3% 27.1% 27.6% 28.0% 27.5% 26.5% 25.3% 24.6% 24.8% 26.4%
Div PH ratio 1.3% 1.4% 1.1% 1.7% 1.9% 1.3% 1.2% 0.8% 0.6% 0.5% 0.4% 1.1%
Combined ratio,
as reported 108.5% 106.5% 105.8% 101.6% 106.0% 108.1% 110.1% 115.8% 107.5% 100.1% 98.1% 106.2%
Reserve adjustments –5.7% –6.9% –2.5% 1.9% 6.8% 7.7% 6.8% –3.2% –7.8% –6.4% –2.3% –1.1%
AY combined ratio 102.8% 99.6% 103.3% 103.6% 112.8% 115.8% 116.9% 112.7% 99.7% 93.7% 95.8% 105.2%
Catastrophe
adjustments –3.2% –0.1% 0.4% 2.3% –0.4% 0.3% 1.7% –2.1% 1.6% 0.0% –0.8% 0.0%
Ultimate AY combined
ratio, cat adjusted 99.7% 99.5% 103.7% 105.8% 112.4% 116.1% 118.6% 110.6% 101.3% 93.7% 95.1% 105.2%
Discount effect –8.2% –7.7% –7.5% –7.7% –7.2% –7.8% –8.8% –5.9% –4.0% –2.7% –4.1% –6.5%
Economic
combined ratio 91.5% 91.8% 96.3% 98.2% 105.2% 108.4% 109.8% 104.7% 97.3% 91.0% 91.0% 98.7%
Sources: A.M. Best, Swiss Re Economic Research & Consulting
Underwriting profitability: the US example
The economic combined ratio provides Table 2 above shows the adjustments made to arrive at the economic com-
new insights into the US industry. bined ratio for US P & C business between 1994 and 2004. It permits a number
of interesting observations:
 The adjustments for reserve changes and extraordinary catastrophe adjust-
ments, while considerably changing some figures, do not materially impact the
average combined ratio. Most of the difference stems from reserve additions
for asbestos and environmental (A & E) claims underwritten before 1984, add-
ing on average 1.7 points to the reported combined ratio. The core reserves
even appear slightly over-reserved, by 0.7 points, for the period 1994 to 2004.
 Allocation of the claims to their accident year altered the combined ratio by
up to 8 points, in either direction, while the effects of the normalization for
catastrophe claims were usually below 3 points.
 The accident-year adjustment reveals 1994, 1995, 2002 and 2003 to be
much better accident years than the conventional combined ratio suggested,
while 1998 to 2001 were much worse accident years.
 The discount effect, which corrects for the time value of claims, has de-
creased over the last three years due to declining interest rates. Between
1994 and 2000 it reduced the combined ratio by 7 to 9 points, but only by
4 points in 2004.

 The accident years 2003 and 2004 were highly profitable, but only slightly
better than those of the last hard-market cycle.
 The eleven-year average economic combined ratio was 98.7%, much better
than the conventional ratio, but implying that underwriting contributed only
little to the overall profitability of the US P & C insurance industry over the last
decade.
 The catastrophe adjustments are largest in the major catastrophe years 1994
(Northridge earthquake) and 2001 (September 11), with negative adjustments
of 3 and 2 points, respectively, and in the most benign catastrophe years of
1997, 2000, and 2002, with positive adjustments of about 2.
 The worst accident year was 2001, according to the conventional combined
ratio, but 2000 according to the economic combined ratio.
 The peak-to-2004 decline — 2001 to 2004 in the conventional combined
ratio — was 18 points, but for the accident year it was 24 points and 19 points
for the economic combined ratio (both 2000 to 2004).
 The highly unprofitable soft-market years were 1998 to 2001.
 While the conventional combined ratio identifies only one year of underwrit-
ing profitability (2004), the economic combined ratio reveals seven years of
underwriting profitability — all years except 1998 to 2001.⁵
⁵ These results are dependent on US reserves adequacy.

The accident year improves the measurement of underwriting profitability
The accident-year combined ratio is a This section discusses the differences between the reported business-year com-
better guide to underwriting profitability. bined ratio and the accident-year combined ratio. The business-year combined
ratio reflects the accounting view, providing investors with an assessment on
changes in an insurer’s net worth. The accident-year combined ratio is better
suited as a guide for management in measuring the underwriting profitability of
business covered in a certain year.⁶ To change to the accident-year perspective,
it is necessary to allocate reserves and their changes to individual accident
years.⁷ Together with the adjustment for catastrophe losses (see next section)
this variable is the input for calculating the time value of future losses which is
discussed in the subsequent section.
Why the accident-year view is important
The business-year combined ratio The conventional business-year combined ratio is geared towards data from
focuses on the current value of assets financial accounting, which measures changes in the net worth of a firm. It con-
and liabilities.
sists of the current – preliminary – estimate of the profitability of insurance
business covered in this year and of a profit component (positive or negative),
reflecting changes in the claims reserves for prior accident years which have not
yet been ultimately settled. These changes in reserves refer to new information
regarding claims from previous years. This view serves the interests of investors
in the company by providing the best estimate of the current values of all assets
and liabilities.
The accident-year data provide a different The goal of the accident-year view is to judge the technical profitability of the
view of the underwriting cycle. business covered in a certain year. Contrary to the business-year view, it allo-
cates all claims ex post to the year in which the risk was covered. It is a better
reflection of the movement of effective pricing and claims costs over the cycle.
However, because significant reserving errors can occur, the ultimate underwrit-
ing profitability is not known with any certainty until several years later. Only
the initial accident-year estimate is known at the time the accounts are closed.
The initial accident-year estimate is simply the business-year estimate minus
reserves changes attributable to prior years (see Figure 2).
The accident-year view is geared toward Management of insurance companies needs a different view than the conven-
steering underwriting. tional business-year combined ratio for steering its underwriting decisions. The
accident-year view provides the estimate of claims costs in the years in which
they had been triggered. This information is important for pricing and steering
new business and for compensation.
⁶ Preferable for these purposes would be the underwriting-year (also treaty-year) view, which allocates
premiums, expenses, and claims to the year in which the business was actually written. However, this in-
formation is not available for market statistics. The accident-year view is a good second-best solution,
since the time lag between underwriting and coverage is usually short and stable.
⁷ Unfortunately this information is only available for the US.

