Has the “Cycle” broken?

The traditional insurance planning/business cycle has become unpredictable to the point of near extinction. This is not to suggest business cycles have become a thing of the past. Every industry experiences peaks and troughs linked to economic trends and other performance indicators. Insurance is no exception.

However, what has changed according to two recent global reports and a body of domestic evidence is that the so-called “hard” and “soft” market cycle that p&c and reinsurers once planned and priced around is presently on life support (if not dead already) – no resuscitation needed.

First Consulting suggests that the traditional cycle is already a thing of the past. This is supported by CNA Re’s report, “Against the Tide: Charting the Course Back to Profitability”, which notes that the return to the levels of sustainable profitability that has historically followed any soft market is, in all measures, long overdue. This analysis was recently echoed by the Insurance Bureau of Canada (IBC) in “Perspectives”, when it asked: When will the pendulum swing? Put in a Canadian context, in the last 50 years, the length of an average underwriting cycle (the point where the combined soft and hard market have done a complete turn) has been 6 to 8 years. In every cycle the price cutting and over capacity of the conventionally longer soft market was more than compensated for by the financial discipline of a shorter, but tighter hard market.

Global phenomena

This is not just a Canadian phenomenon. Since 1948, for example, the length of underwriting cycles at Lloyds of London has varied from five to 11 years, with upturns lasting two to six years, and downturns slightly longer at three to six years. But, the intensity of these cycles has increased in more recent times, and the height and depth of each successive cycle has deepened.

Similarly in Canada, since the last underwriting profit reported in 1978, there have been two short, but pronounced, underwriting cycles where premium increases of up to 20% were required to restore profitability. This was followed by a third less pronounced cycle that preceded the current prolonged soft market environment.

Global capital

When the pendulum does finally move in a more favourable direction, it is unlikely that the swing will be far enough or long enough to repair the damage of a prolonged soft market which has contributed to soft pricing, disappointingly low returns on earnings and a stubbornly high combined ratio of 106.8 (down slightly from 107.8 in 1998, but off considerably from the 102.6 the industry recorded in 1997). First Consulting suggests that the increased global movement of capital will cause near permanent soft market conditions. That is perhaps too extreme to predict, especially when describing the Canadian marketplace. What is clear, however, is that strong capitalization and investment gains made in an aggressive bull market means that some companies can afford to play the historic soft market game for years to come.

In his Perspective article, “Too Much of a Good Thing” (March 1999), Paul Kovacs, chief economist of the IBC, comments, “the reduced risk of an insurance insolvency is welcome, but it is possible to have too much of a good thing”. Nor does such a reduced risk erase the fact that the traditional planning cycle is no longer a path to long-term growth and profitability. So, what is? According to a recent McKinsey & Company report, the best strategy in dealing with the traditional planning cycle is to ignore it. Indeed, when Lloyd’s of London took a sharp axe to capacity after crippling losses in 1991, both premium rates and return on capital experienced a sharp climb.

Nerves and discipline

Does Canadian property & casualty insurance have the discipline to ignore worn out (but tested) approaches to the traditional cycle, particularly when over capacity continues to drive lower pricing as a means to achieving greater marketshare? It is far too early to say. Certainly mergers and acquisitions (including that of Royal with SunAlliance) have altered the landscape. Twenty years ago, when Canadian property & casualty was served by much smaller companies, performance was driven by the industry itself. Today’s companies are not only larger, but are more developed in terms of collecting data that performance can be driven independent of industry trends – including the planning cycle. The First Consulting report argues that mergers and acquisitions have produced insurers large enough to sustain soft market conditions for longer periods without having to squeeze the pricing lever.

Over the longer term, all companies – large and small – will need to excel in product delivery, loss control and process engineering in order to prosper. One of the consistencies of the traditional underwriting cycle, according to CNA Re, is that those who adjust their underwriting the least to cope with a cyclical market also happen to be the ones with positive long-term results. Instead, they employ solid underwriting fundamentals in pursuit of their core business strengths and specialties. They also take a holistic approach to underwriting that sees the process as encompassing more than just the selection of risk, but also the effective engagement of actuarial, claim, loss control and service expertise. They also place major emphasis on developing the talent and skills they require in key underwriting positions. Finally, these companies empower their underwriters to actually underwrite – making business judgments based on the application of sound principles to the individual characteristics and needs of every customer.

Applying a steady hand to the underwriting and pricing of risk is the surest way to provide a consistent market for customers while achieving a reasonable return. Conversely, the facts indicate that the surest way to delivery consistently poor results is to “soften” or “harden” underwriting executive depending on the conditions of the moment.

The hard-line

Engineering a lasting change must begin with a “top to bottom” review by every company of every piece of business on its books. The objective must be to ascertain whether every account is generating appropriate rates of return on a risk-adjusted basis.

These decisions are not easy ones, nor will they be universally popular with producers and customers. However, we believe that these kinds of proactive steps are absolutely critical to ensuring our industry’s ongoing ability to provide clients and brokers access to the stability and product innovation they require from our business. The familiar planning cycle has been bent out of shape to the point of becoming irrelevant to Canadian insurers. As the recent melt-down of Nortel shares on the Toronto Stock Exchange reminds us, investment income can not mask unprofitable underwriting for long.

The industry’s approach must become an unwavering flat line that cuts through the peaks and troughs of hard and soft markets. CNA Re writes: “While renewed emphasis upon core underwriting values is unlikely to ever completely blunt the competitive ebbs and flows of our market place it will go a long way toward keeping our business off the rocks and on course toward a brighter, more consistently profitable future.”