Critical Issue Report
Chicken or egg—Or?
Lloyd's report analyzes insurance industry cycles
By Phil Zinkewicz
Managing property and casualty insurance underwriting cycles was the subject of a report issued late last year by Lloyd’s of London. Thirty years ago, there probably would have been no need for such a report because, back then, industry cycles were predictable. The rule was that three profitable years for the property and casualty industry led to a soft market where prices dropped, leading to three years of hard market conditions where prices rose. It mattered little whether the chicken came first or the egg. Insurers, agents and even insurance buyers were able to prepare for the next cycle with a strong degree of certainty. That is not the case today, and this is one reason why the report falls short of its aim.
The Lloyd’s report says that refusing to “follow the herd,” providing the right incentives for underwriters, and investing in risk measurement tools are useful strategies for managing the insurance cycle.
The report goes on to repeat the 30-year-old scenario already stated: “Historically, the insurance cycle has been characterized by peaks and troughs that reflect the rise and fall of insurance prices. It alternates between periods of soft market conditions, where premium rates are stable or falling and insurance is readily available, and periods of hard market conditions, when rates rise, coverage becomes difficult to find and insurance profits increase. As the market softens to the point that profits diminish or vanish completely, the capital needed to underwrite new business is depleted, and insurers who have not underwritten prudently can lose millions.”
The report offers seven key steps Lloyd’s believes will help the industry become less unpredictable and underwrite on a sustainable basis for the benefit of both policyholders and insurers. These are:
1. Don’t follow the herd.
2. Invest in the latest risk measurement tools.
3. Don’t let surplus capital dictate your underwriting.
4. Don’t be dazzled by higher investment returns.
5. Don’t rely on “the big one” to push prices upwards.
6. Redeploy capital from lines where margins are too thin.
7. Get smarter with underwriter and manager incentives.
Lloyd’s commissioned the report from the Economist Intelligence Unit as part of its 360 Risk Project, which aims “to generate debate” about today’s key risk issues and how best to manage them.
Okay, let’s debate.
We’ve heard it all before
One problem with the report is that the advice it offers might apply to any predictable soft insurance cycle. It’s all been heard before. It doesn’t take into consideration any of the outside forces that have come to twist cycles in the past three decades.
For example, in the early 1980s, the insurance market was predictably turning soft, but the outside force of higher interest rates turned what might have been a “normal” soft market into a bloodbath of competition. Insurers weren’t “following a herd” back then. They were trampling over each other to steal business from the other guy to take advantage of high investment returns that had never existed before.
The next hard market, which came in 1984-85, was not the result of the usual “peaks and troughs,” but rather was the result of three years of insurers—out of greed and stupidity—forgetting completely that they were in the insurance business.
That led to the creation of “new” competition in the form of offshore captives, which had previously been only a convenience to get insurance buyers through hard market conditions. But after 1984-85, those captives became real competition for traditional insurers, leading to a prolonged soft market that started in the early 1990s and lasted to the end of the decade. (What happened to three years on and three years off?)
Enter the new millennium. By this time, another “outside force” began having its way with the property and casualty insurance business. New capital began coming into the insurance arena. Up to the early 1990s, when new capital came into the insurance business, it did so in support of existing insurance and reinsurance companies. But the new capital of the new millennium came in the form of new insurance structures, again usually in offshore areas such as Bermuda. Thus, the insurance business faced more competition.
The new insurance capital
A recent study by Conning Research and Consulting, Inc., discusses the growth of the Bermuda market as a competitive force in the insurance business. “Bermuda has become the place where the capital markets and the market for insurance and reinsurance talent most closely intersect,” says the study. “In the past 20 years, Bermuda has grown from a small haven for captives to a thriving center of insurance, and especially reinsurance,” says Stephan L. Christiansen, director of research at Conning. “By 2004, Bermuda accounted for nearly 12% of the unaffiliated reinsurance ceded from the U.S. market, with $8 billion, up from just over 9%, or $7.1 billion, a year before.”
The Conning Research report—titled “Bermuda: The New Capital of Insurance?”—says that Bermuda’s growth has accelerated, with a significant portion of the nearly $25 billion in new capital raised for the insurance industry in the past year going to Bermuda. “Swift and efficient allocation of capital is at the core of the Bermuda insurance model, and it became even more efficient with the Class of 2005 and the increasing influence of hedge funds,” the report says.
“We expect record earnings for Bermuda in 2006, as much as $10 billion or more in net income, thanks to a relatively benign hurricane season,” says Christiansen. “This will help propel the Bermuda model to continue to innovate in risk transfer efficiency with increased usage of capital market mechanisms such as catastrophe bonds, sidecar reinsurers and industry loss warrants.”
Will Bermuda’s new capital have an impact on the property and casualty underwriting cycle? Rough Notes asked the experts.
Christiansen says the answer to that question is “maybe,” and he points out that part of what creates cycles is the need for companies to grow. “They write additional business by taking that business away from someone else, and that causes prices to drop. Then they pull back and prices go up. That’s the traditional cycle. But when you take Bermuda into the picture and the additional capital there, you could have a situation where demand will not be able to compete with capacity. That could cause the market to remain soft. On the other hand, some of the additional capital that has come in from private investors is set up for a quick exit if needed. If prices soften too much, the additional capital may leave, causing the market to harden.”
Dr. Robert P. Hartwig, president and chief economist for the Insurance Information Institute, said it is too soon to predict if there will be an all-out price war as the result of new capital coming into the property and casualty insurance market. “After all, this new capital came in after Hurricane Katrina to bolster the catastrophe side of the marketplace. Last year was relatively hurricane free, so they will make money and likely stay in the market.
“But when severe losses start coming in, they could retreat,” Hartwig explains. “Also, there could be further consolidation among the new players, so some of the capital may be driven from the market. We should remember that some of the new capital came into the market to satisfy a need in the reinsurance market and in the property and casualty catastrophe market, and that need still exists.”
What is clear here is that property and casualty insurance cyclicality is no longer as simple as insurance company shifts in thinking. The outside forces that have affected the insurance business in the last 30 years have left their mark and need to be considered when managing cycles. It is no longer a matter of not following the herd. *
Phil Zinkewicz is an insurance journalist with some 30 years’ experience covering the international insurance and reinsurance arenas. He was the insurance editor of the Journal of Commerce for a number of years, handling all of its domestic and international supplements. In addition, he regularly writes for a number of London publications.