Figure 2 120%
US P & C, 2001: Business-year vs
accident-year combined ratio
115%
110%
105%
100%
Business Adverse Accident year, Adverse Accident year,
year development initial development, ultimate
prior years estimate accident year estimate*
A&E claims Other adverse development *As of end of 2004

Source: Swiss Re Economic&Consulting
The reserve adjustments are mostly While property claims are usually settled within one or maybe two years, the
to liability lines. situation for liability claims is fundamentally different. The final amount of a liab-
ility claim is often not known until several years after the claim has occurred.
In US medical malpractice, for instance, claims paid at the end of the accident
year make up only 4–6% of premiums earned. The difficulties in predicting
future payments get compounded by the fact that a significant portion of claims
has even not been reported by the time the annual statements are filed and
therefore needs to be estimated by actuaries as so-called IBNR (incurred but
not reported) reserves.
Underwriting profitability of a particular Figure 3 illustrates the different view for US P & C insurers between 1994 and
year is not known with certainty until 2004. The trough for the combined ratio of the previous cycle was not in 1997
years later.
as the business-year view suggests; it was, in fact, two years earlier. Underwrit-
ing conditions actually deteriorated between 1994 and 1997. Also, the busi-
ness-year view failed to indicate the correct peak, which was in 2000, accord-
ing to the accident-year view, not 2001.
Ultimate claims or combined ratios can change over time as new information
becomes available. Comparing the initial accident-year combined ratio with the
“ultimate” accident-year combined ratio as of end of 2004 clearly reveals that
the “soft-market years” 1998–2001 turned out to be considerably worse than
initially estimated and reserved.
The accident years of 2002 and later still contain some uncertainty about the
ultimate underwriting profitability. Confidence in these estimates will increase
as claims mature. The positive reserve development supports the experience
that reserving tends to be more prudent and conservative during hard-market
phases. Thus, adverse development out of the accident years 2002 to 2004 is
unlikely.

Figure 3 120% Combined ratios
US P & C business-year versus
accident-year view
115%
110%
105%
100%
95%
90%
94 95 96 97 98 99 00 01 02 03 04
As reported Accident-year, Accident-year,
initial estimate ultimate estimate
Source: A.M.Best Swiss Re Economic Research&Consulting
The table progresses from the combined The following table shows the various steps from the reported to accident-year
ratio to the accident-year combined ratio. combined ratio. The first step substracts adverse or favorable impacts from
reserves changes concerning prior years, creating the initial accident-year com-
bined ratio. It includes the initial estimate of the ultimate claims costs of the
accident year. The second step adds the adverse developments and subtracts
reserve releases for new business – but allocated to the proper accident years.
Table 3
Reserve adjustments for the US
P & C industry: from business-year
to accident-year combined ratio
In % of net premiums 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Average 2004
1994–2004
Combined ratio, as reported 108.5% 106.5% 105.8% 101.6% 106.0% 108.1% 110.1% 115.8% 107.5% 100.1% 98.1% 106.2%
Reserve adjustments,
prior years1 0.6% 1.3% 2.2% 3.4% 4.5% 3.3% 1.4% –3.8% –4.3% –1.8% –1.2% 0.5%
A & E claims –1.9% –4.1% –2.1% –0.7% –1.0% –1.0% –0.7% –1.4% –2.4% –1.8% –1.1% –1.7%
Initial AY combined ratio 107.2% 103.7% 105.9% 104.3% 109.5% 110.4% 110.8% 110.6% 100.8% 96.5% 95.8% 105.0%
Reserve adjustments,
accident year –4.4% –4.1% –2.6% –0.7% 3.3% 5.4% 6.1% 2.1% –1.1% –2.8% 0.0% 0.1%
AY combined ratio 102.8% 99.6% 103.3% 103.6% 112.8% 115.8% 116.9% 112.7% 99.7% 93.7% 95.8% 105.2%
¹ Excluding A & E claims
A & E reserve changes have been In the table above, the claims incurred changes for asbestos and environmental
negative for the past 20 years. (A & E) claims are shown separately, since they are caused by the tort system’s
creation of retroactive liability, and not by cyclical factors. Charges for asbestos
and environmental claims have lowered underwriting profitability throughout
the past 20 years. These claims relate to US business written prior to 1984.
The adverse impact from A & E claims on the reported combined ratios ranged
between 0.7% and 4.1%, and averaged 1.7% from 1994 to 2004.

Core reserve changes are both positive Changes for all other prior-years’ reserves – the so-called core reserves – are
and negative. caused by cyclical reserving errors, with adverse and positive developments. On
average, the US P & C industry posted positive developments of core reserves of
0.6% of NPE between 1994 and 2004.
The initial reserve adjustments must be Having taken out the business-year reserves adjustments, they need to be allo-
allocated to the appropriate accident year. cated to the appropriate accident years. The changes from the initial to the ulti-
mate reserves are based on the actual development through 2004 and on ex-
pected values for the total development. The development of more recent acci-
dent years is based more on modeling, while the development of older accident
years is based more on actual observations. The accident-year 2004 combined
ratio is entirely based on the initial reserving and is assumed to be adequately
reserved.
Figure 4 8% Reserve additions (+) and releases (–) in % NPE

Development of US P & C insurance,
business-year versus accident-year 6%
view
4%
2%
0%
–2%
–4%
–6%
94 95 96 97 98 99 00 01 02 03 04
Business-year view Accident-year view
Source: A.M.Best, Swiss Re Economic Research&Consulting
Insurers tend to under-reserve in soft Insurers frequently fail to set aside sufficient reserves during soft market years,
markets and over-reserve in hard markets. when terms and conditions are more generous and exposure is greater, and
conversely set reserve levels too high during hard market years, when tight
terms and conditions limit their exposure. Besides the cyclical element, there
are also unexpected developments which can lead to periods of under- or over-
reserving, such as unanticipated inflation or disinflation and changes in the
legal system. Uncertainty about liability risks, together with changing terms and
conditions, make it difficult to estimate future claims based on past experience.
Hence, insurers under-reserved from 1998 to 2001, which needed to be cor-
rected with reserves additions in the business years 2002 to 2004.
Releases of core reserves made Releases of core reserves in the calendar years 1994–2000 made underwriting
1994–2000 look better and results in these years look substantially more favorable than they actually were.
2001–2004 look worse.
Conversely, additions to reserves for prior years have made results look worse
since 2001.

