Dr Robert P. Hartwig examines how economic events in the 1990s have fundamentally transformed how corporate America views insurance and how insurers view themselves.

The crescendo in global financial market instability since mid-1997 demonstrates that property/casualty insurers, like the entire financial services industry, are now operating in an environment over which they exercise very limited control. As insurers survey the economic landscape in the late 1990s, they will find few of the familiar reference points that in decades past helped guide them along the path to growth and profitability. The once rhythmic underwriting cycle, for example, has vanished. In its place, insurers find themselves fully exposed to domestic business cycles and to the uncertainties associated with exchange rate volatility and international capital stampedes. Yet by no means have insurers ceded control of their destiny to today's market chaos. While not masters of their own near-term destiny, insurers are pursuing long-term strategies that will fundamentally reshape the industry well into the next century.

In this article we examine how economic events in the 1990s fundamentally transformed how corporate America views insurance and how insurers view themselves. Several of the more important lessons learned so far in the decade are discussed, as are strategies insurers are employing to cope with their new-found reality. Lessons learned include acceptance of the underwriting cycle's demise, the dominant role of capital flows on industry performance, and the impact of economic growth and recession on the industry.

At the crossroads: the 1990s in retrospect

The fortunes of the United States economy and property/casualty insurers diverged in the 1990s, though neither began the decade on a particularly positive note. The decade opened with the country slipping into recession and making preparations for war in the Middle East. Inflation was accelerating, unemployment was rising, and irresponsible fiscal policies were producing ever-larger federal deficits. But by 1996, after a protracted period of tepid growth, economic activity finally accelerated. Quarter after quarter, the economy surpassed even the most bullish of analysts' expectations, arguably producing the healthiest economy in a generation. Inflation, unemployment, and long-term interest rates fell to 30-year lows in 1997 and 1998. Consumer confidence reached record levels. Even chronic and vexing economic ailments were cured. Medical inflation fell from 9.0% in 1990 to just 2.8% in 1997 and the federal budget, which ran a record deficit of $290 billion in 1992, was in surplus by $70 billion in 1998. For many Americans, memories of the early 1990s receded like a bad dream.

The tale of property/casualty insurers in the 1990s is more tragic - a bad dream that has become the industry's reality. The brutal economic climate of the early 1990s fundamentally restructured corporate America. Companies large and small scrutinized their operations, re-engineered their work processes, and questioned every expense. The objective - increased efficiency - exacted a steep toll on virtually all inputs to the productive process, including insurance. Insurance, like labor, was expendable and commoditized. If technology could supplant labor in the workplace, then certainly the same technology could be brought to bear on the cost of managing risk. Corporations quickly found that higher retentions, self-insurance, captives, and capital markets were all viable alternatives to traditional property/casualty insurance. In effect, these alternatives could substitute for some, if not all, property/casualty coverages. At the same time, state regulation of prices was scaled back and Depression-era legislation that restricted and separated the activities of insurance companies, banks, and other financial intermediaries began to crumble.

The harsh realization of the changed economic environment would not be fully and completely recognized by property/casualty insurers until the mid-1990s.

Whither the underwriting cycle?

The underwriting cycle is, for all intents and purposes, dead. Every attempt by God and man to revive it has failed. Spiraling combined ratios in key lines, unprecedented losses from natural disasters, and occasionally poor investment results have all failed to produce a sustained and widespread impact on pricing. Events such as these would surely have precipitated a hard market in the past. In retrospect, the days of the underwriting cycle were clearly numbered. No general cycle has been observed since the 1960s. Cycles affecting primarily auto insurance and commercial liability coverages occurred in the 1970s and 1980s, respectively. Moreover, the trend toward cash flow underwriting, in which operating results depend more critically on investment performance than underwriting results, obscures and diminishes the importance of the underwriting function.

Waiting for the underwriting cycle to boost prices and profits is unproductive and unwise. It is unproductive because the US property/casualty industry entered the soft phase of the underwriting cycle during the late 1980s - 10 years later, it is still there. No substantial hardening is expected and any hardening that does occur is likely to be short-lived. As a consequence, insurers need to develop growth and investment strategies that do not depend on the predictable tides of prices and profits that once characterized the property/casualty insurance business. To this end, many insurers have adopted a strategy of growth through acquisition, globalization, and diversification.

Wistful remembrances of the underwriting cycle are also unwise. Any event that could precipitate a general hardening of the market in today's highly capitalized and underleveraged environment would have to be a natural or financial cataclysm of unprecedented proportions. The costs would far outweigh the benefits. As the old adage warns: Be careful what you wish for . . .

The demise of the traditional underwriting cycle does not preclude the existence of future cycles. Future cycles are more likely to result from volatility in financial markets and the transmission of the general economy's cyclicality to the property/casualty insurance industry. Again, cash flow underwriting increases the industry's exposure to capital cycles. Increased reliance on investment performance means that financial market cycles are now of paramount importance.

