The long-anticipated insurance market turn appears to be upon us. After a seven-year slide in rates in almost all environments, premium pricing began rising in the third quarter of 2011 and has continued to increase through the first half of 2012. As a result, many industry prognosticators say that current price firming heralds the coming of a hard market.
They are wrong.
As welcome as a hard market may be to the insurance and reinsurance companies that have been battered by high catastrophe losses and anemic investment returns in recent years, a traditional hard market is not coming. While price firming will continue, particularly in the hardest-hit lines, the market is not poised for the type of shift it went through in 1985, 1993, 2001 or even 2005. Underlying market fundamentals simply do not call for a strong market turn. Instead, what will occur is a less dramatic market correction.
In fact, hard markets as we have historically known them are on the brink of extinction. The marketplace has matured over the last 25 years. Improvements in the quality and quantity of underwriting information, better regulatory oversight and more efficient flows of capital have made market cycles shorter, flatter and generally more efficient overall. And as market efficiency improves, prices will more accurately reflect risk. This has created a new market paradigm where cycle fluctuations will no longer be as dramatic as they once were. This is the new normal.
Annus Horribilis
From almost every perspective, 2011 was a horrible year for the insurance industry. Economic loss for 2011 exceeded $370 billion, with insured catastrophe losses reaching at least $116 billion. According to Swiss Re, 2011 was the second-costliest disaster year on record.
A large portion of global loss came from the United States, where catastrophe losses exceeded $42 billion, the nation's costliest figure since 2005 and the fifth costliest year on record. While the United States had only one hurricane make landfall (Irene), losses from tornadoes in the Southeast and Midwest reached $14 billion--nearly two and a half times the insured loss from Irene. Taken together, these tornado losses represent the fifth-costliest event in U.S. history. All told, economic loss in North America exceeded $63 billion.
Natural disasters were prevalent outside of the United States as well, with the largest concentration occurring in Asia. Japan's earthquake and ensuing tsunami and New Zealand's earthquake collectively cost $230 billion in economic damage. However, the majority of these losses were uninsured, "limiting" the total insured loss on these events to a combined $47 billion.
Market Influences
In February 2011, catastrophe modeling company Risk Management Solutions (RMS) released the newest version of its U.S. hurricane risk model. Dubbed "RMS 11.0," the update substantially increased predicted exposure to hurricane losses in inland areas in the Gulf states, Texas and the Northeast.
The new model was adopted by the majority of insurers and reinsurers during 2011, and as a result, the updated data prompted them to shed risk, adjust pricing or purchase more reinsurance protection. Projected loss totals in exposed areas increased by anywhere from 20% to 100%, according to RMS.
External forces certainly did not cooperate in providing the industry with adequate cover. A weak global economy kept exposure down, depressing premium growth and influencing renewal rates. Historically-low interest rates have hurt investment income, providing a smaller offset to the industry's accident-year underwriting loss. And the outlook for the future is grim. Most consider reserve redundancies, which have previously helped prop up industry results, to be completely eroded. The industry has lost its cushion for future years.
In the United States, the 2012 underwriting loss was $29.7 billion, as reported by A.M. Best, which was more than five times greater than the prior-year loss of $5 billion. Overall policyholder surplus declined $6.1 billion or 1.1%. The combined ratio on an accident-year basis was 109.5%, the highest level it has been since 2001.
Despite these negative influences, the U.S. property/casualty insurance industry managed to generate a net income of $26.5 billion thanks to investment returns and reserve releases. This profit generated a positive, yet moderate, return on policyholder surplus of 4.7%, according to A.M. Best.
A Market Shift
The cumulative result of this news was a movement in the market. Beginning in the third quarter of 2011, insurers began to raise prices. This movement continued through the end of 2011 and into the first half of 2012.
Increases on the whole have been moderate. Typical renewals are experiencing single-digit rate increases. The Council of Insurance Agents and Brokers reported average rate increases of 4.4% in the first quarter of 2012, up from 0.9% six months earlier. This is consistent with results reported by Advisen and Marsh.
On a more granular level, however, certain classes are experiencing large increases due to pressures within niche spaces. For example, catastrophe-exposed property risks have experienced increases of up to 20% or more as a result of 2011 losses, changed risk modeling and a contracting windstorm appetite. Similarly, rates for workers compensation are on the rise.
The average bureau-approved rate/loss cost increase was 7.8%, which is the highest average uptick in 20 years, according to the National Council on Compensation Insurance (NCCI). And the U.S. workers compensation market posted a calendar-year combined ratio of 115% for 2011--the worst since 2001.
Discerning Appetites
Generally speaking, insurers are pushing rates based on individual experience or exposure. An increased focus on underwriting fundamentals--as opposed to premium growth--means that risks with difficult loss experience are finding less competitive deals. This means that risks in challenged industry segments find decreasing competition.
One of the most palpable instances of this is contracting risks in New York. Due to exposures from complicated labor laws, rates are up substantially and the market has contracted. Certain classes of habitational real estate are experiencing similar price increases based on previous adverse experience.
Overall, insurers are returning to the fundamentals of underwriting and have become more discriminating in risk selection while at the same time protecting profitable business. It is indeed a delicate dance. An insurer that pushes too hard on renewal pricing for good risks may still find competitors willing to take the business despite modest premium increases. Though most underwriters are under pressure to "get rate" on their renewal books, they can continue to aggressively price new business because new business falls outside the rate change calculation.
This phenomenon, while counterintuitive to the objective of generating an overall underwriting profit, means that an insurer will price the same risk differently depending on whether it is new business or a renewal. It also means that price increases will remain moderate except in the most-challenged lines and individual risks. Insurers that do not individually underwrite accounts and instead push rate across the portfolio will end up with an adverse selection.
A Healthy Market Will Not Turn
This balanced approach to rate change is reflective of the fact that the industry remains healthy. By most historic measures the current market does not show the signs of weakness necessary to predicate a hard market turn. Industry surplus at $564.2 billion remains near record levels, and according to Advisen, there is approximately $85 billion in excess capacity in the market.
While industry return on equity is low by historic standards, this capital does not have a more compelling place to go in a struggling domestic economy or a euro zone in turmoil. Pricing, while dropping for the last seven years, is still above 1999-2000 levels in most lines. And combined ratios, while high, are not high by historic standards. Similarly, net written premium to policy holder surplus is at a ratio of 0.8:1.0--lower than any point in the last 27 years.
Only a major catastrophe or a steep drop in equity markets, as we saw in 2008, will remove this excess capacity. So we appear to be in for a soft landing that allows insurers to improve underwriting results and generate acceptable returns for shareholders through current market movement. This is the new normal: a market that corrects itself more efficiently and with a more benign impact than we have seen historically.