The Inevitability of Market Cycles

At an industry meeting some time ago, I heard someone say: “Insurance is the Shiva of Capital.” I am not a student of world religions, but the reference to the Hindu deity that is both the “destroyer and restorer” of worlds plays frighteningly well in insurance. We are in the business of cycles, soft and hard, profit and loss.

Why do market cycles occur? Can we as an industry do a better job of managing market cycles? Why is it that clients do not need an explanation when their premiums drop by 15%, but cannot wrap their heads around a 15% increase?

There is no single explanation for market cycles and thus there is a danger in oversimplifying the reasons. Although the “the interest rate environment,” or “the catastrophes,” or “the lack of catastrophes” or “the harsh statutory environment” etc. offer interesting perspectives, my view is that the multiplicity of variables that influence our industry often cloak the root causes for the ups and downs in the insurance market.

Like many of you, I have attended conferences, meetings and educational seminars on industry trends. How often have we heard speakers describe the effects of the cycle, and perhaps point to the heavens to suggest why a change in the market is imminent, but almost never venture to answer why cycles occur? You can understand the frustration of buyers: Would people feel confident in our banking systems if they contained the same vagaries that seem to haunt the insurance business?

Data from the Insurance Information Institute shows the U.S. property and casualty market failed to make an underwriting profit for the years between 1978 and 2003. In the past 40 years, the industry has racked up a total underwriting loss of US$440 billion. Contrast this against seven years of underwriting profits that offset the US$440 billion loss by a paltry US$41 billion! What business do you know that can over time lose $10 for every $1 it makes and survive? Apparently only one – insurance.

THRIVING, EVEN IN BAD TIMES

The symbol “9/11” is forever more than just a date: It is an image. In no way diminishing the human loss, the event sent ripples through the insurance world on a number of fronts. Financially, the numbers at the time were daunting: a US$50-billion loss was the generally accepted estimate.

The insurance market had started to firm up in late 1999 or perhaps early 2000. Companies seemed to be “suddenly” under-reserved with massive consolidation followed by evaporation of capacity. This generated rate increases that were gentle at first but hit hard post-9/11.

Even when supported by rising rates, it is remarkable and perhaps lucky that the industry not only survived, but actually thrived in the face of 9/11, the hurricane quartet of 2004 (Ivan, Charley, Frances and Jeanne) and the 2005 group of hurricanes headed up by Katrina, Rita and Wilma. But that deity Shiva did her thing, replenishing the supply of capital to Bermuda, London and New York.

In 2006, which I believe we will soon start referring to as the “good ol’ days,” ratings agency A.M. Best listed 15 U.S. property and casualty insurers as “impaired.” That means the industry had its best year in the past half century and yet 15 insurance companies still went under.

No doubt 2006 was a vintage year for the insurance industry. Virtually no catastrophic losses, benign inflation coupled with solid rate adequacy left the industry in an oddly precarious position: drunk on excess capital. What to do?

Apparently, the answer is to grow market share by using that capital to write more business at rates “just marginally” lower than current levels. In a world devoid of significant competition, this is a great strategy. However, as David Wilmot, Toa Re’s immediate past senior vice president and chief agent in Canada, once said: “I risk making the obvious seem profound by saying that we all can’t grow market share at the same time.” Think about that.

Interestingly, a commercial lines pricing report produced by Market Scout indicates the industry achieved accelerating rate increases for only nine months peaking in July of 2002. In other words, rate increases began decelerating in 2002; in March 2006, rate changes moved into negative territory. Depending on how you count it, we are already between two and four years into our next soft market. Shiva is back with a vengeance.

Aggressive deployment of capacity within the insurance sector is almost always counterproductive for companies, brokers and shareholders. Investors that demand returns on capital seem to ignore the very dynamics of overcapitalized entities.

MOVING FORWARD

Can we manage our way through these cycles? My belief is that if we are going to manage something, we have to understand the fundamental dynamics of all the variables that might have an impact. This would include exploration of the combinations of variables, the magnitude of results that can lead to change, an understanding of the current data, where the change is headed and the variables that affect the change process. At the end of all this, we need to have a plan and must monitor the results. Complicated? Yes, and probably the reason we as an industry don’t manage, but rather ride the tidal wave-like flows of market cycles.

The insurance cycle is affected by a wide-ranging group of related and interrelated forces. Capital markets, interest rates, rating agencies, legal systems, distribution systems and more. The more complex a system, the more moving parts, the greater the likelihood of instability.

In air force terms, a crash is defined as “a landing where the forces of deceleration are so great as to cause structural failure.” Of course it is a landing, just not a very good one. Certainly the forces of deceleration are at work on the rates and revenues of just about every insurer, reinsurer and broker. Promisingly, however, other forces are at work that might make the “landing” a bit more tenable.

First, rating agencies are a de facto license to practice insurance. Capital allocation models have been tightened in a way that that should serve to moderate longer-term destructive behaviours. In this day and age, you lose your rating, you lose the company.

Second, our long-term data is better. Rate monitoring has significantly improved over the past 10 years. Mistakes, overly optimistic projections and reserving can still create perilous inflection points for companies. But most will pull out of the dive earlier than in past cycles because they have better data to help them see the ground in time to respond.

Third, in spite of what P.T. Barnum said, the capital market is slowly learning firsthand how not to be an insurance “sucker.” Major disasters occurring over the past decade have made it abundantly clear to the casual observer that insurance is a damn risky business. Global warming or no global warming, Hurricane Katrina was a wake-up call to the damage a major windstorm can cause. Spates of earthquakes have occurred since the 9.0 monster that caused the tsunami in East Asia. Gratefully, none have ripped open the economic hole that Katrina caused — yet. A billion dollars just doesn’t go as far as it once did; it can be easily erased over the course of a breezy afternoon in October.

Finally, the shadow of Sarbanes-Oxley may provide a modicum of influence to maintain conservatism of capital reserves in the face of cascading rate decreases. It is axiomatic to state that you can’t drop rates 10% each year over three or four years and, in the face of inflationary loss costs and indemnity pressure, deliver the same results.

Have you met my friend, Shiva?