Lessons from the soft market: how to avoid it next time around
The repercussions of the current soft market for P&C insurers and reinsurers in the light of current accident year returns is the focus of much industry discussion. This phenomenon is not new to our industry, however, as the battle scars from the late 1990s are still felt by many underwriters and management teams.
Drivers of the soft pricing cycle The insurance pricing cycle is affected by many factors. Key among these factors is risk selection and underwriting controls and processes. Other important drivers are prior calendar year profitability, level of industry capital, interest rates and expectations around loss cost trends. In prior soft markets, inadequate pricing was driven by a combination of aggressive competition to increase top-line revenue, the overuse of reinsurance to hedge low rates, the use by insurers and reinsurers of multi-year contracts to lock in terms, and an increase in programme business where underwriting authority is delegated to managing general agents (MGAs). The underlying theme was the fundamental relaxation of underwriting standards as evidenced by a general lack of use of technical tools, and the failure to implement and adhere to underwriting controls and to develop underwriting processes designed to include and embrace sound pricing analytics.
Often in a softening market, companies aggressively target business to increase policy counts, and therefore market share, even if it means writing business at significantly lower rates. The underlying rationale of increasing market share to cover marginal costs is based on the assumption that loss costs are estimated correctly. However, even a small change in loss cost trends and an incomplete understanding of the exposures being underwritten can have an amplified impact on the profitability of a book of business due to the larger volume and thinner margins. Exacerbating this problem is the use of underpriced reinsurance. Reinsurers, also plagued by declining premiums and eager for market share, often bear the brunt of this aggressive pricing. Because reinsurers are farther removed from the original risk, and business is written largely on an excess of excess basis, a modest change in the underlying economics can have a significant impact on reinsurers’ results. With rate decreases often two to three times greater than the original actuarial pricing projections, loss ratios could be well over 100 percent and combined ratios close to 200 percent.
During soft markets, it is not unusual for some companies to elect to expand their business by partnering with an MGA and thus avoid sustaining large start-up costs. This strategy can be profitable if appropriate underwriting and claims controls and processes are in place, and the interests of both parties are aligned. However, in prior underwriting cycles, there were far too many instances where this strategy was executed poorly—where the business written by the MGA was not appropriately monitored, and feedback from early reported claims and reserves was largely ignored. Further, where the programme manager is compensated based on volume rather than profit, many companies employing this type of ‘growth’ strategy did in fact expand their businesses, but at unprofitable levels. In many cases, closer oversight and more proactive claims monitoring could have mitigated the sting of the poorly written and managed programme business.
Implications of a prolonged soft market
Aside from the immediate loss of capital resulting from unprofitable business, the most significant impact of a prolonged soft market is the significant reserving problems that tend to follow, which for casualty business often takes considerable time to materialise due to its long longtailed nature. According to Standard & Poor’s,1 the initial reserving estimates for accident years 1997-2001 showed adverse development by almost $60 billion in the 2002-2005 period. Along with these reserve increases and the questions surrounding corporate management and actuarial credibility, the industry also saw a large increase in reinsurance disputes. Reinsurers that thought that the terms of the reinsurance contract or the expected controls in place by their cedants were not being met began to slow down or even stop payments to their ceding companies, causing cash flow and liquidity problems for these companies in a number of cases, as well as raising questions about the potential collectability of the reinsurance asset on the balance sheet. Because of these concerns, some capital-challenged companies struggled to raise additional debt or equity, and as a result, were forced to sell off strong and viable businesses, saw the departure of teams of talented underwriters and executives, or went into voluntary run-off as their ratings were downgraded. Some companies fared even worse, as they were forced into regulatory supervision or became insolvent.
