Nick Line looks at the reserving cycle, while Martin White addresses the issue of managing companies through the underwriting cycle, based on papers(1) they recently presented at GIRO(2003), a conference of general insurance actuaries.

Unlike the causes of the underwriting cycle, the reserving cycle, the subject of the first paper, usually receives little attention. Yet it plays a vital role in the dynamics of the insurance market, and actuaries and others involved in reserving face increasing challenges as a result.

The second paper tries to address the question: how can we manage a company through the underwriting cycle? This question is not at all an actuarial one, though actuaries should be as interested in a solution as anyone.

The reserving cycle

It is the tendency for companies to over-reserve when business is profitable and to under-reserve when business is loss- making. The reserving cycle therefore tends to follow the underwriting cycle, but relates to the strength of reserves, not the adequacy of prices.

Some may think that this cycle is a myth, that companies reserve at the same level of prudence at all times. However, research both in the US and the UK, using publicly available market data, has shown a clear reserving cycle across many lines of business. For example, during the previous hard market in the early to mid-Nineties, companies tended to set reserves that ran off at a profit.

Possible causes of the reserving cycle are many and varied. Actuaries, who have come in for some criticism of late, were first under our microscope.

We also considered company directors who, whilst they may take advice from actuaries, actually bear the responsibility for setting reserves.

Even those unfamiliar with the techniques of actuarial reserving will understand the core principle behind them: use the past as a guide to the future. Clearly this is not applied mechanically; judgment is used to adapt actuarial methods where we expect the future to differ from the past. One aspect of the past that is used to project the future is the claims development pattern, or the 'tail', which you could assume remains constant whatever the level of prices.

In fact, this is not the case. Research shows that the 'tail' is shorter in a hard market and longer in a soft market. This is likely to be due to several factors, including changes to terms and conditions, which can vary enormously over the underwriting cycle.

Another weapon in the actuary's armoury is rate increase data. Surely, by monitoring rate levels and changes in coverage, we can make a good estimate of this year's loss ratio using last year's result?

Based on some preliminary work, we found that rate changes capture the direction of the cycle, but tend to underestimate its extent. This does, admittedly, work both ways: business may be more profitable than calculated.

However, where rate reductions are greater than those reported, the chances of under-reserving are enormous. Again, changes to terms and conditions are likely to be the main culprit. It is often very difficult to quantify the effect of changes in coverage accurately.

Varying tails and inaccurate rate changes make life tough for the reserving actuary. Actuarial methods applied blindly will almost invariably lead to over- and under-reserving as markets harden and soften respectively.

Actuaries are aware of these problems and will make whatever adjustments they can to correct them. However, everyone involved in insurance needs to understand how the underwriting cycle can exacerbate reserving uncertainty.

Another possible source of the reserving cycle is the company's board.

Even if the reserve recommendations are spot on, the directors may choose to book something else. There may be a natural desire to 'put something away' in the good times and to 'hope things get better' in the bad, but the merits of the practice should be examined.

In a world of volatile share prices it is frequently thought to be in a company's interest to 'smooth' results. Smoothing may be considered by many to be acceptable as long as results reflect the underlying profits over the long term. Whether auditors and shareholders all approve of this today is a moot point - especially in a world of Sarbanes-Oxley and International Accounting Standards. Unfortunately, it is not easy to gather data on the extent to which companies deliberately smooth their results and this may be an area for further study.

Whether the directors smooth their results or not, it is vital that they understand the true level of underlying profitability. For if they do not, then they are incapable of managing the underwriting in their organisation and this is the heart of the problem.

The great danger of the reserving cycle is that, in a soft market, companies and their investors do not see how low rates have become until the damage has been done. Underwriting and the supply of capital to back it continue long after they should stop. This phenomenon could be one of the main drivers of the long and painful soft markets that we have endured.

We believe that it is vital for companies to make a realistic assessment of where their markets are in the underwriting cycle. Those who do not do so at the time will only discover where they were when the reserve increases started to hurt.

Managing through the cycle

In the second part of the 'Survival Kit' session at GIRO we presented a paper entitled 'Cynic and idealist: two views of the insurance cycle (and of the general insurance business)'. There is only room here to set out a few of the main ideas, but both papers are available on the web.

There are some radical suggestions, and the paper sets out two opposing views of the world in order to encourage debate. We are not looking to change the market, or challenge the existence of the cycle.

