Staying In the Loop

How is the cycle a good thing? For the believer of the free market’s supremacy, the natural reply is that cycles exist as by-products of the free market and therefore must be good. This opinion is based on the premise that a free-market economy, with its internally generated self-correcting and self-regulating mechanisms, represents the most efficient proposition.

The next good thing about cycles is that they accelerate the exit from a market that presents poorly reserved, capitalized or diversified players.

Next on the positive roster is that scores of financial and other data is generated as the industry goes through a cycle. This data can be beneficially used to determine the indicators of what it takes for a company to achieve its promise to pay future claims. Clients learn to recognise the behaviours that point to those few insurers or reinsurers that are likely to fail. Perhaps the most powerful indicator is pricing, because it is so closely associated with a company’s ability and willingness to correctly assess its exposures. Understanding this data and those behaviours is essential, as the 2001 Nobel Prize winner for Economic Sciences, Canada’s A. Michael Spence, suggested when he showed how “signaling” was instrumental in mitigating the negative consequences of informational asymmetries in today’s marketplaces.

Finally, cycles are fun as they don’t allow business to become a monotonous venture.

THE DOWNSIDE TO CYCLES

Cycles, especially pricing cycles, generate a lot of consumer frustration and backlash. The obvious point is that if cycles are too pronounced they tend to defeat the purpose of insurance and reinsurance, namely to mitigate the volatility of their clients’ asset portfolios.

The other major factor is that cycles create hard times for the industry as it tries to deliver adequate average returns. Because insurance and reinsurance offer results that are inherently volatile, the industry must maintain adequate levels of risk-adjusted capital. However, the perspective of the next downward phase only serves to increase the required level of capital and the cost of servicing it.

ZOOMING IN: LONG-TERM PROFIT

The Insurance Bureau of Canada (IBC) has published historical returns on equity, better known as ROEs, for the Canadian insurance industry. While these returns are at the moment still acceptable over the very long-term, they show a downward trend to an average of 8.3% across the last cycle. That trend needs to be reversed.

What takes place is easy to understand: if an individual company, or indeed the industry, has been profitable for a number of years, then new players are formed to share in these profits. Apparently low barriers facilitate their entry. However, future bad years are inevitable, not only because of the infamous cycle, but also because claim patterns cannot be predicted with certainty. If they could, the need for insurance and reinsurance would disappear. I believe that the real profitability of the industry needs to be measured over a much greater timeframe, covering not one, but three or four cycles, meaning a period of 20 to 30 years.

Thus, whilst low entry barriers are classically considered to be a good thing and a sign of market efficiency, there is a negative side.

Some investors do not fully grasp the truly long-term perspective that one should take to appreciate the industry’s real profitability. However, can they be blamed? Accounting standards require net earnings to be assessed annually, having regard strictly to incurred claims and therefore potentially leading to the underestimation of the true “(claim) cost of the product.” Extra care and effort, including superb analytical capabilities, must be deployed.

This suggests that there may be more unseen entry barriers at play. Indeed, it might appear that entry barriers are low when one focuses on the mind-boggling amounts of available capital, prone to being allocated and re-deployed quickly. There is no question that this reflects extremely well on the wealth and effectiveness of our economies.

MOVING ON UP IN THE CYCLE

Underwriting and actuarial skills and experience, specialised accounting knowledge, the necessity to build a diversified portfolio, specific IT systems, data mining and analysis protocols, the willingness to create a business that is exposed to volatility – all of these and more are needed to create a successful, sustainable insurance or reinsurance operation.

Undertaking and managing these components represents a genuine challenge that can be overlooked by new entrants.

However, pitfalls in these areas explains why the signalling virtue of cycles has yet to deliver its full self-correcting effectiveness. Markets remain imperfect in terms of understanding the true cost of the product which, despite the signals, tends to lead to pricing and other operating practices that are not always as robust as they should be.

Low average returns and sub-optimal pricing consistency and transparency further accentuate the already difficult task facing insurers and reinsurers: namely, to fulfil the following two major roles with efficacy, responsibility and accountability.

EFFICACIOUS EFFICIENCY

Delivering adequate returns to long-term-oriented investors is key to profitable and efficacious operations. Pension funds are a good example of this practice as they are extremely powerful and the future of retirement provisions lies on them.

Next in line is the importance of bringing value to the community. By establishing the incentives to take the appropriate measures at the right time, our industry exercises an important loss prevention function. If the true cost of exposures is underestimated or under-reported, for whatever reason, then societies may fail to act preventively. That, in turn, may lead them towards ever costlier and ever more painful occurrences.

THE NEXT STEP

Cycles are inevitable as they are entrenched in market mechanisms. The underwriting cycle proper and other patterns arising from the variability of loss experience due to random movements and developing trends are inextricably related, but the former is the place where good management can exert a decisive influence and where the industry can at least try to mitigate the cycle.

The central idea to enable the mitigation of the cycle is focusing on stabilising one relatively unbiased metric at a suitably high level: the operating underwriting-year ROE or, in the case of not-for-profit, mutual and co-operative organisations, a proxy ROE.

The pricing component of this has been made more important because investment income has been decreasing over the past ten years. Take the example of Canada: a recent study by Scotia Capital, presented at the IBC Financial Affairs Symposium on March 30, 2005, based on OSFI numbers, shows that Canadian insurance companies’ annual return on investment decreased from 11% in 1996 to 5% in 2004.

Maintaining a heavy focus on achieving an adequate operating ROE predicated upon solid and consistent reserving practices as well as active capital management, and working towards better understanding and disclosure of the true cost of ever-increasing insured and reinsured exposures, are the things that matter.