The cycle challenge

General insurance is a notoriously cyclical business. Present rates are high and insurers are currently earning attractive returns on capital.

This is in sharp contrast to the final few years of the last millennium, which saw one of the longest-lived soft markets in living memory, characterised by competitive pricing and very attractive terms available to policyholders.

The term 'cycle' is commonly used to include movements in loss ratios, prices, profitability, coverage terms or availability of insurance. In practice, there is usually a close relationship between all of these aspects.

Causes

There are a number of common theories about the causes of the cycle, each of which has a differing degree of impact on the amplitude of the swings from top to bottom. In ascending order of credibility, the causes are: collusion; links with macroeconomic cycles; investment volatility; loss shocks; reserve smoothing; underwriting management; and fear of exclusion.

Accusations of collusion have traditionally been levelled at the insurance industry by politicians and others when markets are hard and the cost of cover, including obligatory cover such as employers' liability, becomes prohibitive. Purchasers may not believe that insurers have been voluntarily subsidising their own businesses in the past when soft market conditions have prevailed, but the insurance market does not behave in a way that is consistent with collusion on rate setting. It is frequently argued from within that a greater degree of 'market discipline' would work wonders.

It could be argued that in depressed economic conditions there is likely to be less business activity and, correspondingly, less demand for insurance.

On the other hand, there is some evidence that the propensity to claim may be higher when times are difficult. In practice, it seems difficult to demonstrate any significant link with macro-economic cycles, even allowing for time lags.

Intuitively, it is difficult to believe that the major swings experienced in the insurance market could be driven by general economic conditions.

The pursuit of investment returns has certainly been a significant driver of past cycles. Cash flow underwriting, for instance, accepting business at almost any price for the cash flow generated between premium collection and payment of claims, became particularly tempting when interest rates were very high in the late 1970s. As interest rates fell back, underwriting standards did not always rise accordingly and this was a major cause of the soft market in the early to mid 1980s.

More recently, insurers have been able to cushion the impact of the very poor loss ratios on business written in the late 1990s by investing in equities. However, times have changed. Inflation seems to have been conquered, and the prevailing wisdom is that low interest rates are here to stay.

Investors will not soon forget their experience of the equity markets in the first few years of the new millennium. Correspondingly, it is hard to see that the pursuit of investment returns will encourage a return to cash flow underwriting in the near future.

Events such as the terrorist attacks of 11 September 2001 move rates upward and similar loss shocks can arise when there is a sudden and unexpected increase in long-tail liabilities, for example, those linked with asbestos claims.This includes reserve smoothing. Examination of historical data confirms that there is a significant correlation between the cycle and reserve strength. There is a tendency for reserves to be set towards the lower end of the range during soft markets and the upper end during hard markets.

Market economists would argue that loss shocks should have no effect on future prices, except to the extent that the level of future expected claims has changed. Their general proposition would be that, in a business such as insurance with low barriers to entry, new capital will be attracted if existing market participants raise prices to compensate for past losses.

Indeed, the belief that rates are hardening following shocks undoubtedly facilitates capital raising. After 11 September, however, rates continued to rise even after substantial additional capacity came into the market.

Perhaps loss shocks can precipitate higher prices because cash and capital are removed from the market and capacity is reduced at least temporarily.

The substantial additional capacity that came onto the market relatively quickly post 11 September may not have wholly covered the shortfall. The events of 11 September may have stimulated a belated recognition of systematic underpricing in previous years, although there is evidence that rates were already increasing earlier in 2001.

While loss shocks can and will create cyclical effects, we need to look elsewhere for a full understanding of what drives the cycle. This includes reserve smoothing. Examination of historical data confirms that there is a significant correlation between the cycle and reserve strength. There is a tendency for reserves to be set towards the lower end of the range during soft markets and towards the upper end during hard markets. While this process can hardly be regarded as a cause of the cycle - if there was no cycle, reserve smoothing would arguably disappear - it may exacerbate the cycle. This is because, in soft markets, current results are presented in a more flattering light and the need for remedial action may be postponed.

Another factor influencing the cycle is underwriting management. In areas such as the London market, the checks and balances on the sales/underwriting function frequently seem to be insufficient. Indeed, because underwriters may be set targets based on premium levels, more risks may be written when rates are low.

