1

May 2014

By Harry Shuford Understanding What Drives the Underwriting Cycle

The financial performance of the property and casualty (P&C) industry features a little-recognized set of trends and a widely discussed series of cycles. This paper examines both and concludes that each reflects a predictable response to a common driver—the business cycle and economic trends in general and investment income in particular. The paper provides a description of the conceptual link between underwriting and investment results. The challenge of trying to maintain a reasonable balance between these two fundamental measures of financial performance drives the underwriting cycle.

The analysis begins with the familiar underwriting cycle—a real phenomenon that has been attributed to a range of diverse factors. For more than half a century, both academic and industry observers have tried to bring clarity to discussions of this irregular event.1 To many, the wide swings in underwriting performance reflect irrational market behavior; an irrationality that is baffling to many observers because the industry seems incapable of correcting its behavior.2 Key themes have included “cash flow underwriting,” “excess capacity,” “cutthroat competition,” and “building market share.” The analysis in the initial section of the paper will discuss these elements of the underwriting cycle, and it will become clear that this cycle is merely the predictable outcome of the environment in which the P&C industry operates. Indeed, this analysis clarifies why every hard market has followed an economic recession. The second section highlights the trends in P&C financial performance that underlie the underwriting cycle. Again, economic factors and especially investment returns appear to be the key drivers. The paper concludes with a simple model of financial intermediation to describe the link between underwriting performance and investment returns; describing “everything you need to know to understand the financial drivers of the P&C underwriting cycle”.

The Underwriting Cycle Defined

There are at least two popular descriptions of the underwriting cycle: one focuses on underwriting profitability, the other on underwriting terms and conditions. They reflect the perspectives of the two major market participants. Insurers feel the pain when underwriting losses surge; policyholders grimace when insurers raise premium rates and tighten underwriting standards. The former occurs following the onset of the “soft” part of the market cycle, the latter when the market “hardens.”

Thus the pattern of underwriting profitability offers one approach to identifying the timing of the underwriting cycle. Chart 1 traces the movement of calendar-year underwriting profit margins for the past 35 years. It indicates that over this period, there have been three periods that due to marked improvement in underwriting performance could be identified as pronounced hard markets (beginning in 1975, 1985, 2001); each was followed by a period of deteriorating underwriting results, the sign of a market softening.

1 See “Underwriting Cycles: A Synthesis and Further Directions,” Mary A. Weiss, Journal of Insurance Issues, 2007, for a recent survey of this research. 2 The underwriting cycle exhibits characteristics often attributed to financial bubbles. Much of the academic literature on financial bubbles has focused on explaining why financial market bubbles are consistent with rational investor behavior. See “Bubbles, Financial Crises, and Systemic Risk,” Markus K. Brunnermeier and Martin Oehmke, National Bureau of Economic Research (NBER) working paper 18398, September 2012, for a recent survey of this literature.

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Chart 6

What Drives the Underwriting Cycle?

As mentioned above, there is a range of contributing factors that have been identified for creating the underwriting cycle. This section of the paper examines some of the leading candidates. As Chart 7 indicates, there is likely to be little disagreement over what triggers a market hardening. Each of the hard markets identified above (see page 1) reflects a marked response to weak financial performance. The three periods were preceded by an industry average return on surplus close to or below zero. Each of those periods experienced severe underwriting losses as well (Chart 8). The chart also indicates that underwriting performance improved during the subsequent periods of premium rate increases. The more essential issue is trying to determine why the industry allowed underwriting results to deteriorate in the first place.

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Alan Greenspbetter candida

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rt Shiller, Nobel laureate in ec1990s. The titleerican Enterpris

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ects the industorist attacks in his secular gro

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ss capacity measure of hich tracks cyclical declineo highlight them boom and ousing bubblebegan in late n the “irrationa, rather than

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On to Cash

The analysis o80% of P&C inChart 1) offershas made an unvestment gaipositive and reWhile there areequal, when inare associated

Table 1 and thC4-C6 (in Apprate and yieldsgeneral patternightening mon

hard markets (rend. It also a

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8 Note that theright monetary c

Charts 13 and 1

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of the role of cansurers’ invest clear evidenc

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s on 10-year Tn is apparent: netary policy a(white areas) cppears that th

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not the actual dsuit during a s

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e early 1980s wnder control. It s.