Why do so many insurers and reinsurers fail to manage successfully through the cycle? Is it hopeless? It seems so simple in theory - write when it's profitable, don't when it's not. Do we just lack the bottle to carry it through?

We hear first from a cynic who bemoans the status quo, saying everybody blames everybody else, and we're all doomed to suffer. Then along comes the idealist, accepting much of the cynic's analysis, but believing a company can succeed providing it makes certain radical changes. These include a 'get rich slowly' ethos for managers, employees and shareholders.

We start from the assumption that companies are capable of knowing how profitable current business is expected to be. Unwitting inaccurate reserving, an important part of the reserving cycle discussion above, is not considered in this paper.

There is a serious underlying question: is it worth investing in the highly cyclical international and commercial insurance and reinsurance business, given the proven ability of the London market to absorb, and sometimes lose, huge quantities of shareholders' funds? None of the cynic's view of the world is new. He doesn't advise investing in insurers, and puts his case for being resigned to the status quo. He looks at how the market works, from the viewpoint of key players such as customers, underwriters, brokers, managers and the investment community. Each participant, he argues, acts as he/she does in large part because of the way the other participants act.

For example, brokers will argue for 'continuity' even when rates are unprofitable. Naturally they wish to retain their clients in the face of competition from other brokers. Underwriters, responding to management wishes for increasing market share, and nervous of their jobs if their accounts shrink, will do all they can to retain business.

Admittedly, some companies have 'got religion' and now tell their underwriters to reject any underpriced business. But we heard this story the last time the cycle was in an up phase, and it wasn't generally adhered to in the subsequent downturn. Should we believe it now? The cynic thinks not. He says many stockbrokers regard insurers as a short-term trading opportunity rather than a long-term investment.

The idealist then puts forward a way in which an insurer can act in order to survive - even profit from - the cycle. Whilst many of the cynic's views are in line with accepted wisdom, some of the idealist's suggestions may provoke laughter, or even hostility in some quarters. The following points are taken from his initial summary:

- major changes are needed to incentives and philosophy throughout a company;

- these changes only happen if management gives the right message in actions and words, as seen from both inside and outside the company;

- management with this vision and sufficient confidence to communicate it in public can easily convince shareholders to support them - if there are any such managers already in place;

- but the vision requires managers not to be greedy. Change may need to be led by the shareholders;

- what hope is there that shareholders will drive the necessary change?

Without education of shareholders, or leadership by a few highly influential shareholders, the hope is a forlorn one. But it's not impossible.

At the heart of the idealist's analysis is the need for a deep understanding by shareholders of the dynamics of the insurance business. This requires total openness by management in its public statements, and in particular the willingness to discuss the economic substance of the business when the accounting fails to reflect it fully. The idealist is very happy to see reported premium income and earnings fluctuate widely. Nor does he care about volatility of the share price.

The next step in the argument is to consider exactly how his ideal company should operate, including the behaviour of the different functions within the company. He asks what lines of business the company should write, how accumulations will be controlled, and the disciplines to go with pricing decisions. Line size, reinsurance protections, and the company's attitude to volatile results - including reserving decisions - are next.

Then we get to the interesting part; communications to shareholders and to brokers and customers. The clear pricing strategy is never to write a piece of business at below expected cost. This causes volumes of business to vary enormously over the cycle; hence the need for a clear communication strategy.

After this comes the issue of how to achieve the desired behaviour. Money doesn't motivate everyone, but the incentive structure must align with shareholders and not include options against them. Here are some of the changes the idealist insists upon:

- no share options. Part of senior management cash bonuses used (for quoted companies) to purchase shares in the market, which must be held for a minimum number of years;

- underwriting profit share goes into an experience pool, which is only paid out over time. Losses go into the pool as well; and

- key staff needn't fear for their jobs in the down cycle.

Arguments against the idealist - major problems to overcome:

- finding senior and underwriting staff happy to get rich slowly; and

- finding committed long-term shareholders.

REFERENCES

(1) The papers can be downloaded from the Institute of Actuaries' website using the link http://www.actuaries.org.uk/Display_Page.cgi?url=/board_area/general.htm l.

The papers are 'Line.pdf' on the reserving cycle and 'White.pdf' on the cynic and idealist, listed in the documents section of the page. The authors welcome correspondence. - Nicholas Line, Chief Actuary of Markel International plc in London and Martin White, an actuary with Equitas Ltd in London.