What goes up (Canadian Underwriter - July 2001)

ILLUSTRATION: THE IMAGE BANK

The reason for cyclical rate peaks and valleys in the international insurance and reinsurance market always comes down to the issue of supply.

By Glenn McGillivray, assistant vice president & head of corporate communication at Swiss Reinsurance Co. Canada

WHAT COMES AROUND...

T

o shamelessly contribute to the hackneyed overuse of a famous Mark Twain quote: Reports of the death of the property and casualty insurance cycle have been greatly exaggerated. The cycle is alive and well and living in p&c insurance and reinsurance markets across the globe.

Now, this is not to say that the cycle has not changed – it has. Over the course of the most recent downturn – probably the worst in recent memory – some lines became "commoditized", perhaps permanently. This is a clear side effect of overcompetition and the flood of capital that inundated many markets worldwide. But, all in all, the cycle is largely intact: p&c rates that go down still must eventually go

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up. Shareholders and market forces demand it. But what are these market forces, and what impact do they have on the supply of insurance and reinsurance? As with most goods and services, the economics can be broken down into macro (i.e. those issues that are large scale and greatly homogenous the world over) and micro (i.e. those which are more localized). Let us first look at the big picture.

Macro trends Insufficient capacity. With the latest market downturn still clearly in sight, it is hard to believe that there have been times in the not-so-distant past where it was extremely difficult to place certain risks because

of a dearth of capacity. But this very thing happened, for liability in the early 1980s, and for property in the early 1990s.

Beginning in the early 1980s, the U.S. insurance industry was seeing loss ratios skyrocket on the liability side partly due to higher claims costs associated with asbestos and environmental. The situation was exacerbated by the general trend in U.S. courts to award increasingly higher compensation to injured parties. This forced insurers to increase their loss reserves, and legal uncertainties led to a severe capacity shortage in the U.S. insurance market and, even more so, the reinsurance market. This prompted a massive increase in premium rates and restricted availability of liability covers.

www.canadianunderwriter.ca CANADIAN UNDERWRITER / JULY 2001

A similar thing happened on the property side after a dramatic capital depletion to finally show itself and, eventually, translate to string of natural catastrophes, beginning in 1989 with Hurricane weak bottom-lines.

Hugo and the Loma Prieta earthquake, and culminating in HurriSo, it is clear that rate peaks and valleys associated with the insurcanes Andrew and Iniki in 1992, and the Northridge earthquake in ance and reinsurance market are caused by capacity limitations – that 1994. The result was the bankruptcy of many carriers (eight due to is, supply more so than demand. Now that we have the background of Andrew alone), and the refusal of many more to renew or write new what drives the cycle in the world's p&c marketplace, we will turn to business in heavily exposed areas (which triggered the creation of just a few of the micro trends that are spun-off from these major instate-run insurers and reinsurers of last resort, and regulatory mora- fluences (see figure I, which is based on anecdotal evidence collected toriums on the non-renewal of business). The cost of coverage in- over the most recent soft cycle). creased dramatically for buyers of insurMicro trends The Insurance rating cycle ance. Reinsurers, too, M&As. In the decided they were insurance industry, Top of the cycle Top of the cycle Marked depletion in overexposed to hurrimerger and acquisiOften when the P&C policyholder surplus cycle is on the for 3 or 4 consecutive upswing, the overall canes and earthquakes tion (M&A) booms Competition for years. economy is on the marketshare downswing and pulled out of risky can be spurred for a -intensifies, rates are cut, and U/W results Often positive runoff weaken. More reliance areas, making cat few reasons. First, in slows down as well on investment income. runs dry Rate adequacy covers expensive for a very competitive Rate adequacy -achieved achieved Insurers and ceding companies. market where rates reinsurers ROEs bottom out. Pressure As with most busihave been cut to the Growth in nonfrom shareholders Strong industry traditional intensifies. returns spur some nesses operating in bone, organic growth markets as companies to -buyers of loosen U/W insurance/ free or semi-free marbecomes almost imInsurers strive to standards in a reinsurance seek implement rate quest to grow alternatives kets worldwide, when possible and the increases. marketshare. Start of soft market.

-there is a need not only way an insurer Some reinsurers pull out of certain lines or being filled, someone can grow is by buyretire from business. will step in to fill it. In ing another. Over the Some companies in some markets fail, others retire from certain lines or go out the case of both the licourse of the midRetro market begins to of business. More industry harden, followed by restructurings and layoffs. ability crisis and the 1990s, when cash reinsurance market.

Organic growth is very difficult. More M&As Bottom of the Sensing the upswing, property catastrophe was abundant, M&As some insurers attempt to cycle lock in cheap reinsurance also served as a way crisis, that "someone" via multiyear agreements to deplete capital was Bermuda. that was otherwise Surplus capacity. not being deployed.