Figure 5 10% Reserve additions (+) and releases (–) in % NPE
Non-life insurance reserve development
as a percentage of NPE
5%
0%
–5%
–10%
–15%
94 95 96 97 98 99 00 01 02 03 04
USA Germany UK
Source: A.M.Best, Swiss Re Economic Research&Consulting
Reserve developments were cyclical in Cyclical reserving patterns also exist in other markets. Figure 5 shows that non-
the US, the UK, and Germany. life insurance reserve changes in the US, the UK and Germany followed a similar
cyclical pattern.⁸ All three countries posted reserve releases in the late 1990s
(because the emerging claims experience from earlier years was better than ex-
pected). While in the UK and the US, insurers had to boost reserves for prior acci-
dent years in the early 2000s, the German insurers were still enjoying positive
reserve developments. A look at the average change in reserves from 1994–2004
reveals that US insurers had slightly underestimated their liability losses (–1% of
NPE pa), while UK insurers overestimated them by on average about 1% of NPE
annually. The US figure consists of an average of minus 1.7% of NPE in adverse
development for old asbestos claims and positive 0.5% of NPE for core reserves
released, which is close to the UK figure and indicates that claims estimates were
slightly positively biased. German insurers, by contrast, released an average
9.2% of NPE annually, indicating a conservative reserve policy that resulted in
systematic over-reserving. The German deviation from the average follows the
same cyclical pattern as US and UK insurers’ reserving.
The accident-year ratio clarifies many From the above, it can be concluded:
underwriting cycle issues.  Changes to reserves smooth the amplitude of the underwriting cycle in the
published claims ratio. The amplitude of the cycle widens significantly when
the ultimate development of the claims of each accident year is taken into
account. Hence, it is important to adjust for changes in reserves when inter-
preting short- to medium-term changes in claims ratios.
 Reserves adjustments are less important for analyzing longer-term averages,
since the cyclical reserving pattern tends to be neutral over time.
 Reserve adjustments for US asbestos & environmental (A & E) claims are differ-
ent in this respect, since they are not caused by trend-reverting cyclical fac-
tors but by the tort system’s creation of retroactive liability. The distorting
effect of spiraling A&E reserves on attempts to measure underwriting profit-
ability remains negative and relevant for long-term averages as well.
 Adjustments for changes in reserves tend to be positive for several years, then
negative (they are “auto-correlated”) due to the cyclical nature of reserving
and, hence, are fairly predictable.
⁸ The data reflect the accounting view of claims and claims adjustment expense reserve changes per busi-
ness year.

Large catastrophic losses distort underwriting profitability
Major catastrophes impact on the A second effect which can cause industry claims to deviate from their expected
claims ratio. value is extraordinary catastrophe losses. Low-frequency/high-severity losses
such as major hurricanes, earthquakes, or terrorist attacks are too costly and too
infrequent to be fully diversified in the portfolio of a country within any business
year. For the combined ratio to be used as an indicator of the underlying profit-
ability, extraordinary catastrophe losses need to be factored out, since they need
to be spread over many years. Here are some examples of distorting catastrophe
losses:
 The Canadian ice storm of January 1998 generated losses equaling 6.7% of
total net premiums earned.
 The two winter storms Lothar and Martin devastated some regions of France
and neighboring countries in late December 1999, increasing the 1999 gross
claims ratio of the French non-life industry by more than 10 percentage points
and making it necessary to strengthen reserves in 2000.
 The terrorist attack of September 11, 2001 caused, according to the Insurance
Information Institute, an insured loss of USD 32.5 billion, leading to an
increase of 8–10 percentage points in the US claims ratio after deduction of
the losses borne by foreign insurers and reinsurers.
 The floods of 2002 added an estimated five points to the German claims ratio.
 In 2004, hurricanes Charley, Frances, Jeanne and Ivan accounted for USD 27
billion of insurance claims in the US and the Caribbean. The net impact on the
US property and casualty (P&C) industry’s 2004 earnings is estimated at
USD 12–14 billion, adding about three points to the 2004 net combined ratio.
 In 2004, Japan was hit by ten typhoons, nine of them classified as super-ty-
phoons due to their wind speed. Insured losses amounted to 10.2% of DPW.
 In 2005, the US and Caribbean were hit again by a series of devastating hur-
ricanes. The four hurricanes Dennis, Katrina, Rita, and Wilma caused a record
of USD 66 billion in total insured losses (cf Swiss Re, sigma No 2/2006, p. 15,
for events). According to Property Claims Services (PCS), US P&C insurers
reported claims of USD 38 billion from Katrina alone, equalling 7.6% of DPW.
Because catastrophe losses affect Catastrophes affect many business lines, so it is not easy to exclude “extraordi-
many lines of business, the average nary” catastrophes. Natural catastrophes mainly affect property lines, but man-
must be measured carefully.
made catastrophes – such as September 11, 2001 – contain substantial liabil-
ity claims. Unfortunately, there are few reliable data that single out natural
catastrophe insurance losses. Market data are available for the US (PCS) and
Canada (IBC), based on claims reported by insurers. The source for the Japa-
nese catastrophe losses in Figure 6 is Swiss Re’s catastrophe database.

Figure 6 14% % of P&C direct premium written
Property catastrophe losses as a
percentage of premiums
12%
10%
8%
6%
4%
2%
0%
84 89 94 99 04
USA Canada Japan
Note: 2003 and 2004 values for Canada are preliminary
Sources: A.M.Best, Insurance Bureau of Canada, ISO, Swiss Re Economic Research&Consulting
Normalizing catastrophe losses entails As catastrophe losses create fluctuations in the claims ratio that are random and
knowledge of the last 20 years of catas- do not reflect any underlying change in market conditions, it is useful to normal-
trophe losses.
ize the combined ratio for catastrophe losses.
Normalizing for catastrophe losses implies replacing actual losses with expected
losses or cat exposure. However, the effective exposure of the insurance indus-
try to natural and man-made catastrophes is hard to determine. Historic data is
of limited value, since there has been a significant increase in global catastro-
phe losses since the late 1980s.⁹ However, choosing an appropriate value for
the normalized catastrophe losses depends on accurate trend assumptions re-
garding growth of insured assets in storm- and earthquake-exposed areas and
changes in global climate or weather patterns. Even sophisticated state-of-the-
art catastrophe loss models do not always reflect the actual exposure to such
events, as illustrated by the post-Katrina experience.
Given the uncertainty in estimating the actual exposure, one needs to pursue
second-best solutions. A pragmatic approach for normalizing catastrophe loss-
es is to substitute the actual catastrophe losses by the average catastrophe loss
burden.¹⁰ For ex-post assessments of the underwriting conditions of the industry
as a whole, this approach appears sufficient, while it would be insufficient as a
guide for pricing and underwriting decisions. The effective cat loss burden of the
industry also has an impact on balance-sheets, earnings, and cash-flows affect-
ing supply and demand in the marketplace.
⁹ See for example Swiss Re, “Opportunities and risks of climate change”, 2002.
¹⁰ Since net figures are used in this study, the underwriting results are already smoothed by reinsurance.
Equalization reserves serve as an additional instrument of catastophe smoothing in the accounting
regimes of some countries. They can therefore be considered a substitute for reinsurance. However,
because heterogeneous rules and definitions compromise the comparability of profitability measures,
the underwriting result has been standardized in this sigma by excluding equalization reserves.

