Will the lessons of the past be remembered this renewals season, asks Ronn Mullins, or will it be a case of making hay while the sun shines?
"Mr Scorpion wants to cross the river, but can't swim. He goes to the frog, who can, and asks for a ride. Frog, knowing the scorpion's impulsive reputation, says, 'If I give you a ride on my back, you'll sting me.' Scorpion replies, 'It would not be in my best interests to sting you since, as I'll be on your back, we both would drown.' Frog considers this logic for a while and finally accepts the deal. The scorpion climbs on his back and off they go into the river. Halfway across, the frog feels a burning in his side and realises the scorpion has stung him after all. As they both sink beneath the water the frog cries out, 'Why did you sting me, Mr Scorpion, for now we both will drown?' Scorpion explains, 'I can't help it, it's in my nature'."
Consider that Mr Scorpion is the leadership of the reinsurance industry and the optimistic, trusting investment/regulatory/ratings/commercial sector, the frog. The scorpion with robust assertions that it will never again indulge in cutthroat competition and under pricing actions that resulted in past dismal-earning years convinces the frog that it has learned its lesson. The frog relaxes, looks favourably on the industry, but is soon shocked when the industry begins cutting prices and almost giving the product away, no questions asked. After all, it's in the industry's nature.
Unlike most cycles where the intervals can be measured with some accuracy and predictability, the reinsurance cycle seems to rise and fall with little relevance to stern logic or fancy mathematical formulas. The industry has to contend with punishing regulations and laws, political, economic and consumer pressures, rating agency overview, new competitors and, hovering above all that, the destructive forces of nature and man-made acts that can catastrophically affect the cycle, converting overnight a profitable year into a losing one.
Using the combined ratio as an available and historic measuring device to separate the profitable underwriting years from those that were not, from 1979 until 2003 there was no year in which the P/C insurance industry had a combined ratio under 100%, the point where losses, loss expense and policyholder dividends equal earned/written premiums. There has been only one year since 1970 when the underwriting loss for the insurance sector was so colossal it overwhelmed investment income producing a net loss of $7bn in 2001. The reinsurance sector's combined ratio tracks the ups and downs of the P/C industry, only reaching greater highs and having more volatility. In 2004, like the P/C insurance industry, US reinsurance companies turned in a combined ratio of 98.1%, reaping billions of dollars in profits.
Cycles here to stay
Insurance is an industry characterised by cycles, says Jonathan Isherwood, leader of GE Insurance Solutions Global Property Business Unit, and he doesn't believe that in its current form it will ever go away. "It can be moderated by management actions, and controllable factors, but there is a fundamental cycle," he said. "It is a commodity business driven by supply and demand."
Cycles have historically been driven by supply and demand imbalances, agreed Mark Lescault, chief underwriting officer, Swiss Re Americas, and noted that an optimal balance is difficult to reach and impossible to maintain. "The fluctuation in available capacity will underlie the continuing cyclical nature of the insurance industry," he said. "While I believe cycles will always exist, their amplitude can be moderated with the discipline that focuses on bottom line results rather than top-line premiums as a company's first priority."
Tom Upton, managing director, Standard & Poor's, said, "Clearly, supply and demand works to influence pricing and thus cycles. If there is an abundance of capital, it will have an effect of dampening prices but we have not seen any suggestion of this. I don't see January renewals turning down."
At the opening of session of McKinsey's European P&C CEO Conference in London in April 2005, a survey of the CEOs there showed that 68% said, "My company will continue to price rationally even through a downturn in the cycle." Thirty-two percent said they will not continue to price rationally in the next cycle. But when asked if they thought their competitors would continue to price rationally, only 19% said yes, 81% said no.
Insurers and reinsurers learned many painful and expensive lessons from the last soft market of the late 1990s, said Matthias Weber, member of the Extended Management Board, Americas Division, Swiss Re Americas. "Managements developed new processes and put in place tougher controls that were all focused on getting back to the basics of solid underwriting, claims handling and reserving," he said. "It is easy to correct the sins of the past when their consequences are still fresh or even continuing over a number of years. The true test will be management's resolve to maintain strict implementation going forward and not just as a short-term reaction to a problem. The companies that maintain this discipline will be the ones that outperform their peers and produce sustainable returns for their shareholders."
A report from ISO's Property Claim Services (PCS) as of 29 November puts the estimate for 2005 catastrophe losses at $50.3bn - an all-time record.
The year's three most devastating hurricanes - Katrina, Rita and Wilma - together account for $45.2bn, or 90%, of the total catastrophe loss from 22 events. The hurricane season this year - the most active ever with 13 named hurricanes - officially ended on 30 November. But PCS warns that 2005 catastrophe losses are likely to climb with additional claims expected from the three hurricanes and possibly winter storms.
According to a survey of reinsurers' statutory underwriting results conducted by the Reinsurance Association of America, a group of 26 US property/casualty reinsurers wrote $18.8bn of net premiums during the nine months ended 30 September 2005, compared with $22.3bn in the 2004 period. The reinsurers' combined ratio was 124.1%, compared with 103.9% for the period in 2004.
