Critical Issue Report

What's driving the soft market?

Industry analysts point to a new set of forces

By Phil Zinkewicz

Insurance industry analysts and observers generally agree that the property and casualty insurance business is currently in a soft market. Fair enough. But the question must be asked: What is driving this particular soft market?

Those of us who have been around long enough can remember the soft market of the early 1980s, which was driven by excessively high interest rates. Property and casualty insurers succumbed to the siren song of high investment yields and began writing even the most volatile business at bargain rates, much to their chagrin a few years later. Then there was the extended soft market of the 1990s, which was driven by a booming stock market. Here again, cash flow underwriting dominated the business of insurance.

However, this soft market is different. There are no soaring interest rates, and the stock market is certainly not booming. Moreover, the economy in general is in the doldrums. In other words, there are no outside forces influencing underwriting decision making. The fall-off in pricing is the result of the simple law of supply and demand. There’s too much capacity out there and not enough demand to absorb it. Is this bad for the industry? Analysts’ views on this question vary.

Recently, Standard & Poor’s Ratings Services said that it had revised its outlook for the U.S. commercial lines sector from stable to negative. S&P credit analyst John Iten said: “Our decision to revise this sector outlook reflects our concern over two issues—the ongoing decline in pricing for commercial lines and decreases in investment income. Price competition persists across virtually all commercial lines, with prices continuing to decline, albeit at a somewhat moderated pace in the second quarter.”

Iten continued: “Based on industry pricing surveys and information that companies provided in their second-quarter earnings releases, we believe pricing in the second quarter for renewal business declined at a mid-single-digit rate in most lines and a low-double-digit rate for new business. Although some companies and outside observers have suggested that the rate of deterioration might have bottomed out in the second quarter, rates are still declining steadily. Absent an extraordinary event, we do not see anything reversing the general downward direction of rates over the next six to 12 months.”

Over the next 12 to18 months, Iten said, the decline in rates will adversely affect underwriting results. “We expect that full-year 2008 underwriting results for most commercial lines writers will remain relatively strong, with the U.S. property/casualty industry’s combined ratio still less than 100%. However, we believe underwriting performance will deteriorate through the remainder of 2008 and through much of 2009.”

There is no question that S&P is painting a bleak picture of the industry’s current position, but is it really as bleak as all that? While Iten is understandably concerned about declines in pricing, he admits that the declines have been “at a moderate pace,” at least for the second quarter.

In past soft markets, where outside forces played a role, all caution was thrown to the wind and pricing dropped dramatically, causing great concern. With no cash flow underwriting motivation, however, it appears that insurers are doing their best to control this soft market. Iten noted that the industry’s combined ratio remains under 100. That’s not bad for a soft market in its fourth year. Check out previous soft markets and see what the loss ratios were back then.

A brighter view

Taking a more optimistic view of the industry’s status is Conning Research and Consulting. A forecast and analysis by Conning suggests that the property/casualty industry is “strong” and “should be able to withstand the current price deterioration.”

According to Conning analyst Clint Harris, “The outlook for the next three years, through 2010, is generally soft for the property/casualty industry as a whole. We project continued deterioration in underwriting margins and implied return on equity. However, the largest year-over-year increase in combined ratio is in 2008 and, while this reflects a return to normal catastrophe losses, much of this deterioration is self-inflicted, as premium prices and premium rate adequacy continue to fall.”

Stephen Christiansen, director of research for Conning, added: “Looking beyond this year, our forecast contains a somewhat more optimistic view of 2009 and 2010 because we anticipate a modest rebound in the economy and also a moderating competitive environment. We project a return to net premium rate increases beginning in some lines as early as 2009. In fact, we are already beginning to observe some insurers taking corrective actions in their markets because of poor results.”

Again, this situation is different from previous soft markets. In the past, only outside forces could bring insurers out of a competitive cycle—a fall in interest rates, a faltering stock market, a catastrophic occurrence. This soft market has at least some insurers, according to Conning, acting wisely.

Impact of mortgage crisis

Finally, there is analysis from the Insurance Information Institute (I.I.I.). Dr. Robert P. Hartwig, CPCU, I.I.I. president and an economist, commented on the mortgage crisis and its effects on the current property/casualty market. “The first quarter’s underwriting performance was influenced primarily by significant underwriting losses reported by many mortgage and financial guarantee insurers,” Hartwig said. “While it is not unusual for results in any given quarter to be driven by the experience of a small number of lines or by a specific event, it is rare for lines that account for just a sliver of industry premiums to produce large-scale impacts on industry performance,” he remarked.

Hartwig added, however, that “stripping out the mortgage and financial guarantee insurer results yields a combined ratio of 96.7, up from 92.1 in the first quarter of 2007 and 95.6 for all of 2007. The deterioration is generally in line with expectations and reflects the effects of a sustained, highly competitive pricing environment for most types of insurance, particularly commercial lines, as well as adverse claim frequency and/or severity trends in some key lines.”

Hartwig continued, “According to the Council of Insurance Agents and Brokers, commercial renewals for larger brokered accounts were down 13.5% during the first quarter. Of course, actual changes experienced by individual insurers can vary substantially, and few commercial insurers are actually reporting premium declines of this magnitude.”

Once more we see a soft market that has persisted for some years, but thus far nothing like the devastating soft markets of previous cycles. How much more problematic would this soft market be if insurers were foolishly chasing premium dollars for investment purposes as they have done so often in the past? Insurers are holding their ground this time around. And, as they might learn from the current soft cycle, that’s a good thing for the business over the long term.

The author
Phil Zinkewicz is an insurance journalist with more than 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 their domestic and international supplements.