Large catastrophic losses distort underwriting profitability
Figure 7 120%
Catastrophe adjustment of the US P & C
accident-year combined ratio 115%
110%
105%
100%
95%
90%
94 95 96 97 98 99 00 01 02 03 04
Accident-year combined ratio Accident-year combined ratio, catastrophe adjusted

Costly catastrophe loss years provide Figure 7 illustrates the effects of normalizing the US P & C accident-year com-
significant negative adjustments to bined ratio for catastrophe losses. Actual cat losses as a percent of NPE are sub-
the combined ratio.
tracted and the 10-year average is added back. The effect is a reduction of the
combined ratio in the catastrophe years 1994 (Northridge Earthquake), 2001
(WTC terrorist attack), and 2004 (four hurricane landfalls). The combined ratio
is raised in the below-average years of 1997, 2000, and 2002. The effect is a
clearer definition of the underwriting cycle, the average measurement of profit-
ability for the period remains unchanged.
Normalizing for catastrophe losses To summarize the effects of normalizing catastrophe losses:
provides a better understanding of  Costly catastrophe losses from hurricanes, earthquakes, or major terrorist
short-term underwriting profitability.
attacks can cause significant negative impacts to the combined ratio.
 Adjustments for catastrophe losses are particularly important for interpreting
short-term changes, for example in quarterly claims ratios.
 The main lines of business affected are property lines such as homeowners,
auto physical damage, and commercial property insurance. Man-made catas-
trophes can also affect liability lines.
 Unusual catastrophe losses are random and cannot be predicted.
 Catastrophe adjustments are less important for analyzing longer-term aver-
ages, since the stochastic variations balance each other out over time.

Recognition of the time value of money – discounting future claims
The third adjustment takes into account After discussing the reserve and catastrophe adjustments, resulting in the catas-
the time value of money by discounting trophe-adjusted accident-year combined ratio, this section addresses the third
adjustment: the effect of discounting future claims payments. It corrects for the
fact that standard accounting data generally do not recognize the time value of
expected future claims payments,¹¹ by discounting future claims payments to
the accident year.¹² The impact of this discount effect can differ substantially,
depending on the time lag between premium and claims payments and on the
discount rate applied.
The economic value of future The advantage of this method is that it makes it easier to compare combined
claims payments is less than stated ratios between short-tail and long-tail lines of business, facilitating comparisons
in financial reporting.
among companies which might have a different business mix, such as a higher
or lower proportion of liability lines. It also helps to compare over time and be-
tween countries that have different levels of interest rates. The economic com-
bined ratio is always lower than the conventionally calculated accident-year
combined ratio, since it is obtained by discounting future claims. This can be
seen in Figure 8, which compares the economic combined ratio and the con-
ventional combined ratio for the US P & C business. The interest rates used for
discounting are the risk-free rates for bonds with two-year maturity in the corre-
sponding accident years. The reason for choosing the two-year bond was that
US claims are paid on average 2.3 years after the corresponding premiums
have been collected.
Figure 8 120%
The economic combined ratio for
US P & C insurers 115%
110%
105%
100%
95%
90%
85%
94 95 96 97 98 99 00 01 02 03 04
Accident-year combined ratio, catastrophe adjusted Economic combined ratio
Interest rates have fallen, reducing Figure 8 also shows that the discount effect was considerably greater in 1994
the discount effect. than in 2003. This is attributable to a decline in the discount rate. The nominal
combined ratio of 99.7% in 1994 yielded almost the same underwriting profit-
ability as the 94.9% combined ratio of 2004.
¹¹ Exceptions, for example, are property & casualty lines in Canada and workers’ compensation in the US.
¹² Underwriting expenses are assumed to fall entirely in the accident year and hence are not discounted.

The discount effect needs to be There are only a few countries where – for example in the US – detailed claims
approximated for most markets. pattern data are available for calculating the duration of the business. For most
countries a simplified approach is needed. The approximation used here for
the duration is the relation of adjusted technical reserves¹³ to claims incurred.
According to this approximation, all the major markets have an average maturity
of claims of two to 2½ years. The yield on two-year government bonds is there-
fore used in discounting.
Accident year data is not available in Another obstacle to cross-country comparison is the limited availability of acci-
all countries. dent-year data. Table 4 and Figures 9 and 10 therefore show discounted busi-
ness-year combined ratios instead of economic combined ratios. This approxi-
mation of the economic combined ratio is still distorted by changes in reserves.
However, this effect is less material for longer-term averages such as in Table 4,
since cyclical effects even out over time.
The discount effects vary across the Table 4 compares the conventional and economic combined ratios (proxied by
six countries. discounted business-year combined ratios) in the six countries and shows the
size of the discount effects. The discount effects vary between countries, with
Japan being a major outlier. The reason here is the low interest rates in Japan in
this period. The average discounted combined ratios of all analyzed markets are
below 100, indicating a positive profit contribution through underwriting. Inter-
estingly, the discount effect also changes the ranking of the markets in terms of
underwriting profitability. The results indicate that comparisons of countries’
combined ratios can be misleading unless proper account is taken of the time
value of claims.
Table 4
Comparison of discounted combined
ratios for the major non-life markets
United States Canada UK Germany France Japan

1994–2004 1994–2004 1994–2004 1994–2004 1995–2004 1996–2003
Combined ratio 106.2% 103.1% 104.2% 99.9% 105.2% 99.4%
Discount effect 8.2% 8.7% 9.0% 6.4% 7.9% 0.4%
Discounted combined ratio 98.0% 94.3% 95.2% 93.5% 97.3% 99.0%
Note: For comparability US business-year combined ratios were used, and not the catastrophe-adjusted accident-year combined ratio as in other tables.
Source: Swiss Re, Economic Research & Consulting
A declining discount effect increases the A glance at the development of the discount effects over time reveals another
need for lower conventional combined important development (see Figure 9). Between 1994 and 2003 the discount
ratios.
effect in percent of NPE dropped by between 4.1 points (Germany) and 8.5
points (US) in the major markets, except Japan. This development is due to the
decline in interest rates in Northern America and Europe and means that it is
becoming increasingly important to focus on underwriting results.
¹³ Reported premium reserves at the end of the financial year understate the average cash-flow due to pre-
paid premiums, because the majority of contracts are written at the beginning of the financial year, result-
ing in no unearned premium reserves. Instead, 50% of premiums minus costs is used as a sensible proxy.
This follows from the assumption that all contracts are annual, premiums are paid upfront, costs are im-
mediately deducted and claims occur on average in the middle of the contract period.