The underwriting loss was $412m, which produced a net loss of $133.6m for the first nine months of 2005.
The record catastrophe losses in primary and reinsurance this year certainly will reverse what appeared in the first half to be a profitable year for the industry. While the industry may turn in an underwriting loss for 2005, the need to use surplus to pay claims and set up reserves to cover losses from the hurricanes may halt what was beginning to be an increasingly competitive market. Upton said, "I think there is no question natural and man-made developments can disrupt cycles. In early 2005, there was some softening in a number of lines, but thankfully we did not see instances where there were unrealistic pricing wars. Instead, I would like to think that more sophistical risk management and pricing sophistication have made companies unwilling to turn a blind eye to writing business willy-nilly. Now, in terms of pricing behaviour, it is easy to see a hardening in almost every line of the companies we talked to."
Sophisticated self interest
Tremendous changes in technology, plummeting computer data storage costs, strong advances in predictive models, greater use of credit scoring, all of these related sophisticated analytical techniques allow insurance people to ascertain risk much more accurately and precisely than in the past.
"These technologies have made it easier for upper management to monitor the operations and impose discipline across operations," said Mike Murray, assistant vice president of Financial Analysis, Insurance Services Office.
"I mean that management of insurance and reinsurance companies have a much greater ability to drill down and see that individual desk underwriters are adhering to company policies and underlying pricing and other guidelines. There are enablers in place."
Jeff Berg, vice president and senior analyst at Moody's, believes the industry has learned a lot about risk management and more precise underwriting over the last several years, but at the same time, "the third quarter catastrophe losses were such a significant single event loss that these storms will again provide more opportunities for companies to improve their risk management, aggregation of risk, and risk tolerance levels and ultimately pricing for those risks they still wish to underwrite."
New risks continually emerge from a variety of areas - technological advances, disease, and legal changes to name a few. "Our challenge," said Swiss Re's Lescault, "is to identify, analyse, manage and adapt to the change so that we can bring it into the underwriting of our products before, rather than after it manifests in significant claims activity."
ISO's Murray feels that even with all the power provided by science and technology, senior management at individual insurance and reinsurance companies make the decisions about how their companies will participate in specific markets. "People still have input into the process, even when the decision is automated," he said. "I am an economist and believe people tend to operate on perceived best interest for their company and themselves. This is what drives cycles. It is often not the case that what is in the best interest of a company is in the best interest of the overall industry. A company competes for market share by lowering its own prices to attract new business to spread its costs and improve its overall rate of return. If only one company does it, then that one company will do well. If each company begins competing for business in that reckless fashion, it happens that no one succeeds."
Upton optimistically hopes the industry will stand firm on pricing. "Everyone says, 'No, we have learned our lesson'," he said, "but we can only hope that is the case."
The human element
In the 1980s and early 1990s, interest rates soared and companies began writing business at less than realistic pricing to get the premium to increase investment income, thus driving the industry into an underwriting loss. Isherwood doesn't see that happening again very soon. "Interest rates are too low," he said. "Still there may be some insurers and reinsurers that believe they are sitting on a larger loss that further inquiry will reveal. They may think that the new losses will require further reserving and that they had better write a bigger book to cover the losses with more premiums."
As interest rates continue to increase in 2006 it may detract from the strength of pricing increases. "The wild card is not the interest rate," ISO's Murray observed, "but it is capital flows. The capital inflows and behaviour of that capital will more directly influence insurance and reinsurance markets." While the new capital being raised in 2005 is a fraction of what was invested following 9/11, "it is not clear when this capital raising business will come to a close," he continued. "Having capital is not the same as actually deploying that capital. If management and investors are willing to be patient and the entities are viewed as in the game for the long haul to preserve capital, to take advantage of true opportunities, then that capital may be employed in an orderly manner. If they want to write as much business as they can, then the new capital may have a disruptive effect on the market."
"While the effects of the 2005 hurricane season will be dramatic, and are not yet fully realised, we still anticipate that industry-wide property/casualty insurers will report strong results for the 2005-2007 period, with industry-wide ROEs above 7%," said Clint Harris, analyst at Conning Research & Consulting. He predicts that due to increasing price competition, the property/casualty industry performance will turn down somewhat over the next three years, but doesn't see the cycle hitting record lows.
The industry is solid, according to Upton of Standard & Poor's. "I think that the best thing from the disasters in 2005 was that no one insurance or reinsurance company went under, yet. This speaks well for the discipline of industry management and the productive use of resources.
"That said, when you write insurance, you are in the business of predicting the future, and there is always the problem of self deception. People being people, I don't think you can ever take the human element out of it, it will never disappear entirely. I think, however, the business will be managed better than it has been in the past."
Pano Karambelas, vice president, senior analyst, Moody's, paraphrasing Mark Twain's response when his obituary was prematurely printed, observed, "Any idea of the impending demise of the insurance cycle is greatly exaggerated."
- Ronald Gift Mullins is an insurance journalist based in New York City.