9

driver of, the uoft market of m

focus first on ivation that the s a critical partast 35 years. CIn marked con

The pursuit of ncial performanld move in the

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Chart 12

nditions using rates is based

heir trends.8 Wsoft market cobove their longnetary policy eprominent for arkets typically

when Paul Volkresulted in a d

underwriting cymore premium

interest rates; P&C industry t of the P&C inChart 12 illustntrast to underinvestment rence, there is oe opposite direresponse to in

the proxies fod on Charts 13

While there is snditions (red a

g-term trend lineasing and intethe longer-tai

y are relatively

ker became hedramatic revers

ycle. The othem in order to ge

fixed income seldom earns

ndustry’s busintrates the singrwriting, inves

eturns clearly mone clear messection. This suncreases in po

or premium rat3 and 14, whicome variation areas in the grne. Similarly, terest rates thal commercial l

y short compa

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er leading hypoenerate more

securities mas an underwritness model; thular importanctment returns

makes businessage: with all e

uggests that haotential investm

te changes in ch plot the Fed across lines oraph) are assothe three broaat are below thlines than for pred to soft ma

eral Reserve anrn of interest ra

othesis is investment

ke up over ting profit (seehe industry ce of are strongly

ss sense. else being ard markets ment returns.

Charts 4 and deral Funds of insurance, aociated with adly-based he long-term personal lines

arkets (i.e., the

nd imposed ates and is why

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Chart 13b

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art 14a

art 14b

13

The previous discussion of the role of unrealized gains in the industry’s stock portfolio indicates that investment returns in the stock market have also contributed to changes in insurance market conditions. Indeed, the steady rise in stock market returns that began in the early 1990s (Chart 15) likely played a role in the soft market that characterized most of the 1990s.

Chart 15

The Underwriting Cycle Tracks the Business Cycle

Insurance rates must respond to changes in financial markets, especially interest rates. More importantly, market forces compel insurers to compete on price, leading to soft market conditions when investment potential appears to be strong. The wide swings in underwriting performance and total profitability indicate that price competition during soft markets is often more than vibrant, but that assessment is much easier to make in hindsight. As indicated above, insurance market conditions are driven by economic conditions, especially by the stance of monetary policy. The Federal Reserve frequently misjudges the timing of changes in economic conditions;9 it would be surprising if the property and casualty insurance sector were able to consistently out-forecast the Fed. The inability to accurately forecast the timing of financial markets is a major factor in the observed volatility in the industry’s underwriting results.

Other factors also influence insurer business decisions. Calendar year financial results are central to external assessments of management performance.10 Accounting conventions therefore likely come into play. There are several moving as well as non-moving parts to be considered. For example, as suggested above, strong financial markets bring on soft insurance markets. The weakening underwriting results will depress reported earnings; however, unrealized gains on common stock, which typically grow during these periods, are not reflected in earned income but do show up as an addition to reported surplus. This unrealized “income” could reasonably be viewed as an offset to the diminished reported earnings from underwriting. In contrast, fixed income securities are carried at amortized cost rather than at the lower market values linked to increases in interest rates. Thus these unrealized losses do not impact reported income, the asset values on the balance sheet, or reported surplus. On the liability side the reserves for future claim payments typically are also carried at estimated ultimate costs rather than being discounted to reflect the time value of money. These estimated ultimate costs are also 9 See for example: “Who’s to Blame for the Bubble?”, D. Quinn Mills, Harvard Business Review, May 2001; “Greenspan Concedes that the Fed Failed to Gauge the Bubble,” Sewell Chan, New York Times, March 18, 2012; “A Historical Analysis of Monetary Policy Rules,” John B. Taylor, in Monetary Policy Rules, John B. Taylor, editor, National Bureau of Economic Research, University of Chicago Press, January 1999. 10 While reported calendar year results are a primary focus of external stakeholders, accident year and policy year results are the prime focus for underwriting and other internal management assessments.

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The pand tunde

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rtain and frequch improve rep

ot easy to manarkably effectivysis of longer-t

m Cycles to

ultimate measribution of undistent but high. This confirmreflects the co

period from 19herefore ROSrwriting then t

ce, however, thking distance rtheless clear,rwriting cycle,plined profitabars to place u

uently are adjuported underw

nage a busineve at managingterm trends in

o Trends

ure of financiaerwriting to the

hly cyclical unds that underwontribution of i

975 to 1985 illuS, rebounded furned negativ

hat beginning between the t, improvement investment mle underwritingnderwriting in

usted to reflecriting performa

ess in such an g its return on the financial p

al performancee annual retur

derwriting lossriting is the kenvestment ga

ustrates two kfrom the negate, and ROS b

with 1986, invwo lines. Chat in underwritin

markets drive thg results matea secondary p

ct reserve strenance.)

