When is the hard market going to come to an end? is a question brokers keep being asked but it is a question that cannot be answered without first examining what lies behind the hard market cycle. But nor is it the most important question to be asking; are there more fundamental structural changes taking place in the industry that will last beyond any further hardening and softening of the market cycle?

The current hard market was caused by the conjunction of continued poor underwriting results, the growing need to strengthen reserves and huge investment losses. Carriers' balance sheets were caught in a `perfect storm'. The liability side of the balance sheet has been buffeted by increasing asbestos and pollution reserves and fears of further waves of claims from stress, tobacco, mould, IPO laddering, etc. At the same time the asset side was being ripped apart by writedowns on the investment portfolios, from falling share prices and rising bond defaults, losses on credit derivatives, all against an economic background dominated by low growth, low interest rates and looming fears of asset deflation.

Storm survival
To survive this storm, carriers have had to increase premium rates and mitigate exposures by tightening terms and conditions - usual hard market defence tactics. But, more important, carriers have also been making tough strategic decisions over the last couple of years to withdraw entirely from particular territories and/or classes of business (even at a time when premium rates in some classes are now at a ten-year high) because the expected returns are too low for the perceived volatility of the business. This `retreat from risk' means that if and when the market softens, it will not look anything like the market of the late-1990s. There will be fewer carriers, and they will still be writing for underwriting profit and not market share or cashflow (it may be 20 or 30 years before the next bull stockmarket). This reduced appetite for assuming the risks that our corporate clients wish, and need, to transfer is more worrying for the long-term health of the insurance industry than the extended soft markets that traditionally have followed somewhat shorter hard markets.

The conventional view of the main cause of previous hard markets (such as the liability crises in the mid-1970s and mid-1980s, and the property cat crisis in the early to mid-1990s) is of rapidly growing loss costs outrunning premiums. Broadly, these losses weakened carriers' balance sheets and players withdrew from the market (some voluntarily and some involuntarily). This reduced the capacity available, and premium rates naturally increased until either losses came back in line with premiums and/or new capital came into the industry.

However, the main cause of the market hardening that started in January 2001 was not just the level of losses that were being incurred. These had been running ahead of premium growth for some years, as evidenced by the reported combined ratios of well above 115% for many insurers and well above 125% for some of the largest reinsurers. One straw that further weakened the camel's back was the continued need to increase reserves for old losses, for liabilities such as asbestos and pollution. But the haystack that finally broke the camel's back was the onset of the bear stock market. For most of the 1990s, insurers and reinsurers had only survived the deteriorating underwriting results because of the exceptional gains delivered on their investments from the bull stock market. The bottom fell out of that strategy big time in 2001 and 2002.

The scale of capital depletion that has hit the industry over the last two to three years is staggering. The consensus is that the combination of investment writedowns, reserve strengthening and incurred losses have taken around $200bn out of the industry. This dwarfs the approximate $30bn of capital that has been raised since WTC, most of it to repair damaged balance sheets, with only around $12bn coming in as new, unencumbered capital for start-up companies. This net reduction of around $170bn in capital means that carriers can only write less premium - even though percentage increases in rates for most classes are in double, if not triple, digits.

This combination of reduced ability and appetite to write risk is hitting clients hard.

There are few winners in all this. New start-up carriers can trade into the more favourable market conditions, without the need to increase reserves for past liabilities, and can adopt a conservative investment policy. Lloyd's is a relative winner, playing to its traditional strength as the international excess and surplus market where clients go when domestic capacity becomes expensive or scarce, coupled with investment guidelines which have meant that syndicates have very little exposure to the equity markets. European reinsurers have suffered more than US reinsurers because European companies have usually had a much greater proportion of their investments in equities than US companies, which invest more in bonds.

Client interest
Clients may gain in the long run, although it may not seem like it to many of them at present. Their ultimate best interests are served by having a stable and sustainable insurance and reinsurance industry willing to accept risk; soft and hard market cycles of growing volatility do not serve either clients' or carriers' interests. So if we emerge in the mid-2000s with fewer, better-capitalised carriers and with a real appetite for accepting risk (but only at the right terms and conditions) and a better balance between soft and hard markets, then the interests of all parties will be served. Otherwise we all run the risk of shrinking into oblivion.