Figure 9 12%
Discount effect of major non-life markets
as a percentage of NPE
10%
8%
6%
4%
2%
0%
94 95 96 97 98 99 00 01 02 03 04
US Canada UK Germany France Japan
Source: Swiss Re Economic Research&Consulting
Economic combined ratios were less The implications of the discounted combined ratio are shown in Figure 10.
attractive in 2003 than ten years ago. The 2003 and 2004 economic combined ratios are comparable to the years
1994–1997. Prior to discounting, the conventional combined ratio for 2003
looked better than 1994–1997.
Figure 10 110%
Discounted combined ratios of major
non-life markets 105%
100%
95%
90%
85%
80%
94 95 96 97 98 99 00 01 02 03 04
US Canada UK Germany France Japan
Source: Swiss Re Economic Research&Consulting
Underwriting results deteriorated in In the 1990s – particularly the second half – combined ratios rose and under-
all major markets in the 1990s. writing margins deteriorated in all countries of the sample, due to global soft
market conditions and the effects of deregulation in Europe. By the end of
2000, profits in the non-life insurance industry were significantly depressed.
The situation at that time was characterized by:¹⁴
 An overall price gap of 9 to 14 percentage points against break-even,
depending on the market.
 Commercial lines and reinsurance rates were deficient by some 30–50%.
 Price gaps were even wider in some small market segments such as aviation.¹⁵
¹⁴ See Swiss Re, sigma No 5/2001, “Profitability of the non-life insurance industry: it’s back-to-basics time”.
¹⁵ See Swiss Re, sigma No 4/2002, “The global non-life insurance markets in a time of capacity shortage”.

Underwriting results improved in all Markets began to react as equity markets slumped sharply in 2000. The indus-
markets after 2001. try’s capital base contracted after 2000 as a consequence of worsening under-
writing and investment portfolio losses.
 Commercial lines and reinsurance premium rates began to improve in late
2000, with rates rising and terms and conditions tightening.
 After September 11, the hardening of the market accelerated.
 The recoveries in underwriting profitability were substantial by 2003 and
improved further in most countries in 2004.
Discounting future claims provides a more To sum up the effects of discounting the combined ratio:
accurate view of underwriting profitability.  In order to assess the economic profitability of past underwriting decisions, it
is necessary to recognize the investment income opportunity that is related to
the underwriting activity. This can be done by discounting claims payments
to the time when the business was written, since the interest rate used to dis-
count also represents the prevailing investment opportunity.
 The magnitude of this discount effect differs between the major markets, due
to disparities in the average time lag of claims payments and interest rates.
 Typical claims payment patterns are structural parameters of countries or
lines of business prognosticated by actuaries in their pricing models. The dis-
count effect is fairly predictable, given the interest rate levels at the time of
underwriting.
 Between 1994 and 2003, there was a common downward trend in the dis-
count effect, due to the secular fall in interest rates. The drop in the discount
effect as a percentage of NPE ranged from 4.4 points in Germany to 8.5
points in the US. The US discount effect rebounded slightly in 2004, due to
a rise in medium-term interest rates.
 The declining discount rate necessitates a combined ratio that is lower by the
same magnitude in order to keep profitability unchanged.
 It is important to make allowance for the discount effect when comparing
combined ratios over time. For the economic combined ratio, 2003 is com-
parable to 1994–1997, but for the conventional combined ratio, 2003 is
much lower than in 1994–1997.
 Discounting recalibrates the combined ratio, so that 100% truly indicates the
watershed between profit and loss. This property remains the same over time
as interest rates change, between long-and short-tail lines of business, and
between different countries or companies.

Current underwriting profitability:
Economic combined ratio by line of business
There is a wide range in claims duration Adjusting the combined ratios for the time value of claims – by discounting the
across the lines of business. claims – normalizes reported underwriting results for the claims-paying tail. This
is very important in comparing different lines of business. The average time lag
between when premiums are collected and claims are paid, known as the “tail”,
differs widely between lines of business. In extreme cases, commercial liability
awards may be paid out decades after the policy was written and the premium
income collected.
This section analyzes the current underwriting profitability of five large non-life
insurance markets¹⁶ on a per-line basis. Table 5 shows the 2004 claims and com-
bined ratios on an accident-year basis for the US and UK, adjusted for prior-years’
reserve changes, but not for catastrophe losses.
Table 5
US and UK economic combined ratios
by line of business
Accident-year Accident-year Average Discount Discount Economic

combined ratio claims ratio duration rate effect % NPE combined ratio
US, accident-year 2004, net
Fire and allied 72.1% 49.1% 1.0 1.9% 0.9% 71.2%
Homeowners 99.6% 70.8% 1.0 1.9% 1.3% 98.3%
Personal auto 95.6% 71.8% 1.7 2.2% 2.7% 93.0%
Commercial multi-peril 97.5% 64.1% 2.3 2.5% 3.8% 93.7%
Commercial auto 95.6% 67.4% 2.4 2.5% 4.2% 91.4%
Workers’ comp 97.7% 74.8% 3.4 2.8% 7.4% 90.3%
General liability 97.1% 70.2% 3.6 3.0% 7.9% 89.3%
Medical malpractice 104.6% 88.7% 4.2 3.2% 12.6% 92.0%
Total 95.8% 70.5% 2.3 2.5% 4.1% 91.7%
Note: Not adjusted for catastrophe losses, contrary to table 1
Sources: Swiss Re Economic Research & Consulting estimates for accident-year combined and claims ratios, US Treasury Department – Bureau of the Public Debt
for interest rates, Onesource (Highline Data) Schedule P data and Swiss Re estimates for claims payment patterns
United Kingdom, accident year 2004, net

Accident and health 98.5% 69.2% 0.9 4.4% 2.6% 95.9%
Motor 103.1% 81.9% 1.9 4.6% 7.1% 96.0%
Property 94.7% 59.2% 1.4 4.5% 3.6% 91.1%
Liability 91.7% 68.1% 5.1 4.8% 18.4% 73.3%
Pecuniary loss 91.5% 41.8% 1.3 4.5% 2.5% 89.0%
Reinsurance, marine, aviation, transport 108.6% 75.5% 1.3 4.5% 4.4% 104.2%
Total 98.5% 68.6% 1.8 3.8% 4.9% 93.7%
Note on the calculation of the various items:
Average duration: US: Swiss Re Economic Research & Consulting estimates of claims payments patterns; UK: ten-year average of adjusted technical reserves/
claims incurred; see also footnote 8.
Discount rate: risk-free government bond yield of matching maturity, 2004 average.
Discount effect: ([1+ discount rate] duration –1) × claims ratio
Economic or discounted combined ratio: combined ratio minus discount effect
Sources: S & P, Synthesys Non-life 2004, excl. funded 3year business; Bloomberg for interest rates
¹⁶ Excluding Japan due to non-availability of data.