The position is often exacerbated by poor management information and a slow feedback cycle. This is, in part, inevitable, because uncertainty over reserving levels for business written means there is no firm basis from which to project. In addition, assessing accurately how much prices are moving can be difficult, particularly if one is trying to embrace movements in exposure, quality of risk, changes in deductibles or other terms and conditions, as well as in price.

Fear of exclusion seems to rest on the proposition that business should be written in soft markets in order to be secured in any hard markets.

It also reflects the unfounded fear that, if business is relinquished in the soft market, it will not be regained in the hard market. This argument does not hold water. Business is either price-sensitive or it is not.

Brokers do not move business to less expensive insurers because they no longer favour a particular insurer, or because they have a burning desire to cut their own commission income. They do it because they fear that if they do not, a competitor will. That logic is just as effective in hard markets as it is in soft markets.

Lack of management information/underwriter control are the foremost drivers of the cycle and market participants who are able to improve management information systems and introduce cultural changes stand the best chance of reducing the impact of the cycle on their businesses.

Strategies

The planning process is critical and senior management must make it clear that its strategic thinking and planning encompasses the cycle, that it expects soft markets to reappear at some stage and that its reaction will be to cut back significantly on levels of business written.

The results of this kind of view of the future are unlikely to be wholly palatable. It is much easier to live with relatively high-level fixed expenses in businesses that are more consistently profitable. However, if an outcome is to highlight the need for a more flexible cost base, then that must be for the long-term good.

Also important is aligning the interests of individuals and the business.

Most of the ideas that may be worth exploring in this context involve improving the flexibility of response. In a cyclical business, the ability to expand or downsize quickly and painlessly is a considerable asset.

The effect is to convert a fixed expense into one that is variable. Putting underwriters and others on more flexible contractual terms may be one solution. These could include lower base salaries and higher performance-related pay, stock options within corporate structures and shorter working weeks during soft markets.

There are, of course, limits as to how far or how fast management can go with this process. In practice, underwriters need to maintain a significant market presence in terms of relationships and understanding pricing developments.

Price monitoring and modelling is significant. The key questions that insurers can ask themselves to establish their position and potential in the market might include: Am I competitive in those market segments where I want to be? Where can I raise prices without losing market share?

Am I leaving money on the table? Where might I gain significant market share through small price concessions?

In underwriter-led markets, reliable management information is often more difficult to come by. Claims costs are typically far less predictable.

Better management information can make a major contribution and there are two key elements that this information should provide - a firm basis for the recent past and the means to capture the essence of movements in prices.

The best available recent historical information would include the results of the most recent actuarial review and other inputs to the assessment of reserves. There is a significant amount of valuable information here in terms of trying to establish a basis for future projections and it is all too often overlooked.

Once the best possible projection base has been established, management can start to look forward, using models of pricing movements, including the effect of changes in attachment points, terms and conditions, and so on. Combined, these two clearly have the potential to provide an early warning signal when things are going wrong and business is being written on an unprofitable basis. They can also help to update budgets and forecasts for the current period. Critically, underwriters and others populating the model need to contribute data honestly and openly.

It could be argued that implementing a management information collection process is too difficult and time-intensive, but an insurer would certainly be well advised to at least explore the cost benefits of such an exercise and give its implementation some very serious thought.

The last soft market touched bottom in 2000. Rates on most lines were already hardening prior to 11 September and continued to strengthen through to mid 2003. Since then, rates have stabilised and have begun to decline in a number of areas.

Most commercial lines of business are currently being written at profitable rates. Due to strengthening of reserves, this is not necessarily fully reflected in the financial results.

One of the features of the current hard market has been the amount of discussion and debate about how to avoid the errors of the past as the next soft market beckons. This greater awareness and recognition of the issues must be healthy, but the ultimate test will be whether, in practice, the market will be willing to undertake the necessary actions.

Conclusions

It is safe to say that the cycle will not disappear. Although opinions are consistent that the next soft market will appear, there are conflicting opinions about when it will appear and whether it is already approaching.

Insurers can and should take steps to minimise the impact on their individual businesses. The changes needed are simple in principle, but they touch on a number of key business activities - marketing, underwriting, pricing and planning - and imply that insurers need to become more flexible and more agile. If all market participants were to adopt these changes, the cycle would still be with us but its impact would be considerably reduced.

This can only be to the benefit of shareholders and those employed within the industry.