Unfortunately, also with most businesses operating in free or semiThe impact of these corporate marriages (particularly the megafree markets worldwide, in time, too many companies will attempt mergers of late) is that the underlying demand for reinsurance was perto fill a market need. Coupled with other factors, such as booming manently eroded in certain markets, such as Canada. Simply put, larger equity markets (which provide capital for more insurance and reincompanies retain more risk, or reinsure via internal programs. surance upstarts, or for the expansion of existing players) and in no Over-dependence on investment income. In this country last time at all rates in many lines begin to plummet as players vie for year, the industry paid out $1.08 for every dollar of premium put on marketshare.

The Bermuda market began to shrink in the mid- to late-1990s the books (i.e. the combined ratio was 108%). It does not take much as loss experience improved, international competition ratcheted analysis to arrive at the conclusion that success in the investment upward, markets began to soften and surpluses ballooned. The area is critical under such circumstances. In a soft market, when tides that helped create the ideal conditions under which the rates are too low, the problem is exacerbated. The situation is also Bermudan insurance and reinsurance market saw its rise, had worsened when investment markets are strong: as long as the supply of capital is forthcoming, inattention to underwriting can become turned. But the segment was not alone.

Many (mostly mature) markets worldwide found that too many prolonged, dragging out the soft market for a few extra years.

Abandonment of certain lines or outright retirement from players were fighting for a shrinking piece of the pie. And in the absence of any really costly natural catastrophes, and given bal- business. Given time, the chickens eventually come home to looning capital markets, many insurers were salting away massive roost, and the pressure to reposition becomes all too real. For some amounts of cash. When capital is in high supply and the business companies, the tough times call for tough measures, and they must environment is highly competitive, some carriers tend to loosen drop certain unprofitable lines (or treaty contracts in the case of their underwriting standards in order to grow their books. If the reinsurers), sell the operation or go into runoff. The irony is that frequency and/or severity of claims, and other expenses, begin to this often happens when the cycle is poised to turn for the better. skyrocket during this time, the results can be disastrous. This is Of course, those that must take these drastic measures help to drive what happened in the mid- to late-nineties. The trouble was that the hardening as they remove capacity from the market. This is the so much cash had been amassed that it took several years for the "catch-22" of the insurance cycle. Š Swiss Reinsurance Company Canada

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www.canadianunderwriter.ca CANADIAN UNDERWRITER / JULY 2001

The impact on reinsurance. Eventual turnarounds in the p&c cycle are often partly driven by the reinsurance side of the equation. The first inkling of a firming in rates often comes from the retro market. In 1999/2000, several Bermudan and London market companies retreated from reinsuring reinsurers. And one of the three Australian carriers that closed its doors in 2000 was heavily involved in the international retro market. Reinsurers consequently have to hold on to more risk or pay significantly more for retro protection. This eventually has an inflationary effect on reinsurance rates, which may to some degree eventually flow down to the primary side.

The rise of non-traditional solutions.

When primary and, subsequently, reinsurance markets start to harden, more captives are created, and more non-traditional risk transfer/risk financing solutions are sought.

An A.M. Best report released in April showed steady growth rates for captive insurance companies – between 4.5% and 5.5% over the past several years – with an

acceleration in growth in 2000. By year-end 1999, the alternative insurance market comprised nearly 40% of the total commercial market in the U.S., and A.M. Best believes that market share will approach 50% in 2003. The market for captives, it said, will continue to grow in 2001, due to a continued firming trend in prices in commercial lines.

According to the most recent sigma study from Swiss Re (3/2001 "Capital market innovation in the insurance industry"), "by far the most important determinant of capital market insurance solutions is whether they can offer issuers competitive pricing". The issuance volume of catastrophe securitisations alone, says Swiss Re, should grow from its current annual level of US$1 billion to approximately US$10 billion by 2010.

Conclusion Many industry veterans had never in their careers seen a market downturn quite like the most recent. It was such a prolonged soft cycle, and there were so many major structural changes in the industry at

the same time, that it is understandable why some believe the cycle is dead. After all, many managers claim that they have taken drastic steps to improve their books, but are still generating lackluster underwriting results.

In response to this last concern, it should be noted that rate adequacy is not the "be-all and end-all" of the business.

Rate increases are of little consequence if claims costs and other expenses increase in tandem. Take the Canadian market in 2000 – overall net earned premium growth showed a 7.1% increase. Unfortunately, claims incurred jumped from $13.483 billion in 1999 to $15.097 billion in 2000, essentially wiping out this premium growth.

So, while the industry is starting to see some small successes with its frontal assault on low premium rates, it must be careful that it not be outflanked by skyrocketing expenses. The price cycle is not dead, nor is it on life support. But this latest downturn did not happen overnight, and it will not correct overnight. cu