Current underwriting profitability: Economic combined ratio by line of business
The discount effect takes into account the The third and the fourth columns show the average duration of claims payments
claims ratio, discount rate and duration of and the pertinent discount rate. The yields on government bonds of matching
the line of business.
maturity were used as discount rates. The discount effect as a percentage of
NPE is calculated from the claims ratio, the maturity and the discount rate. Sub-
tracting the discount effect from the accident-year combined ratios returns the
economic combined ratios for each line of business.
For Germany, France and Canada, Similar calculations were performed for Germany, France, and Canada. Tails for
the business year must be used. each line of business are estimated based on adjusted technical reserves data.¹⁷
Unlike the US and UK examples, however, combined ratios are based on busi-
ness-year views, since information on accident-year claims was not available
by line of business. Discounted claims ratios were calculated for Canada, since
expense ratios were not available by line of business. These differences do not
affect the calculations of the discount effect.
Table 6
Discounted combined ratios by line
of business (business-year view)
for Germany, France, and Canada
Combined Claims Average Discount Discount Discounted

Country/Line of business ratio ratio duration rate effect combined ratio
Germany, direct gross business, 2004
Accident 88.2% 34.4% 6.5 3.6% 8.0% 80.2%
Liability 95.6% 64.2% 4.0 3.1% 7.9% 87.8%
Motor 94.6% 77.6% 2.1 2.5% 4.2% 90.4%
Property 87.1% 53.8% 1.3 2.3% 1.5% 85.6%
Personal 96.2% 61.6% 1.0 2.2% 1.4% 94.8%
Commercial 78.3% 46.1% 1.5 2.3% 1.6% 76.7%
Marine and Aviation 90.0% 63.6% 1.9 2.4% 2.9% 87.0%
Credit 68.7% 33.2% 2.5 2.6% 2.2% 66.5%
Other 95.8% 65.1% 1.9 2.4% 3.0% 92.7%
Total 91.9% 63.5% 2.3 2.6% 3.9% 88.1%
France, direct gross business, 2004

Accident and health 98.1% 72.8% 1.4 2.3% 2.4% 95.7%
Property 87.7% 62.4% 1.4 2.3% 1.9% 85.8%
Motor 99.8% 80.0% 2.0 2.5% 4.0% 95.9%
Marine and Aviation 76.1% 51.4% 3.0 2.8% 4.5% 71.6%
General liability 100.4% 79.9% 5.6 3.4% 16.8% 83.7%
Credit 65.2% 36.7% 2.2 2.6% 2.2% 63.1%
Construction liability 136.9% 120.3% 7.1 3.7% 35.3% 101.7%
Other 94.3% 55.1% 1.4 2.3% 1.8% 92.5%
Total 96.0% 72.7% 2.4 2.6% 4.6% 91.4%
Canada, net business, 2004 *

Auto 68.5% 2.0 3.3% 4.6% 63.9%
Liability 77.1% 3.9 4.0% 12.4% 64.7%
Commercial property 42.3% 1.3 3.1% 1.8% 40.6%
Personal property 61.2% 1.0 3.0% 1.8% 59.4%
Marine 38.7% 1.7 3.2% 2.2% 36.6%
Other 34.1% 1.5 3.1% 1.6% 32.5%
Total 89.7% 62.6% 2.0 3.3% 4.1% 89.7%
* discounted claims ratios for the lines of business
Source: Swiss Re Economic Research & Consulting
¹⁷ See footnote 13 on page 22.

All lines of business were profitable The tables reveal positive profit contributions and often profitable underwriting
after discounting future claims. conditions across all analyzed markets and all lines of business: the economic
and the discounted combined ratios are all below 100%. Across the board, busi-
ness was very profitable in Germany and in Canada in 2004. After adjustments,
the US and UK have a comparable profitability, due to the higher interest rates in
the UK. Results for France look similar, though these are for business-year. The
results are even better than indicated by the discounted combined ratio for Ger-
many and Canada, since adverse reserve developments and extraordinary catas-
trophe losses, which are not excluded in the discounted results shown, had a
negative effect on results in 2004.
Even liability lines were profitable, despite Long-tail lines are also below the 100% threshold for the discounted combined
high conventional combined ratios. ratio. Even the construction liability line in France, with a combined ratio of
137%, has a discounted combined ratio of 102%, due to its long – 7.1 years –
duration. Though current interest rates are low, the discount effect of long-tail
lines has a significant impact on underwriting profitability.
The power of discounting
Table 7 Claims ratios Discount rates

Discount effect: duration of four years, 3% 4% 5% 6%
various discount rates and claims ratios 60% 7.5% 10.2% 12.9% 15.7%
65% 8.2% 11.0% 14.0% 17.1%
70% 8.8% 11.9% 15.1% 18.4%
75% 9.4% 12.7% 16.2% 19.7%
80% 10.0% 13.6% 17.2% 21.0%
Table 7 demonstrates the power of the discount effect for various discount rates
and claims ratios, using a duration of four years, which is close to the average for
liability lines in many countries. For example, with a 3% discount rate and a claims
ratio of 70%, the discount effect is 8.8% for a business line with a four-year tail.
The total discount effect ranges between The total discount effect for each country is proportional to the average duration
3.7% and 4.9% of NPE. and ranges from 3.7% in the US and 3.9% of NPE in Germany to 4.9% of NPE in
the UK. Differences in discount rates are small in the current low-yield environ-
ment and following the convergence of interest rates in Europe. Average tails of
the overall business are quite similar and range between 1.8 in the UK and 2.3
in the US, Germany, and France, despite significant differences in local liability
regimes.¹⁸
¹⁸ See Swiss Re, sigma No 6/2004, “The economics of liability losses – insuring a moving target”.

Current underwriting profitability: Economic combined ratio by line of business
Tails in different lines of business range There are more significant differences between individual lines of business
between 0.9 and 7.1 years. across countries. In general, liability lines have the longest duration. The French
construction defect liability line (décennale) has the longest tail in the sample,
at 7.1 years. UK and French general liability followed at 5.2 and 5.6 years, US
medical malpractice at 4.2 years, while US general liability has the shortest
average tail of all liability lines at 3.6 years. The accident and health line in
Germany is also characterized by a long duration, 6.5 years. The average tails of
motor lines of insurance range from 1.7 in the US to 2.1 years in Germany. The
property lines show the shortest average tails, lying in a close range between
1.0 (US homeowners and Canadian personal property) and 1.4 years (UK).
The discount effect for various lines of The differences in the discount effect are very pronounced, since longer dura-
business ranges from 1% to 35% of NPE. tions are often matched with higher interest rates or higher claims ratios. The
French construction defect liability line has the highest discount effect at 35%
of NPE, followed by UK general liability at 18%, French general liability at 17%,
Canadian general liability at 12%, US medical malpractice at 11%, German
accident insurance at 8%, and US general liability at 7%. The lowest discount
effects are found in the property lines: 1%–3% of NPE.
Companies and countries differ in terms It is important to allow for these differences in the discount effect when compar-
of business mix. ing combined ratios in different lines of business or of companies and countries
with different business mixes. Specialized property (re)insurers usually exhibit
lower combined ratios than casualty (re)insurers, but also benefit less from a
discount effect. Cross-country comparisons also need to incorporate the busi-
ness mix, for example when emerging markets are compared with mature mar-
kets. Most emerging markets’ business has a shorter tail due to a lower fraction
of liability business. Hence, lower combined ratios are needed to achieve the
same profit margins as mature insurance markets with a higher proportion of
long-tail business.
In summary, the discounted business-line To sum up the application of the economic combined ratio to the different lines
view provides many useful insights. of business:
 It is important to make allowance for the discount effect when comparing the
combined ratios of different lines of business or of companies with different
business mixes. Specialized property insurers benefit less from the discount
effect and will need to post lower combined ratios.
 Differences in business mix are also relevant to profitability comparisons
between emerging markets, which write more property business, and mature
markets, which write more long-tail business.
 Differences in discount rates are small in the current low-yield environment
and following the convergence of interest rates in Europe.
 There are more significant differences between individual lines of business
across countries. Durations in different lines of business range between 0.9
and 7.1 years.
 The differences in the discount effect between various business lines are very
pronounced in 2003 and 2004, since longer durations are paired with higher
interest rates. The discount effects of various main lines of business in the US,
the UK, Germany, France and Canada range between 1% and 35% of NPE.
France has the widest variation in discount effects – 2% to 35% – because of
its broad range of durations.