The current focus on capital management, understanding the missteps made in prior market cycles, and better use of technical tools and technology, can prepare us to navigate through the severe impacts of a soft market, or at least shorten its duration. In fact, many companies have prospered through prior soft markets, largely due to strong balance sheets, talented management teams, disciplined underwriting and robust underwriting controls. Strategies that can help companies navigate through a soft market include:
• Avoidance of optimistic and aggressive reserving
• Commitment to active price monitoring
• Attention to early warning indicators, and
• Disciplined capital, expense and premium management.
"The current focus on capital management, understanding the missteps made in prior market cycles, and better use of technical tools and technology, can prepare us to navigate through the severe impacts of a soft market, or at least shorten its duration."
For many companies, optimistic and aggressive reserving can prolong the duration of the soft market and increase the severity of loss. By recognising profits too soon via the pegged loss ratio versus actual and expected emergence, companies may be doing themselves a disservice. Given the long tail on casualty business, ignoring early signals from loss activity or not proactively managing and auditing claims can create a false sense of security. Additionally, reserving actuaries and management would do well to pay attention to industry results and the views of the business from the wide range of industry and financial experts in the financial services arena. Often management strives to find reasons to justify why their results are better than average, rather than understand what would make their results mimic the industry. This exercise can provide powerful insights into their business and eliminate the ‘just kidding yourself’ phase of the reserving cycle. Another factor that contributes to aggressive reserving is where reserves are booked below the actuarial best estimate. In a soft market, these estimates tend to have a downward bias, and so booking below such an estimate could create problems in the future, especially if a catastrophe occurs and the company finds itself needing to raise capital. Today’s Sarbanes Oxley environment helps mitigate this risk as both boards and corporate management teams pay more attention to the reserve levels on the balance sheet.
A second tool is active price monitoring. Actuaries are in a strong position to be the gatekeepers of this process, which has both expanded in use and evolved since the late 1990s thanks to technology advances. Understanding changes in price (adjusted for exposure, rate and structure), along with a point of view on prior accident year profitability, and further comparing these to industry norms, can provide management with strong insights into current accident year returns. While the impact of changes in terms and conditions creates some additional noise, a strong focus on the magnitude and direction of price changes (weakening/strengthening) relative to industry statistics may provide additional detail at the contract level, giving companies greater insight to understand the market conditions and ultimately help companies develop a strategy around these changes.
Expanding analytics to incorporate additional metrics such as hit ratios (bound accounts to priced accounts), new business flow, average premium level and growth in policy count can provide further insight into the underlying business. In particular, the growth in policy count could indicate that a company has relaxed its underwriting standards or simply signify the successful execution of a growth strategy. The reasons for large increases in policy counts can often be understood by underwriting teams and claims staff, who have early visibility to new exposures, and the types of claims reported can serve as a partner in understanding changes to the underlying business. On the reinsurance side, analysing signed lines to authorised lines and changes in the number of treaty participants may also be telling signs with regard to market capacity. Significantly declining retention ratios are another key indicator of increased competition.
It is possible to actively navigate our way through the soft market with disciplined capital, expense and premium management. By managing capital and its deployment, and by maintaining focus on the more profitable risks, companies can deliver returns that meet shareholders’ expectations. Expense management is another proactive tool to use in a soft market cycle, because although expense ratios can increase, they have no development tail. Premium management is another critical area for companies to focus attention on, as analysts, rating agencies and regulators evaluate premium growth in casualty premium as well as underlying rate levels and market conditions. Management’s attention in these areas will provide a robust system of checks and balances, which will allow a company to stay focused on top-line growth in tough markets.
Today’s soft market is real, but not new, and it can be navigated by strong management teams who are committed to building sustainable results over short-term gains. With management relying on experience and disciplined underwriting, companies should be able to avoid the mistakes of prior soft markets and be in a strong position for the market turn. At the heart of these processes and controls lies a corporate culture that actively encourages all employees to build shareholder value by avoiding excessive risk.
Mike Angelina is chief risk officer and chief actuary at Endurance Specialty Holdings Ltd. He can be contacted at: firstname.lastname@example.org