Who's Afraid of the Big Bad Wolf?
The Insurance Cycle
THE RHA REVIEW
Volume 2, No. 3, Second Quarter 1996
By Robert N. Hughes, CPCU, ARM
One of the hardest lessons life has taught me has been that "when everything is going great … duck!" Although I admit that this is an overly cynical view of life, it does seem, as I look backward in time from my now more mature viewpoint, that the worst has a habit of appearing just when it looks like you had all the snakes killed.
Such is the case with the so-called "insurance cycle." Just when we all thought it had settled into a nicely predictable pattern of six-year swings between low rates/high capacity and high rates/low capacity, the halcyon days (at least for policyholders) of the current buyers’ market has lengthened into what is now an eight-year swing going on who knows how long. Commercial buyers of insurance have reacted to this long epoch of low rates in numerous ways … outsourcing risk management functions, closing captives, reducing retentions and generally establishing insurance as their principal risk-financing mechanism.
The effect on the insurance industry has been curious. A number of adverse elements (inadequate rates, rampant competition, long-term liabilities, an uncertain financial market, burgeoning catastrophe exposures) are forcing significant movement toward consolidation. This phenomenon has, in the past, invariably resulted in a hardening of market conditions, particularly prices. Instead, A.M. Best Co. predicts that just the opposite will result … prices will continue to be "soft" for at least several more years.1 Why? Briefly, because regulators will continue to be consumer-oriented and because the industry made a fortune on its equities in 1995 (27 percent of $19 billion), resulting in an increase in surplus of $30.8 billion.
On the surface things look good. Unfortunately, there may well be "something rotten in Denmark." Companies like Cigna and Home are being allowed by regulators to follow the lead of Hartford and Talagen and play "good bank/bad bank" by funneling their asbestos and environmental liabilities into runoff or inactive pools or companies. The industry is becoming polarized into "haves and have nots," making it almost impossible for boutique or "niche" players to stay alive, much less exert influence in the market. With the industry dominated by a few giants, they will be able to manipulate reserves to manage underwriting cycles. It could well become next to impossible to gain underwriting flexibility, and industries which might be deemed to be "problem risks" could be out in the cold, forced to deal with financially suspect companies.
The most discomforting thing about the situation is that the axiom "the bigger they are, the harder they fall" still applies. It is my belief that the major carriers are underreserved by hundreds of billions and are hoping to achieve substantial premium growth and maintain 1995 investment income percentages for several years, thus "writing themselves out of the hole." It could work, but what happens if the hurricanes really do get bigger (as predicted) and we have a couple of large U.S. earthquakes in the same year? And what happens if Congress cooks up another CERCLA? And what happens if interest rates skyrocket, causing another stock market crash and at the same time devaluing the companies’ current bond portfolios? And what happens if Lloyd’s of London really doesn’t make it? Well, if all that happens, we will probably have another 1984.
We now have a generation of risk management and insurance practitioners who have not been through a single bona fide "hard market" and have no idea what to expect. I must confess that one of the sure signs of age occurs when you find your circle of friends at conventions or seminars spending all their time sharing mutual incredulity at the current state of affairs. "Doesn’t anybody remember 1984? Excess attachments went from the hundreds of thousands to the millions. Some layers of coverage disappeared entirely. Some pricing increased 1,000 percent. Wholesale cancellations and non-renewals. Layoffs by the thousands."
Actually, it’s a very good question. The first reaction for all but the most cynical is, "we’ve all forgotten and some never knew." It occurs to me, however, that maybe, just maybe, the opposite is the case. Maybe the market refuses to harden because folks in high places in the insurance industry remember all too well and are playing both ends against the middle in a very dangerous cat-and-mouse game. Maybe there has been some very basic technical change which has yet to be completely understood. Or maybe the conditions that are conducive to "soft" markets have just hung around longer than usual.
Why is it important to even think about it? Well, to put it simply, it’s all about whether we’re going to be the little pigs who played all day and built their stick house on the beach or whether we’ll build strong houses of stone on a hill so we can see the wolf coming and make appropriate plans.
Here are my very brief thoughts on the matter. The only thing we know for sure is that the insurance market is either going to "turn" or it isn’t. If all, or any significant portion, of the aforementioned ills befall us, then there will most certainly be a convulsive turn. Companies which have outsourced their risk management function to insurance brokers will find themselves dealing with advisors with no advice. Insurance will not be the "drug of choice," as there will not be enough of it to go around. Associations will scramble to put together risk-retention groups and captives and discover that they should have started when the sun was shining instead of in the middle of the storm. "Claims Made" will descend upon the liability market like the plague, and "buffer layers" will appear between retention layers and first-umbrella layers, at gigantic cost to the policyholders.
But if things continue like they are, insurance will be cheap, brokers will have plenty of time to be advisors, and all will seem well. It might, to some, seem like a good time to play on the beach and live in a cabana built of sticks. It is my belief, however, that now is the time to look for high ground and check out the price of bricks. That howling we hear might indeed be just the sounds of revelry, but, then again, it might very well be a pack of "big bad wolves," and if it is we’d better know what we’re going to do when they come over the hill.
1BestWeek, Property/Casualty Supplement, January 3, 1996.