Taking the slow boat to a hard market

Advisen study cautions that once here, the hard market may be more prolonged than usual

By Phil Zinkewicz

There has been a good deal of speculation in the insurance industry as to when the current soft market will end. Now comes a special report from Advisen Ltd. that offers the old good news/bad news scenario. The good news is that the hard market is on its way. The bad news is that it may not be arriving very soon. The usual property and casualty insurance industry cycle is out of whack, according to the Advisen report.

Advisen Ltd. is among the leading providers of information, analytics and technology to the global commercial insurance industry. Titled “The Hard Market Is Coming (But Don’t Hold Your Breath),” the report is authored by Advisen Executive Vice President David K. Bradford, a co-founder of Advisen, who leads the research and editorial team. He is Advisen’s senior insurance industry analyst and editor-in-chief of Advisen’s various publications.

“A five-year soft market, fueled by chronic overcapacity, is coming to an end. Following two years of record profits, losses from both underwriting and investment activities are destroying excess insurance capacity, signaling that the bottom of the commercial insurance pricing cycle is near,” says Bradford.

Bradford says that average rates for commercial insurance will level off by the second quarter of 2009 and will begin to creep higher beginning the fourth quarter of 2009 or the first quarter of 2010. “However, a deepening global recession may delay the return of hard market conditions by suppressing demand for insurance. In the absence of major natural catastrophes, which could trigger skyrocketing premiums, the hard market will be more gradual, and also more prolonged, than has been the case in recent cycles.”

In an interview, Rough Notes asked Bradford to be more specific about a falling demand for insurance. “Well, with so many businesses laying off workers during this recession, it stands to reason that the demand for workers compensation will decrease,” says Bradford. “Also, with firms beginning to tighten their belts, they may choose to self-insure some of their exposures or take higher deductibles.”

The Advisen report says that the current economic environment impacts both the supply of and the demand for commercial property and casualty insurance. According to Bradford: “On the supply side of the equation, plummeting stock markets, frozen credit markets and, in some cases, investments in ‘toxic’ mortgage-backed assets, caused many insurers to post investment losses in the third quarter of 2008. These investment losses are on top of underwriting losses driven by five years of price cutting, higher than average catastrophic losses and reserves for directors and officers liability and errors and omissions liability claims resulting from the subprime mortgage meltdown and the subsequent credit crisis.”

Advisen estimates the property and casualty insurance industry was roughly $100 billion overcapitalized as of the end of 2007. “In other words,” states Bradford, “policyholders’ surplus—statutory accounting terminology for the capital supporting underwriting operations—needed to be reduced by about $100 billion through losses, dividends, share buy-backs or other means to bring insurance supply in line with demand. U.S. policyholders’ surplus declined $36.8 billion, or 7%, for the 12 months that ended September 30, 2008, according to A.M. Best. Consultancy Towers Perrin forecasts as much as an $80 billion decrease in surplus by the end of 2008.”

Bradford’s report notes that, while $80 billion represents a significant chunk of the $100 billion in excess capacity—and moves the market much closer to the bottom of the soft market cycle—the demand side of the supply-and-demand equation also has changed since the end of 2007. “According to the International Monetary Fund, the global economy is now in a recession with growth projected at 2.2% for 2009, down from 3.7% projected for 2008. The IMF projects that advanced economies as a group will contract 0.3%, with the U.S. contracting 0.7%.

“As companies downsize,” continues Bradford, “the demand for insurance not only decreases, it decreases at a pace faster than the contraction of the overall economy. While going without insurance is not an option for most companies, many will look for ways to slash their insurance bills. An obvious option is to raise retentions (though perhaps a short-sighted one in a soft market, when some policies are priced below cost). The use of captives and other alternative risk-financing mechanisms will increase. More companies will gravitate to low-cost providers, even if it is necessary to loosen financial security criteria. These are typical responses to hard market conditions, but it is likely that companies will resort to them even before the market turns as they are squeezed by a deteriorating economy. All these factors will help prolong the current soft market.”

Bradford says that, in the second quarter of 2009, the current soft market will have a “soft landing” but that prices will probably begin to rebound by the fourth quarter of 2009 or the first quarter of 2010. However, he says one or more natural catastrophes would speed things up.

The AIG situation has raised some serious questions, according to Bradford’s report. Some insurers are criticizing AIG for prolonging the soft market. He mentions, in particular, Liberty Mutual Group’s chairman, president and CEO, Edmund F. Kelly, who Bradford says has complained that AIG has increased its market share. Other insurers have expressed similar concerns.

Rough Notes asked Bradford about his assessment of the situation. He said that AIG is competing vigorously, but not irresponsibly. “Brokers generally concur that AIG should not be singled out for driving down rates because other insurers are also fueling the soft market,” he said.

Finally, the Advisen executive ended on a high note. “Typically, rising premiums attract new capacity to the insurance market. Business-friendly offshore domiciles—especially Bermuda—make it comparatively simple to quickly launch new insurance and reinsurance companies to take advantage of higher rates. Between 2000 and the end of 2003, for example, investors pumped more than $20 billion into new companies in the United States. The influx of new capacity, though intended to take advantage of rising premiums, increases competition and eventually chokes the hard market.”

However, Bradford maintains that the current economic conditions might prevent that from happening and that the coming hard market will persist longer.