Flavors of Insurance, Part I

I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other. This article will attempt to go through the vast wasteland that is the insurance industry, and attempt to point out some of the more interesting aspects of it.

There are three major risk factors with insurers: the underwriting cycle, investment returns, and expense control.

The Underwriting Cycle

The property/casualty insurance industry, like all mature industries, is a cyclical business. Cyclical businesses revolve around pricing, which involves the relative degree of capacity available in the industry.

The P/C industry derives its capacity to write business from the amount of surplus available to support business. This creates a four-phase cycle for the industry.

1.      When surplus is abundant, rate-cutting is prevalent, and generally poorer-quality business gets written in an effort to retain market share. Terms and conditions for insurance are loose. During this period, the prices of P/C companies fall relatively hard, as prospective estimates of profitability fall.

2.      After enough poor quality business gets written, and premium rates decrease meaningfully, high quality companies exit lines of business, or buy reinsurance, and low quality companies begin to look impaired. At these times, the stock prices of high quality firms fall a little, and low quality firms fall more.

3.      As the results of bad business become evident, reserves get raised, sometimes drastically, and surplus declines. When surplus is deficient, premium rates rise, and the stocks of companies that have survived the cycle rise dramatically. The best business from both a profit and risk control standpoint, gets written in this phase of the cycle Terms and conditions for insurance are tight.

4.      When surplus becomes adequate, premium growth rate slows, and stock prices rise slowly, at roughly the rate of retained earnings. This continues until surplus is abundant.

Catastrophes, when they happen, temporarily reduce surplus, and improve pricing. The companies least affected by the cat rally, and those most affected, tend to fall, or rise little. Major catastrophes can cause the cycle to bottom, or extend the positive side of the cycle, because surplus is diminished.

The rating agencies tend to cut ratings near phase 2, and raise them near phase 4. Diminished ratings decrease the amount of business that an insurer can write, and further limit the willingness of prospective purchasers of insurance, particularly long-tailed coverages, who want to be sure that the company that they buy insurance from will be around to pay claims.

Investment Returns

Strong investment returns increase surplus. In a bull market, some companies become more aggressive about writing business so that they can earn money from investments. This is particularly true of companies that sell coverages that result in long-tailed liabilities. Strong investment returns prolong phases 1 and 4 of the cycle. Investment returns were so strong throughout the 1990s that insurers often compromised underwriting standards, leading to much of the troubles that occurred in the industry from late 2000 to early 2003. Not only were investment returns low or negative, but the results of prior poor underwriting were realized through reserve adjustments that diminished surplus.

Expense Control

Every time a premium gets calculated, there is an estimate embedded in the premium for expense. Expenses typically take three forms: policy acquisition, claims adjustment, and operational. There is a tendency for expenses to drift higher when investment returns are strong, and when the market is softening due to greater competition.

Now I will discuss each sub-industry separately. Included in each discussion is a description of products, risks, and industry performance over the last ten years. The graphs show the performance of each sub-industry over the last ten years, derived from my own proprietary indexes. At the end, I give my outlook for each sub-industry.

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Bringing it to the Present

This series was written seven years ago in an all-nighter for my new boss.  The piece never saw the light of day, which annoyed me, though I liked my boss, and I never complained about it.

As I publish the ten-or-so pieces of it, because it was long, at the end of each installment, I will try to update the insurance subindustries to the present.  But it would be useful for anyone reading this to look at my presentation to the Southeastern Actuaries Conference on the Amazing Decade for Insurance Stocks.  Aside from that, I have lost the graphs of the original presentation.  My apologies.

Insurance is an amazing business.  Insurers make promises.  Many of the promises are uncertain with respect to amount and/or timing.  That makes the accounting complex.  This is one of the reasons why examining the qualitative aspects of an insurance company to understand how a management team makes decisions is so valuable.

Anyway, more to come here, and I hope you all enjoy this series.