Appendix I: Standardization of underwriting and pre-tax results
Since there is no common international standard for how to measure underwrit-

ing profitability, comparing underwriting results between markets first needs
a common definition. For the purpose of this study, the underwriting result is
defined narrowly (see Figure 11). It refers to premiums earned minus claims
incurred, underwriting expenses and policyholders’ dividends, plus technical
income. The underwriting result is a nominal amount – for example in USD or
EUR – which can be calculated from companies’ income statements or from
supervisory authorities’ market statistics.
Figure 11
Income statement of a non-life Technical part Non-technical part
insurance company
Earned premiums Net investment result
– Claims incurred (including capital gains/losses)
– Underwriting expenses + Other non-technical income/charges
– Dividends to Policyholders – Taxes
+ Other technical income/charges – Extraordinary items
= Underwriting result = Non-technical result
Although some differences certainly persist, for example the definitions of the
various items and how they are handled in the various accounting systems,
these adjustments still considerably improve the comparability of the data.
Table 8
Reconciliation between published data
and standardized accounts for 2003
Germany France UK Japan

Profit and loss account EUR, m EUR, m GBP, m JPY, bn
Premiums earned 44 682 42 812 28 321 7 321
Reported technical result –783 2 008 –742 1 476
exclude changes in equalization reserves 1 919 –232 * ¹)
exclude allocated investment returns –441 –3 174 –732
include cost booked in the non-technical account –908 –1 318
Standardised net underwriting result –213 –1 398 –11 158
Investment result 6 306 4 218 3 228 473

Current result 5 540 3 911 3 155
Realised gains and value adjustments 767 307 73
Other income/charges –5 –473 –150 20

Reported pre-tax result 4 170 2 580 3 596 651
exclude changes in equalization reserves 1 919 –232 172
exclude unrealized capital gains ²) –700
Standardised pre-tax result 6 088 2 348 3 068 651
¹) changes in equalization reserves are not part of the technical account in UK

²) investment value adjustments which contain mostly unrealised capital gains

For analytical reasons, the underwriting result should reflect the effective claims
costs plus the costs related to the insurance activity. In other words, allocated
investment income and changes in the equalization reserves are excluded from
the underwriting result. This is already the standard for the US and the Canada
figures, but not for the other markets.
The allocated investment income rightly acknowledges the importance of earn-

ings on the technical reserves as part of the underwriting result. However, there
is no common standard for calculating this item. Thus, in a first step, it appears
reasonable to target the “pure” underwriting result, and afterwards build in the
investment income from the technical reserves.
The purpose of equalization reserves is – like reinsurance – to diversify low fre-

quency/high severity risks over time. Equalization reserves are treated differently
in the various jurisdictions. To make data from different markets comparable, ad-
ditions to and releases from equalization reserves are exluded from the profit and
loss account.
In Germany, a considerable amount of general administrative costs is booked in

the non-technical account. One could argue that corporate center costs are not
really related to underwriting and that it would be difficult to allocate those costs
to the various lines of business. However, the market statistics are based on indi-
vidual insurance companies whose only purpose is to sell insurance policies;
therefore it seems reasonable to allocate the general expenses to the technical
account, too.
The UK statutory filings, contrary to other accounting practices, also include

unrealized capital gains and losses. Although these can frequently constitute a
significant part of the changes to an insurer’s capital position, the present study
excludes them for the sake of comparability.
The Japanese non-life insurers sell so-called maturity-refund policies, which com-
bine insurance coverage with savings. In order to get comparable data, the im-
pact of the savings part has been factored out of the income statements.

Appendix II: Definitions and sources
Glossary
Accident-year view A method of measuring underwriting performance by matching all claims per-
taining to a given year with all the expenses and premiums earned during the
same year. Consequently, subsequent revisions of the claims estimate are also
assigned to the accident year.
Adverse development: Increase in claims estimates compared to the previous financial statement.
Adverse development increases business-year claims incurred.
Business-year view: A method of measuring performance by matching all claims incurred during a
year with all the premiums earned during the same year. Claims incurred
include changes in the reserves for claims that occurred in prior underwriting
years. Method used in financial accounting.
Claims incurred: Claims paid plus change in claims reserves, including claims adjustment ex-
penses such as legal fees, external and internal claims adjustment expenses.
Claims ratio: Claims incurred as a percentage of premiums earned.
Claims reserves: Provision for incurred claims which have not yet been finally settled.
Combined ratio: Performance measure based on undiscounted business-year view. Claims ratio
plus expense ratio plus policyholder dividend ratio.
Dividends to policyholders: Profit-sharing with policyholders, predominantly used by mutuals, but also fre-
quently used by stock companies as a marketing variable (motor policies).
Economic combined ratio: Performance measure based on discounted accident-year view. Claims ratio
plus expense ratio plus policyholder dividend ratio.
Expense ratio: Underwriting expenses as a percentage of premiums written.
Initial claims/combined ratio: Combined ratio based on the initial assessment of ultimate claims payments in
the financial statement for the accident year.
Other technical income/charges: Items such as changes in technical reserves other than claims and claims ad-
justment reserves, and other expenses and incomes.
Policyholder dividend ratio: Dividend to policyholders as a percentage of premiums earned.
Premiums earned: Premiums for all policies providing coverage during a specific accounting period.
The premiums for policies whose terms do not coincide with the accounting year
are deferred accordingly.
Premiums written: Premiums for all policies sold during a specific accounting period.
Ultimate claims/combined ratio: Combined ratio based on the revised assessment of ultimate claims payments.
Ultimate claims/combined ratios increase or decrease with development of
reserves. Ultimate claims estimates improve as claims develop but remain esti-
mates.

