Insurance cycle

“The tendency to swing between profitable and unprofitable periods over time is commonly known as the "underwriting" or "insurance" cycle." (Wikipedia article on Insurance)

What is the Insurance Cycle

Lloyd's Franchise Performance Director Rolf Tolle recently stated that “mitigating the insurance cycle was the “biggest challenge” facing managing agents in the next few years” [Rolf Tolle, The cycle challenge - 12 July 2007, http://www.lloyds.com/News_Centre/Features_from_Lloyds/The_cycle_challenge.htm (accessed 21st August 2007)] .

All industries experience cycles of growth and decline, 'boom and bust'. These cycles are particularly important in the insurance and re-insurance industry as they are especially unpredictable.

Lloyd's of London research in 2006 revealed, for the second year running, that Lloyd’s underwriters see managing the insurance cycle as the top challenge for the insurance industry, and nearly two-thirds believe that the industry at large is not doing enough to respond to the challenge [Lloyd's Annual Underwriter Survey, 2006 http://www.lloyds.com/News_Centre/360_risk_project/Managing_the_cycle.htm (accessed 21st August 2007)] .

The Insurance Cycle affects all areas of insurance except life insurance, where there is enough data and a large base of similar risks (i.e. people) to accurately predict claims, and therefore minimise the risk that the cycle poses to business.

History

The insurance cycle is a phenomenon that been recognised since at least the 1920s. Since then it has been considered an insurance 'fact of life'. The corporate culture that dominates insurance assumes that inherent uncertainty of the business must logically lead to a cyclical business model. Lloyd's counters that this has become “a self-fulfilling prophecy” [Lloyd’s, Managing the Cycle – How the Market can Take Control http://www.lloyds.com/NR/rdonlyres/A27B9CEB-6F19-4364-BD0A-02AA92384544/0/360_ManagingtheCycle06_12_06.pdf (accessed 21st August 2007).] .

More recently, insurers have attempted to model the cycle and base their policy pricing and risk exposure accordingly.

Description of the Cycle

For the sake of argument [The cycle has no start. It is a cycle. Obviously.] let's start from a 'soft' period in the cycle, that is a period in which premiums are low, capital base is high and competition is high. Premiums continue to fall as naive insurers offer cover at unrealistic rates, and established businesses are forced to compete or risk losing business in the long term.

The next stage is precipitated by a catastrophe or similar significant loss, for example Hurricane Andrew or the attacks on the World Trade Center. The graph below shows the effect that these two events had on insurance premiums.

After a major claims burst, less stable companies are driven out of the market which decreases competition. In addition this, large claims have left even larger companies with less capital. Therefore, premiums rise rapidly. The market hardens, and underwriters are less likely to take on risks.

In turn, this lack of competition and high rates looks suddenly very profitable, and more companies join the market whilst existing business begin to lower rates to compete. This causes a market saturation and Insurance Cycle begins again.

Dealing with the Insurance Cycle

Whilst many underwriters believe that the cycle is out of their hands, Lloyd’s is trying to push for more proactive management of the ups and downs of the industry. In 2006 they published their ‘Seven Steps’ to managing the insurance cycle:

1. Don’t follow the herd. Insurers need to be prepared to walk away from markets when prices fall below a prudent, risk-based premium.

2. Invest in the latest risk management tools. Insurers must push for continuous improvement of these tools based on the latest science around issues such as climate change, and make full use of them to communicate their pricing and coverage decisions.

3. Don’t let surplus capital dictate your underwriting. An excess of capital available for underwriting can easily push an insurer to deploy the capital in unsustainable ways, rather than having that capital migrate to other uses such as hedge funds and equities, or returning it to shareholders.

4. Don’t be dazzled by higher investment returns. Don’t let higher investment returns replace disciplined underwriting as base rates creep up on both sides of the Atlantic. Notionally, splitting the business into insurance and asset management operations, and monitoring each separately, is one way to achieve this.

5. Don’t rely on “the big one” to push prices upwards. The spectacular insured loss should not be used as an excuse to raise prices in unrelated lines of business. Regulators, rating agencies, and analysts - not to mention insurance buyers – are increasingly resisting such behaviour.

6. Redeploy capital from lines where margins are unsustainable. There is little that individual insurers can do to alter overall supply-and-demand conditions. But insurers can set up internal monitoring systems to ensure that they scale back in lines in which margins have become unsustainable and migrate to other lines.

7. Get smarter with underwriter and manager incentives. Incentives for key staff should be structured to reward efficient deployment of capital, linking such rewards to target shareholder returns rather than volume growth. [Lloyd’s, Seven steps to managing the cycle, http://www.lloyds.com/News_Centre/Press_releases/Seven_steps_to_managing_the_cycle.htm (accessed 21st August)]

The Lloyd’s Managing Cycle report has several problems. It focuses on the industry as a whole being able to work together to reduce the effect of market fluctuations. However, this is somewhat unrealistic, as if underwriters do not write business in a soft market (i.e. at cheap prices for the customer), it will be hard to win this business back in a hard market due to loyalty issues.

Rolf Tolle asserts that “There is nothing complex about the cycle. It is about having the courage of your convictions to act with strength.” [Todd, Cycle Challenge] . Swiss Re argue that instead of ‘beating’ the cycle, insurers should learn to anticipate it’s fluctuations. “Cycle management is essentially proper timing. Monitoring the market, predicting market trends and accurately assessing prices play an important role” [Swiss Re, The insurance cycle as an entrepreneurial challenge, http://www.swissre.com/Internet/pwsfilpr.nsf/vwFilebyIDKEYLu/MBUI-5FNDYC/$FILE/insurance_cycle_en.pdf Accessed 21st August 2007] .

Swiss Re give several examples of potential business strategies. One is to write risks at a roughly fixed rate. This is clearly not practicable as it does not allow for the cyclical nature of the market. Another is to fail to react fast enough to changes in the market, which leaves a company even more exposed. The recommended strategy is one that relies on prediction of the business cycle and setting premiums based on models and experience.

The Future of the Insurance Cycle

The unpredictable nature of the insurance industry makes it very unlikely that the cycle can be eliminated. For several years Lloyd's have been urging caution in soft periods and restraint in hard periods. We are currently entering a soft period of high competition and falling premiums. This suggests that the free market has not heeded the warnings of previous periods. Having said this, the insurance industry as a whole is several hundred years old and has survived several other softening and hardening periods.

Notes