Why PC Casualty Commercial Risk Market Cycles are NOT Dead

Introduction

A few years ago there was an article in the insurance trade press announcing the demise of the insurance cycle or that period in time when prices and terms move from “readily available” to “restricted” and then back again. Often referred as the soft market to hard market cycle, the author suggested that some fundamental changes in the economic landscape had altered the basis for cyclical behavior of the insurance market, particularly in commercial lines. This would explain why the insurance market remained competitive for over a dozen years following the “hard” market of 1984-85 in spite of crisis conditions in workers compensation insurance and two major catastrophe events (i.e. Hurricane Andrew and the Northridge earthquake) in the early 1990’s. The advances in technology, productivity, globalization and financial markets didn’t change the fundamentals of the insurance markets but did help to mask the signals in the US thereby extending the cycle duration. The return to competitiveness in 2006 with rates declining and risk capacity abundant once again put us in a soft market that continues in 2008. What is it that makes this market so cyclical?

Insurance as a Cyclical Marketplace

It is not by happenstance that market cycles take place in the insurance business but rather it follows the basic economic laws of how competitive markets operate. While there are influences on the market that can and do change the duration of cycle segments, the economic laws of supply and demand make for competitive cyclical swings to take place.

Supply : There are over 900 insurance groups operating in the US comprising over 2000 property and casualty insurance companies. Per capita, it represents 10 times the number of insurers operating in any other industrialized nation in the world. This is supplemented by numerous foreign insurers (including Lloyds of London and Bermuda companies) who are authorized to write in this market by state regulation or via subsidiaries, as well as dozens of reinsurance companies that support direct insurers. Participation in the US market attracted significant new capital following the 2001 terrorist attacks by the formation of new insurance and reinsurance companies particularly in Bermuda. This happened again after the devastating hurricane losses of 2004-2005.

The surplus (Net Worth) of US domiciled insurers increased from $308.5 Billion at the end of 1997 to more than $519 Billion at the close of 2007. Although surplus dipped to $285 Billion after the terror attacks it recovered with multiple injections of new funds from investors. Surplus is a regulatory measure of how much premium an insurer can write (i.e. net of reinsurance) as a 3:1 ratio must not be exceeded. If surplus utilization and premiums on available market business are not in equilibrium, either prices fall to fill the capacity for more business (soft market) or prices will rise as capacity for business shrinks (hard market). The US Property Casualty market is rarely in a state of equilibrium except for brief periods of transition.

Demand : The demand for insurance is very much tied to the economic conditions but is considered to be inelastic. In periods of economic expansion the demand for commercial insurance will increase but if the supply (surplus) of coverage is constrained by a high price, the demand may be diverted to buyer self retentions or other alternative risk financing techniques. If commercial insurance capacity and pricing become reasonable the demand will be altered to the purchase of insurance from commercial insurers. While the tendency of business may be toward transfer of risk, the emergence of risk management disciplines and its use by organizations of all types, places insurance purchasing as one of the last process considerations.

Duration of Cycles

In addition to the basic principles of supply and demand underlying the reason for the competitive nature of the market several other contributing factors have influence the duration of the P/C cycles.

Lack of Unique Products: the commercial insurance business has been marketing essentially the same products for decades. While carriers may offer “special extensions” of coverage terms, the fact is that the primary coverage is almost identical among companies. Since coverage terms can not be copyrighted, they can be and are often duplicated. Without any real coverage distinction carriers compete essentially on the basis of price;

Ease of Market Entry: the ability for new entrants into the insurance market can easily be accomplished to avoid multiple state regulation either as a surplus lines (non-admitted) carrier or as a reinsurance carrier. Depending on the business to be written these company forms might be an attractive and expedient method of entry;

Influence of Investments: Insurers earn a substantial part of their earning from investment of capital funds, premium in-flows and claim reserves. While insurers can have a steady stream of investment income from market interest and dividends, they do engage in trading practices which have exposed them to variations in realized (Income Statement) and unrealized (Balance Sheet) capital gains and losses. The following realized and unrealized gains and losses produced a corresponding impact to insurer surplus positions (in Billions of Dollars):

1997……….$39.8       2003………$31.8

1998……….$36.2       2004………$19.7

1999……….$10.9       2005………$6.3

2000……….$1.0         2006………$23.4

2001……… ($11.2)    2007………$8.4

2002……… ($22.0)

So these elements can and have contributed to the market cycles of the past and are still factors which can prolong a given cycle or shorten its’ duration.

CONCLUSION

The cyclical US commercial lines market will continue as long as these supply and demand characteristics remain in place. Buyers and risk managers have embraced alternative risk transfer (ART) programs as a means of dealing with the market uncertainty of availability and pricing of risks. These ART programs remain fluid as clients adjust the balance between these plans and commercial insurance to give them the desired management outcome. Some might argue that this has further fueled the cyclical duration by leaving the commercial insurance market to deal with more of the severity of risk exposures as client take the more predictable risk frequency into the ART programs. But buyers are not likely to give up these programs as they offer some means of control. In like fashion underwriters will continue to find ways of remaining a viable and necessary resource to the risk manager. In a strange way both need each other as much today as never before!