July 1, 2001 by Canadian Underwriter
To shamelessly contribute to the hackneyed overuse of a famous Mark Twain quote: Reports of the death of the property and casualty insurance cycle have been greatly exaggerated. The cycle is alive and well and living in p&c insurance and reinsurance markets across the globe.
Now, this is not to say that the cycle has not changed – it has. Over the course of the most recent downturn – probably the worst in recent memory – some lines became “commoditized”, perhaps permanently. This is a clear side effect of over-competition and the flood of capital that inundated many markets worldwide. But, all in all, the cycle is largely intact: p&c rates that go down still must eventually go up. Shareholders and market forces demand it. But what are these market forces, and what impact do they have on the supply of insurance and reinsurance? As with most goods and services, the economics can be broken down into macro (i.e. those issues that are large scale and greatly homogenous the world over) and micro (i.e. those which are more localized). Let us first look at the big picture.
Insufficient capacity. With the latest market downturn still clearly in sight, it is hard to believe that there have been times in the not-so-distant past where it was extremely difficult to place certain risks because of a dearth of capacity. But this very thing happened, for liability in the early 1980s, and for property in the early 1990s.
Beginning in the early 1980s, the U.S. insurance industry was seeing loss ratios skyrocket on the liability side partly due to higher claims costs associated with asbestos and environmental. The situation was exacerbated by the general trend in U.S. courts to award increasingly higher compensation to injured parties. This forced insurers to increase their loss reserves, and legal uncertainties led to a severe capacity shortage in the U.S. insurance market and, even more so, the reinsurance market. This prompted a massive increase in premium rates and restricted availability of liability covers.
A similar thing happened on the property side after a dramatic string of natural catastrophes, beginning in 1989 with Hurricane Hugo and the Loma Prieta earthquake, and culminating in Hurricanes Andrew and Iniki in 1992, and the Northridge earthquake in 1994. The result was the bankruptcy of many carriers (eight due to Andrew alone), and the refusal of many more to renew or write new business in heavily exposed areas (which triggered the creation of state-run insurers and reinsurers of last resort, and regulatory moratoriums on the non-renewal of business). The cost of coverage increased dramatically for buyers of insurance. Reinsurers, too, decided they were overexposed to hurricanes and earthquakes and pulled out of risky areas, making cat covers expensive for ceding companies.
As with most businesses operating in free or semi-free markets worldwide, when there is a need not being filled, someone will step in to fill it. In the case of both the liability crisis and the property catastrophe crisis, that “someone” was Bermuda.
Surplus capacity. Unfortunately, also with most businesses operating in free or semi-free markets worldwide, in time, too many companies will attempt to fill a market need. Coupled with other factors, such as booming equity markets (which provide capital for more insurance and reinsurance upstarts, or for the expansion of existing players) and in no time at all rates in many lines begin to plummet as players vie for marketshare.
The Bermuda market began to shrink in the mid- to late-1990s as loss experience improved, international competition ratcheted upward, markets began to soften and surpluses ballooned. The tides that helped create the ideal conditions under which the Bermudan insurance and reinsurance market saw its rise, had turned. But the segment was not alone.
Many (mostly mature) markets worldwide found that too many players were fighting for a shrinking piece of the pie. And in the absence of any really costly natural catastrophes, and given ballooning capital markets, many insurers were salting away massive amounts of cash. When capital is in high supply and the business environment is highly competitive, some carriers tend to loosen their underwriting standards in order to grow their books. If the frequency and/or severity of claims, and other expenses, begin to skyrocket during this time, the results can be disastrous. This is what happened in the mid- to late-nineties. The trouble was that so much cash had been amassed that it took several years for the capital depletion to finally show itself and, eventually, translate to weak bottom-lines.
So, it is clear that rate peaks and valleys associated with the insurance and reinsurance market are caused by capacity limitations – that is, supply more so than demand. Now that we have the background of what drives the cycle in the world’s p&c marketplace, we will turn to just a few of the micro trends that are spun-off from these major influences (see figure I, which is based on anecdotal evidence collected over the most recent soft cycle).