Capital punishment

Industry observers bemoan the recent rapid accumulation of capital on property/casualty insurer balance sheets. Of course, from the perspective of policyholders and regulators, the industry's rapid build-up of capital is a positive development. The ratio of net written premium to surplus ratio fell to 0.90 in 1997, its lowest level in more than 50 years.

Investors take quite a different view. Ridding the industry of "overcapacity" has become their mantra. Unfortunately, most strategies for expunging excess capital do little to improve long-term growth and profitability. Stock buybacks are among the most popular strategies with investors. While buybacks may provide investors with a small boost in share price, they do not address the company's fundamental growth problem. Of course, insurers could always increase dividends to policyholders and/or shareholders. There is intuitive appeal to this approach since it releases the excess capital to its owners, though the issue of long-term growth remains unresolved.

Many insurers view the abundance of capital as a unique opportunity for growth. Some companies have redoubled efforts to grow "organically" through investments in product development and geographic expansion. But the prospect of growth through merger and acquisition has captured all the headlines in 1997 and 1998. Mergers and acquisition make sense if the combined entity can generate economies of scale, results in significant "cross-selling" opportunities, and/or increases market concentration. While wildly popular with investors, the ultimate success of such deals is, of course, by no means assured and will ultimately be tested in the marketplace.

Abundant capital also permits insurers to make substantial investments in technology. Enhancements to an insurers' technological infrastructure are often expected to yield significant efficiencies, generally through reductions in claim costs and/or expenses. More efficient claims handling procedures, the rapid identification of fraudulent activity, and internet and telephone sales are common applications.

Overcapacity has also provided insurers with considerable latitude in their pricing of policies. Combined with the incentive to expand geographically and into new lines, insurers frequently find themselves engaged in intense battles for market share. Price discounts are the weapon of choice. While not a strategy for reducing overcapacity, intense price competition in many property/casualty lines will prove to be quite effective at bleeding capital from the industry. Such a strategy sacrifices profitability for the sake of market share. Deteriorating combined ratios are the only possible outcome.

Finally, it is with some irony that in the midst of a perceived glut of capital, insurers find themselves in search of still more. The principal justification for demutualization, for example, is access to the equity capital markets. Likewise, the objective of securitization is to tap the vast resources of the world's capital markets.

Villain and savior in one, global capital markets are destined to play a larger and possibly dominant role in the evolution of property/casualty insurance.

Economic cycles

Industry folklore suggests that the property/casualty insurance industry enjoys a special immunity from the economic currents that sweep across the United States economy, but premium and profitability data for the past 25 to 30 years indicate otherwise. Real (inflation-adjusted) premium volume, is quite pro-cyclical, tending to rise during periods of economic expansion and slow down or even decrease during periods of recession and economic sluggishness. As indicated in Chart 2, real premium growth was negative during all or part of each of the last four recessions: 1973-75, 1980, 1981/82, and 1990/91. Returns on equity (ROE), depicted in Chart 3, were likewise adversely impacted by recession, generally trending lower during these periods (while also consistently trailing the Fortune 500 group).

Property/casualty insurance has been and will continue to be subject to the same global economic forces that determine the fortunes of all industries. Economic turmoil in Asia and Latin America, for example, has roiled US financial markets and adversely impacted insurers through their investment portfolios even though the industry's direct exposure to these economies is limited.


US property/casualty insurers held $766 billion in cash and invested assets in 1997. Two-thirds of these investments were held in the form of bonds, another 18% as common stock. This substantial portfolio is the principal portal connecting the US property/casualty insurance industry to the outside world, despite the fact that less than 5% of the industry's stock and bond holdings are from foreign sources. Part of the industry's new reality is the recognition that even a dollar-denominated portfolio of impeccable quality will be shaken by global financial instability.

In spite of the uncertainty in many of the world's economies, property/casualty insurers are seeking to make their mark in this new era of financial service conglomerates. Current trends toward consolidation, financial services integration, demutualization, globalization, deregulation, and securitization will continue, albeit at a somewhat more cautious pace. Hazards abound, but if the vision of the industry is realized, the insurer of the 21st century will offer a seamless array of personal and commercial financial products and services custom tailored to the specifications of customers around the world.

Dr Robert P. Hartwig is vice president and economist for the Insurance Information Institute (III). Prior to joining the III, he served as director of economic research and senior economist with the National Council on Compensation Insurance (NCCI). He has also worked as senior economist for the Swiss Reinsurance Group and as senior statistician for the United States Consumer Product Safety Commission. He is a member of the American Economic Association, the American Risk and Insurance Association, and the National Association of Business Economics.