uncertain but surplus over t

performance o

e in the insurarn on surplus fes. These are

ey driver of thein, which is sh

ey findings in tive ROS in 19egan to fall as

vestment gain rt 18 highlightsng performanche need for un

erialize. Undouposition to inv

Ch

14

ngthening (add

competitive ethe underwriti

of the P&C ind

nce industry isfrom 1975 throe mirrored in the swings in thehown in Chart

the analysis o975, peaking as investment g

relative to surs the fact that ce. The messanderwriting proubtedly many estment mana

hart 16

ding to underw

environment. Inng cycle. This

dustry.

s return on suough 2012. It she industry’s re industry’s RO17.

of the underwrat an ROS of jgain relative to

rplus began a this downtren

age is that oveofits—as invesindustry obseragement.

writing losses)

n reality, the Ps assessment

rplus (ROS). Cshows the samreturn on surplOS. The sprea

riting cycle aboust under 30%

o surplus grew

steady declinend is mirrored er the long-termstment gain oprvers will find t

) or reserve re

P&C industry his based on th

Chart 16 depicme pattern as lus, also showad between the

ove. First, und% in 1978. Secw steadily throu

e as evidenceby a cyclical, m, as well as opportunities dethis unsettling

eleases

has been he

cts the Chart 1—

wn in the e two

derwriting, cond, ugh 1985.

ed by the but over the eteriorate,

g in that it

15

Chart 17

Chart 18

16

Defining the Role of Underwriting

In discussions about the financial sector, the P&C insurance industry is typically termed a “financial intermediary,” putting it in a category that includes banks, savings and loan associations, and credit unions. This likely seems confusing to many; the other institutions accept deposits—a financial transaction—while the P&C industry sells insurance.11 These seem like very different activities. However, the comparison actually helps to explain the role of underwriting in managing the financial performance of the P&C industry.

In the most basic business model, banks take on liabilities in the form of deposits and then convert them into income-generating assets. The interest paid on the deposits is the banks’ cost of funds. Following this framework, P&C companies take on liabilities by selling insurance policies and then converting them into income-generating assets. Underwriting losses are the cost of funds for the P&C industry.12 The role of underwriting and claims administration is to manage the P&C firms’ cost of funds. These functions are not secondary; they are essential. This is a much more difficult task than that faced by banks managing their cost of funds. Most bank deposits have a fixed term and a fixed rate of interest; for those with variable rates there is a clear link to the rates on the bank’s assets. Claim costs, on the other hand, are remarkably uncertain and vulnerable to economic, regulatory, and environmental shocks.

Managing the cost of funds for the P&C industry is a daunting task. The industry has performed well in absolute terms and astonishingly well compared to other financial intermediaries. The thrift industry (savings and loans and mutual savings banks) has been bankrupt at least twice since the 1970s. The recent federal “bail out” of the banking industry reflects management as well as regulatory shortcomings in the banking sector. In contrast, the P&C industry just keeps on doing business as usual—through financial crises, environmental trauma, underwriting cycles, and all.

As with all financial intermediaries, the challenge in managing the P&C marketplace lies in achieving a balance between the cost of funds and the return on investments. The ultimate measure is the return on surplus. Chart 19 clearly indicates that through the trends and cycles of the marketplace, the P&C industry has handled this challenge well. The balance between underwriting performance and investment gain has generated a long-term trend line for the industry’s ROS in excess of 10%.

Summary

All you need to know to understand the property and casualty underwriting cycle:

Cashflow underwriting in pursuit of investment gains is more of a driver of the underwriting cycle than excess capacity

As investment gain opportunities deteriorate, disciplined profitable underwriting results materialize

As interest rates decrease, hard markets follow. As interest rates increase, soft markets follow.

Underwriting results are the key driver of the direction of return on surplus

11 By definition, a financial intermediary is a middleman, collecting and pooling funds from, for example, savers, and then lending or otherwise investing those funds with borrowers. The pooling typically provides risk sharing on both the asset and liability sides of the intermediary’s balance sheet. 12 An advantage of the P&C industry—when investment potential is low, it actually has the ability to earn a profit on its source of funds. At today’s low interest rates, many banks pay virtually nothing on deposits, earn a bit by holding balances in the Federal Reserve, and try to earn a small profit by charging fees for banking services.

