Cpcu 540 Ch.12

Front 1

Overview of underwriting cycle

Back 1

A cyclical pattern of insurance pricing. Consists of periods of increasing premiums and profits followed by periods of decreasing premiums and profits.

Insurance cycles actually have very similar characteristics to general business cycles. However insurance cycle and business cycle do not move together.

At any one time, the state of the insurance industry is based upon the cumulative result of actions taken over prior cycles.

Front 2

Reasons for underwriting cycle

Back 2

Reasons why cycles occur: Structural change (cumulative change that occurs in cycles over a period of years or a long period of time. Change in society and business. Change in industry). Demand for products (insurance demand is fairly stable compared to other products). Supply of products (insurance supply can change rapidly).

Front 3

Profit cycle

Back 3

More appropriate description of the underwriting cycle. The cycle is driven by expectations of profit. Cycle is measured by the operating ratio which measures underwriting and investment income. Includes a hard market and soft market.

At any one time the state of the insurance industry is based upon the cumulative result of actions taken over prior cycles.

Front 4

Hard market

Back 4

Market begins hardening when insurers increase premiums and tighten underwriting. Competition declines, increased profits (decreasing profit ratio), buyers have hard time obtaining coverage.

When the profit cycle reaches a trough the market begins softening.

Is a sellers market.

Front 5

Insurer strategies during a hard market include

Back 5

Increase premiums, review and evaluate current reserves, restrict coverage, restrict producers representing the insurer, increase staff, reunderwriting (imposing deductibles, non-renewals and surcharges to existing policies).

Front 6

Soft market

Back 6

Characteristics of a soft market: decreased premiums, increased competition (offer better deals to compete), loose underwriting standards, insurer profits decrease or become losses, increasing operating ratio.

When cycle reaches a peak, new hard market begins.

Front 7

Insurer strategies during soft market

Back 7

Lower premiums, loosen underwriting standards, expand coverage, offer specialized products or rate credits, reduce staff, maintain existing premium levels and sustain a loss in market share.

Front 8

Influences on underwriting cycle

Back 8

Profitability influences underwriting cycle. Financial factors include: investment income, insurer capacity, return on equity and cash flow.

Front 9

Investment income

Back 9

If insurer investment income declines, insurer profitability declines. Profitability declines will need to be offset with improved underwriting results. At some point declining profits will bottom out, at which point the cycle will turn from a soft market to a hard market. Insurers that loosen underwriting standards in a soft market could be highly susceptible to reductions in investment income.

Insurance industry experienced underwriting losses from 1978-2004.

Front 10

Capacity

Back 10

The amount of risk an insurer can assume relative to their surplus. Premium-to-surplus ratio of less than 3 to 1 is usually required by regulators. Capacity is risk that CAN be assumed, while supply is risk that WILL be assumed.

Excess capacity is considered one of the factors that helps contribute to an extended soft market.

Front 11

Return on equity

Back 11

Insurers will use available capacity if expected return exceeds their return on equity target. Return is generated through underwriting and investment operations. If return on equity is too low, insurers often increase premiums or restrict coverage. If many insurers increase premiums, a hard market will begin.

Insurer will most likely take on expansion if the return-on-equity threshold is exceeded.

Front 12

Cash flow

Back 12

Insurers cannot survive with negative cash flow. Typically leads to insolvency. May be caused by inadequate reserves. Usually results in increased prices, expense reduction and more strict underwriting. When majority of insurers experience a negative cash flow it may lead to a hard market.

Cash flow underwriting relies on investment income to offset underwriting losses. Often used to achieve competitive premiums in a soft market.

Front 13

Supply and demand theory

Back 13

Supply and demand principles applicable to other products also apply to insurance. Demand is inversely related to price, (the higher the price, the lower the demand). Supply is directly related to price, (the higher the price, the more supply offered). Supply and demand are equal at the market equilibrium price.

Front 14

Supply and demand theory pt.2

Back 14

If there are no constraints of prices, market equilibrium will be attained in a free market. If prices are higher than equilibrium, supply will be too great, causing price reduction. If prices are lower than equilibrium, demand will be too great, causing price increase.

Front 15

Insurance supply

Back 15

Represents the amount of aggregate risk all insurers are willing to accept. Increase in supply can lead to price decrease and softening affect on profit cycle. Decrease in supply can lead to price increase and hardening affect on profit cycle.

With property/casualty insurance, losses are not known when the premium is established. Supply can change dramatically over a short period of time.

Front 16

Insurance supply pt.2

Back 16

Factors affecting insurance supply:

Reinsurance (purchase increases insurer capacity and can provide surplus relief, usually results in increased supply, however, insurance supply may decrease if reinsurance supply decreases or reinsurance prices increase).

Ease of entry (entry of new competitors increases the supply of insurance).

Front 17

Insurance supply pt.3

Back 17

Factors affecting insurance supply:

Difficulty of exit (the difficulty of an insurer exiting the market keeps capital committed to the market, which tends to increase supply).

Regulatory environment (regulatory constraints may reduce supply of insurance, minimum financial requirements may cause insurer to choose not to sell particular line, rate increase regulations may cause insurer to choose not to sell particular line).

Front 18

Insurance supply pt.4

Back 18

Factors affecting insurance supply:

Dedicated capital (insurers must support written policies with dedicated capital, capital can't be moved to other areas, contributes to increase supply).

Underreserving (artificially inflates surplus, increases capital and supply).

Profit expectations (High profit expectations usually result in decreased supply b/c insurers tend to tighten underwriting standards and increase premiums.).

Front 19

Insurance demand

Back 19

Represents the ability and desire to purchase a product. Elastic demand is willingness to purchase a product declines if price increases. Inelastic demand is willingness to purchase a product remains constant if price increases. If demand for a product is elastic, the demand (and revenue) will increase after a drop in price.

E.x. if demand decreases and supply remains the same, equilibrium price will fall. This is reflected in a leftward shift of the demand curve.

Insurance demand has both elastic and inelastic characteristics.

Front 20

Insurance demand pt.2

Back 20

Elasticity of insurance demand: price variations affect insurance demand. Price increases may cause reduction of coverage or increase in deductibles. Alternative methods of disk financing decrease demand for insurance.

Inelasticity of insurance demand: may be requires to purchase insurance. Insurance must be renewed regularly.

Front 21

Underwriting cycle

Back 21

Insurance profit cycle is controlled by supply. Demand is relatively inelastic. Supply is highly variable.

Changes in supply cause the rise and fall of profitability. Insurance cycles typically do not match general business cycles. Most non-insurance business cycles are controlled by demand.