By Jim Holmes, CPA, Managing Partner
There has been a lot of discussion recently regarding the insurance marketplace. Many have predicted a continuing change in the marketplace throughout 2020 and beyond. Faced with unprecedented structural change and a cyclical supply and demand model that can no longer support the industry’s growth and long-term goals, the insurance market today is commanding a path toward greater profitability. Insurers are hardening their positions across several lines of coverage on the front end, and conserving capacity in the underwriting process on the back end. Thus, the insurance market is really in transition.
A transitional insurance marketplace is literally what the term implies–a market that is moving from one cycle or condition to the next. All industries experience cycles of decline and growth. These conditions are very important in the insurance industry and often unpredictable. Many refer to these cycles or conditions as “soft” market or “hard” market conditions.
During a soft market, there are often looser underwriting standards, broader coverage options and lower rate structures and premiums. Premiums continue to decrease as insurers often offer coverage at unrealistic rates as they feel pressure to compete or risk losing business. As the market firms, underwriting standards become more stringent, carriers have reduced capacity and are thus less likely to take on risks. Premiums rise rapidly in a hard market, often at a rate much faster than they decreased.
Historically, soft markets are very temporary. Lower premiums lower underwriting profits, and the industry’s return on average net worth begins to deteriorate. The industry also starts attracting less capital. As liabilities begin to erode policyholder surplus, insurance companies are forced to raise rates and thus premiums, underwriting tightens and coverage is restricted.
Insurance carriers have two main sources of revenue: investment income and underwriting profit.
Investment income is income generated by investments held by the individual carrier. Property and casualty insurance carriers invest in assets; stocks, bonds, real estate, etc. There are regulations as to the types of assets in which insurers can invest in order to ensure the carriers will remain solvent and have available money to pay claims.
An insurance carrier’s largest asset is most often bonds—corporate, municipal or government—due to their relative safe return. Underwriting profit is the difference between premium collected and total claims and expenses paid. An insurer that collects more in premium than it pays out in claims and expenses earns an underwriting profit. Any insurer that pays more in claims and expenses than it collects in premiums has an underwriting loss. Because insurance carriers have two sources of income, they can often lose money on one but still generate an overall profit. When interest rates are high insurers often rely on investment income to make up for any underwriting loss. When carriers have profits, markets remain soft. When carriers encounter overall financial losses, the market turns towards hard.
That said, there are several other factors relative to the insurance carrier environment to consider:
- Capital Surplus—sizable amounts of capital surplus create the pressure to deploy capital in the marketplace via increased policy count which causes the pricing environment to be competitive and thus impact rates in positively
- Capacity—growth-oriented cycles drive increased offerings of capacity (limits) which leads to lower associated costs. Availability of limits from a single source are more economical than utilizing multiple sources
- Return on Invested Capital—the rate of return available in all investment tranches impacts capital surplus
- Loss Ratios—as rates decline, losses generally remain static which leads to increased loss ratios and declines in capital
- Catastrophic Events—large losses impact all facets of the insurance cycle
All of these factors outlined above affect the cycle of the insurance market accordingly.
We believe that it is critically important to know and understand where you are in this continuum and plan accordingly. At present we are transitioning from a protracted soft market cycle to what we will describe as a firming market period as we do not believe that a truly hard market is in lens for the next 18-24 months.