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AC

Ctwmmbtyr

Appendix 1—Pt+1

Tak

ln(P

rea

ln(r

Appendix 2—Conditions

Charts A1 a anwo hard mark

market as undmeasured by tbelief that as inypically these

reversed.

—The Addit

1 / Pt = (rt+1 * X

ke the log

Pt+1 / Pt) = ln((r

arrange

rt+1 / rt) = ln(Pt+

—The Work

nd b trace the ets (1985 to 1erwriting standhe combined nsurers tightenare better tha

tive Nature Xt+1) / (rt * Xt)

rt+1 * Xt+1) / (rt *

+1 / Pt) - ln(Xt+1

kers Compe

path of the vo990 and 2000dards were tigratio, improven their standar

an the average

of Log Rate

* Xt))

/ Xt)

ensation Re

oluntary and re0 to 2005), theghtened. Intered as policyholrds, they drop e policies alrea

17

Chart 19

es of Growt

esidual Mark

esidual market residual mark

estingly, the unders moved frthe policyhold

ady in the resid

th

ket Is an Ind

ts from 1985 tket grew as a nderwriting perom the voluntders that they dual market. D

dicator of C

through 2012. share of the to

erformance of tary market. Tdeem less att

During the soft

Changes in

They reveal total workers cthe residual m

This is consistetractive; it appft markets, the

Market

hat during thecompensation market, as ent with the ears that patterns were

e

18

Chart A1a

Chart A1b

Appendix 3—Trends Within the Trends

Chart 18 illustrates the long-term trends in investment gain and underwriting results relative to surplus. Other significant trends are embedded in these. Charts B1 and B2 depict two that contribute to the downtrend in investment gains: both the average return on assets and the reserve-to-surplus ratio have been trending downward. Reserves are the primary source of funds for investment. The former reflects the broad downtrend in interest rates over this period; much of this decline is

0

5

10

15

20

25

30

35

40

45

50

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

UW Gain - pvt UW Gain - RM RM Share

Calendar Year (UW Gain – pvt and RM Share), Policy Year (UW Gain – RM)

Residual Market Share of the WC Market Grew During Hard Markets

U/W Gain Market Share

The gray shaded regions represent periods of economic recession in the U.S.Underwriting gain is defined as 100 minus the combined ratio. Market share is in percent.

Residual Market Share of the WC Market Fell During Soft Markets

0

5

10

15

20

25

30

35

40

45

50

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

UW Gain - pvt UW Gain - RM RM Share

Calendar Year (UW Gain – pvt and RM Share), Policy Year (UW Gain – RM)

U/W Gain Market Share

The gray shaded regions represent periods of economic recession in the U.S.Underwriting gain is defined as 100 minus the combined ratio. Market share is in percent.

drss

due to the easrelative to premsurplus ratio (Csurplus.

ing of expectemium (Chart 1Chart 9) falls. I

ed inflation. Un). A given undIt should be no

nderwriting proderwriting loss oted that these

19

ofit margins (ewill have a les

e are related—

Chart B1

Chart B2

essentially 1 mss negative ef

—both ratios a

minus the combffect on the RO

are impacted b

bined ratio) arOS as the pre

by the relative

e measured mium-to-increases in

App

The dprempersoPrivacontaprem

endix 4—Ex

discussion waium rate chan

onal lines. Theate Ownershipain the series oium rates.

xhibits By L

s largely limitenges were calce proxies for ch; Final Sales oon by-line cha

Line

ed to financial culated for worhanges in expof Domestic Pranges in net wr

performance rkers compens

posure were, reroduct; and Owritten premium

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20

of the total P&sation, commeespectively, chwner-Occupie

m, proxy expos

hart C1

hart C2

&C industry. Sercial lines othhanges in Tota

ed Real Estatesure, and the p

imilar estimateher than workeal Annual Wag

e at Market Vaproxy estimate

es of proxies fers compensages—All Induslue. Charts C1e of changes i

for tion, and stries, 1–C6 n

21

Chart C3

Chart C4

Ch

Ch

22

hart C5

hart C6

23

By-Line Financial Triggers for a Hard Market

Return on surplus is the appropriate measure for judging profitability for the total P&C industry. An alternative for by-line analysis is pretax operating gain. This is more appropriate because it does not require an allocation of surplus by line. Charts D1 through D4 show pretax operating gain on a by-line basis; pretax operating gain for the total P&C industry is also shown for comparison. The circled areas on the charts indicate periods of hard markets.

Chart D1

Chart D2

24

Chart D3

Chart D4

25

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