Appendix II: Definitions and sources
Underwriting expenses: Internal and external (broker, independent agents) acquisition costs, plus gen-
eral administrative expenses, except for claims adjustment costs and invest-
ment-related costs.
Underwriting result: Earned premiums minus claims incurred, underwriting expenses and dividends
to policyholders, plus other technical income/charges.
Underwriting-year A method of measuring underwriting performance by matching all premiums,

(also treaty-year) view: expenses, and claims to the year in which the business was written.
Data sources
Canada: Insurance Bureau of Canada (IBC) and Canadian Statistics.
France: CCAIMP, Totalisation des comptes des sociétés non-vie.
Germany: BaFin, Schaden/Unfallversicherungen. Professional reinsurers are not included.
Japan: Hoken kenkyujo (Insurance Research Institute), The statistics of Japanese

non-life insurance business. Excluding professional reinsurers.
United Kingdom: Standard & Poors, Synthesis Non-life, based on FSA returns. The market figures
are based on a sample of the leading 100 UK non-life insurers active between
1994 and 2004, excluding reinsurers.
United States: A.M. Best, Best’s aggregates & averages, property/casualty, and Insurance Serv-
ices Office (ISO).

Recent sigma publications
No 3/2006 Measuring underwriting profitability of the non-life insurance industry

No 2/2006 Natural catastrophes and man-made disasters 2005: high earthquake casualties,
new dimension in windstorm losses
No 1/2006 Getting together: globals take the lead in life insurance M & A
No 5/2005 Insurance in emerging markets: focus on liability developments

No 4/2005 Innovating to insure the uninsurable
No 3/2005 Insurers’ cost of capital and economic value creation: principles and practical implications
No 2/2005 World insurance 2004: growing premiums and stronger balance sheets
No 1/2005 Natural catastrophes and man-made disasters in 2004: more than 300 000 fatalities,
record insured losses
No 7/2004 The impact of IFRS on the insurance industry

No 6/2004 The economics of liability losses – insuring a moving target
No 5/2004 Exploiting the growth potential of emerging insurance markets – China and India in the spotlight
No 4/2004 Mortality protection: the core of life
No 3/2004 World insurance 2003: insurance industry on the road to recovery
No 2/2004 Commercial insurance and reinsurance brokerage – love thy middleman
No 1/2004 Natural catastrophes and man-made disasters in 2003: many fatalities, comparatively moderate
insured losses
No 8/2003 World insurance in 2002: high premium growth in non-life insurance

No 7/2003 Emerging insurance markets: lessons learned from financial crises
No 6/2003 Asia’s non-life insurance markets: recent developments and the evolving corporate landscape
No 5/2003 Reinsurance – a systemic risk?
No 4/2003 Insurance company ratings
No 3/2003 Unit-linked life insurance in western Europe: regaining momentum?
No 2/2003 Natural catastrophes and man-made disasters in 2002: high flood loss burden
No 1/2003 The picture of ART
No 7/2002 Bancassurance developments in Asia – shifting into a higher gear

No 6/2002 World insurance in 2001: turbulent financial markets and high claims burden impact premium growth
No 5/2002 Third party asset management for insurers
No 4/2002 Global non-life insurance in a time of capacity shortage
No 3/2002 The London market in the throes of change
No 2/2002 Insurance in Latin America: growth opportunities and the challenge to increase profitability
No 1/2002 Natural catastrophes and man-made disasters in 2001: man-made losses take on a new dimension

Economic Research & Consulting
Mythenquai 50/60
P.O. Box
8022 Zurich
Switzerland
Telephone +41 43 285 2551

Fax +41 43 285 4749
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3.-Capítulo 2 - Measuring - Underwriting - Profitability

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sigma

No 3/2006 Measuring underwriting profitability

7 The conventional versus the

13 The accident year improves

18 Large catastrophic losses

21 Recognition of the time value

25 Current underwriting profitability:

Telephone +41 43 285 2551

New York Office:

Telephone +1 212 317 5135

Reproduction in whole or in part or use

Although all the information used in this

Swiss Re, sigma No 3/2006 3

However, in order to judge the ultimate profitability, further information is re-

4 Swiss Re, sigma No 3/2006

The economic combined ratio is designed to measure underwriting profitability

Swiss Re, sigma No 3/2006 5

6 Swiss Re, sigma No 3/2006

In this section, the concept of the economic combined ratio is introduced. It is

Definition of the conventional combined ratio

² For a more detailed discussion of the adjustments, see Appendix I.

Swiss Re, sigma No 3/2006 7

United States Canada UK Germany France Japan

¹ Includes other technical income and charges

Source: Swiss Re Economic Research & Consulting

8 Swiss Re, sigma No 3/2006

Definition of the economic combined ratio

Swiss Re, sigma No 3/2006 9

Additionally, due to constraints on the availability of data, we rely on accident-

Business-year claims ratio (Claims incurred in the business year/NPE)

10 Swiss Re, sigma No 3/2006

Sources: A.M. Best, Swiss Re Economic Research & Consulting

Underwriting profitability: the US example

Swiss Re, sigma No 3/2006 11

⁵ These results are dependent on US reserves adequacy.

12 Swiss Re, sigma No 3/2006

Why the accident-year view is important

Swiss Re, sigma No 3/2006 13

A&E claims Other adverse development *As of end of 2004

14 Swiss Re, sigma No 3/2006

Swiss Re, sigma No 3/2006 15

Figure 4 8% Reserve additions (+) and releases (–) in % NPE

Source: A.M.Best, Swiss Re Economic Research&Consulting

16 Swiss Re, sigma No 3/2006

Source: A.M.Best, Swiss Re Economic Research&Consulting

Swiss Re, sigma No 3/2006 17

18 Swiss Re, sigma No 3/2006

Sources: A.M.Best, Insurance Bureau of Canada, ISO, Swiss Re Economic Research&Consulting

Swiss Re, sigma No 3/2006 19

Accident-year combined ratio Accident-year combined ratio, catastrophe adjusted

20 Swiss Re, sigma No 3/2006

Swiss Re, sigma No 3/2006 21

United States Canada UK Germany France Japan

Source: Swiss Re, Economic Research & Consulting

22 Swiss Re, sigma No 3/2006

Swiss Re, sigma No 3/2006 23

24 Swiss Re, sigma No 3/2006

Accident-year Accident-year Average Discount Discount Economic

Note: Not adjusted for catastrophe losses, contrary to table 1

United Kingdom, accident year 2004, net

¹⁶ Excluding Japan due to non-availability of data.

Swiss Re, sigma No 3/2006 25

Combined Claims Average Discount Discount Discounted