M&As. In the insurance industry, merger and acquisition (M&A) booms can be spurred for a few reasons. First, in a very competitive market where rates have been cut to the bone, organic growth becomes almost impossible and the only way an insurer can grow is by buying another. Over the course of the mid-1990s, when cash was abundant, M&As also served as a way to deplete capital that was otherwise not being deployed.
The impact of these corporate marriages (particularly the mega-mergers of late) is that the underlying demand for reinsurance was permanently eroded in certain markets, such as Canada. Simply put, larger companies retain more risk, or reinsure via internal programs.
Over-dependence on investment income. In this country last year, the industry paid out $1.08 for every dollar of premium put on the books (i.e. the combined ratio was 108%). It does not take much analysis to arrive at the conclusion that success in the investment area is critical under such circumstances. In a soft market, when rates are too low, the problem is exacerbated. The situation is also worsened when investment markets are strong: as long as the supply of capital is forthcoming, inattention to underwriting can become prolonged, dragging out the soft market for a few extra years.
Abandonment of certain lines or outright retirement from business. Given time, the chickens eventually come home to roost, and the pressure to reposition becomes all too real. For some companies, the tough times call for tough measures, and they must drop certain unprofitable lines (or treaty contracts in the case of reinsurers), sell the operation or go into runoff. The irony is that this often happens when the cycle is poised to turn for the better. Of course, those that must take these drastic measures help to drive the hardening as they remove capacity from the market. This is the “catch-22” of the insurance cycle.
The impact on reinsurance. Eventual turnarounds in the p&c cycle are often partly driven by the reinsurance side of the equation. The first inkling of a firming in rates often comes from the retro market. In 1999/2000, several Bermudan and London market companies retreated from reinsuring reinsurers. And one of the three Australian carriers that closed its doors in 2000 was heavily involved in the international retro market. Reinsurers consequently have to hold on to more risk or pay significantly more for retro protection. This eventually has an inflationary effect on reinsurance rates, which may to some degree eventually flow down to the primary side.
The rise of non-traditional solutions. When primary and, subsequently, reinsurance markets start to harden, more captives are created, and more non-traditional risk transfer/risk financing solutions are sought. An A.M. Best report released in April showed steady growth rates for captive insurance companies – between 4.5% and 5.5% over the past several years – with an acceleration in growth in 2000. By year-end 1999, the alte
rnative insurance market comprised nearly 40% of the total commercial market in the U.S., and A.M. Best believes that market share will approach 50% in 2003. The market for captives, it said, will continue to grow in 2001, due to a continued firming trend in prices in commercial lines.
According to the most recent sigma study from Swiss Re (3/2001 “Capital market innovation in the insurance industry”), “by far the most important determinant of capital market insurance solutions is whether they can offer issuers competitive pricing”. The issuance volume of catastrophe securitisations alone, says Swiss Re, should grow from its current annual level of US$1 billion to approximately US$10 billion by 2010.
Many industry veterans had never in their careers seen a market downturn quite like the most recent. It was such a prolonged soft cycle, and there were so many major structural changes in the industry at the same time, that it is understandable why some believe the cycle is dead. After all, many managers claim that they have taken drastic steps to improve their books, but are still generating lackluster underwriting results.
In response to this last concern, it should be noted that rate adequacy is not the “be-all and end-all” of the business. Rate increases are of little consequence if claims costs and other expenses increase in tandem. Take the Canadian market in 2000 – overall net earned premium growth showed a 7.1% increase. Unfortunately, claims incurred jumped from $13.483 billion in 1999 to $15.097 billion in 2000, essentially wiping out this premium growth.
So, while the industry is starting to see some small successes with its frontal assault on low premium rates, it must be careful that it not be outflanked by skyrocketing expenses. The price cycle is not dead, nor is it on life support. But this latest downturn did not happen overnight, and it will not correct overnight.