Jonathan Isherwood asks whether it is wishful thinking to assume that the many changes which the re/insurance industry has undergone in recent years will result in a more effective management of the re/insurance cycle?
Has the re/insurance industry finally learned how to manage cycles?
A look at years of historical evidence suggests the industry inevitably will again fall into a period of cutthroat price competition. However, dramatic changes have occurred in the insurance industry over the past four years. Indeed, there appears to be the emergence of a new business landscape where rates will keep bumping up and down according to competitive forces and claims experience, but not at the extremes or volatility seen in years past.
Is this wishful thinking or has the industry finally woken up to hard business realities? Encouragingly, a survey sponsored by GE Insurance Solutions revealed that 85% of respondents believed their companies were well prepared for the next deterioration in market cycles.
Nevertheless, the industry's history in this area is not very promising, similar to the New Year's resolution that gets forgotten by March. Indeed, the survey's respondents also revealed there are obstacles to effective cycle management, which may weaken current resolve. For example, it found that the top three obstacles to an effective underwriting cycle management process were:
- Difficulties in sustaining client/broker relationships if exiting classes of business in a soft market (cited by 49% of those surveyed);
- Difficulties in determining/monitoring premium rate adequacy (cited by 46% of those surveyed); and
- Difficulties in determining when the underwriting cycle will turn (cited by 43% of those surveyed). (See figure 1).
One could speculate that market pressures again will lead the industry down the slippery slope of excessive rate competition. But there are other factors at work, which may favour more sensible underwriting practices, ie, ones that generate underwriting profits and, hence, long-term market stability. Managers have learned the price of underwriting at levels that are below the cost of risk. Over the past several years, a few re/insurers have teetered on the edge of insolvency; some have gone into run-off; financial security ratings have declined across the industry; other companies have been forced to exit unprofitable markets; and many industry players are still paying for the soft market rates charged in the 1997 to 2001 period.
In addition, the requirements of Sarbanes-Oxley have concentrated the minds of company directors doing business in the US on adopting proper risk management, capital management and cycle management techniques. It is their responsibility to assure that their companies have prudent management reporting and controls. European companies also are facing increasing regulatory pressures with the introduction of Solvency II, the proposed European Union directive, which is due to go into effect in the next few years. The directive is intended to increase the transparency of the industry's financial statements and institute a risk-based capital approach to determine the assets a company must retain to support its underwriting.
Risk management is another name for cycle management and capital management.
Capital needs to be managed in order to position it in profitable lines of business, while risk management tools are needed to assure that capital matches volatility. According to the survey, 95% of respondents agreed with the statement: "Effective and competent risk management can reduce solvency capital requirements." (The 95% figure was comprised of 51% of respondents who fully agreed with the statement and 44% who agreed somewhat with the statement.) (See figure 2).
The survey also found that 84% of the respondents agreed that "Solvency II will lead to increased transparency in an insurer's financial strength/weakness." (The 84% figure was comprised of 35% of respondents who fully agreed with the statement and 49% who agreed somewhat with the statement).
As a result of Solvency II and International Accounting Standards, 46% of the companies surveyed - on a Pan-European basis - have already implemented activities to improve monitoring and actuarial calculation of loss reserves, while another 37% were in the midst of implementing such activities or had future projects planned.
The need for strong capital and cycle management systems has an added poignancy, given the fact that the global investment community has grown increasingly impatient with the industry's consistent poor return on equity.
The industry needs to charge adequate rates in order to provide stability for its shareholders.
Last but not least, there is the issue of rising claims costs, for both liability and property business. Liability claims need adequate underlying rates; the reserving increases required by many companies in the industry as a result of the 1997 to 2001 competitive rating period aptly demonstrate the perils of inadequate pricing. At the same time, catastrophes are increasing in their frequency and severity; catastrophe rates should be dictated by the parameters of advanced modelling techniques rather than the vagaries of market forces.
The landscape for the re/insurance industry indeed has changed in four short years. The pressures preventing a return to unwise underwriting behaviour are very strong.
Perhaps, however, the dynamic of insurance cycles is different for small-to-medium-sized European insurers - the subjects of the survey - than it is for other global markets (see figure 3). Perhaps indications of a commitment to cycle management is an anomaly of smaller European insurers.
After all, 69% of survey respondents indicated that the duration of a cycle was typically five years. On the other hand, it is commonly thought that the global re/insurance market has cycles that last about seven years.
(For the purposes of this article, a cycle can be defined as the time it takes for rates to drop from their peak and rise to another peak.
It also can be defined as the time it takes for rates to go from one rate trough to another rate trough.)
Although there are different forces affecting retail and wholesale (reinsurance) cycles, both are driven by the law of supply and demand. For both segments of the industry, heavy competition and a flush of capacity, tend to drive rates down. All participants in the marketplace are affected by global as well as local forces; it's just a matter of scale and timing.
Do the new business realities portend an end to the cycle? Hardly likely - rates will continue to fluctuate according to competitive pressures, available capacity and claims experience. Indeed, despite the natural catastrophes experienced in 2004, reinsurance property rates have dipped slightly. However, that does not indicate they will drop to the lows of the late 1990s.
The big effect of the new pressures on the industry likely will be to decrease the volatility of the cycles as well as their length, particularly for the reinsurance sector. There are strong suggestions that future cycles will experience fewer extreme rating highs and lows. Although rating adjustments will be made, the market will react more quickly, resisting rates that threaten prudent risk management practices. This is a good sign. Quick reactions are an indication of a healthy re/insurer, which moves rates up and down according to its own business needs, rather than following the competitive herd, as has long been the tradition of cycles past.
Jonathan Isherwood is Global Property Leader at GE Insurance Solutions.