Sector’s cash flow suggests hard market in 2008; finite re probes hasten cycles

The power to predict property-casualty pricing cycles accurately has long eluded the best minds in the industry–but analysts at Cochran Caronia & Company have developed a technique that might be quite useful for anyone trying to guess where prices are headed.

We believe cash flow is a reliable tool to predict pricing cycles, and based on current industry conditions, we’re predicting a significant drop in industry cash flow in 2006, and the bottoming out of the pricing cycle by 2007.

To a remarkably consistent degree, we have found that premium pricing in the p-c sector more than doubles about one year after a meaningful drop in industry operating cash flow. In the nine up-and-down cycles of p-c underwriting since 1942, cash flow sharply hit bottom one year before each of eight upturns in premiums. (There was one exception, though. In the current cycle, there was a two-year delay between negative cash flow and the cycle uptick.)

The reverse of this pattern is also found to be true. When cash flow rises significantly, p-c premium price hikes lose steam, bringing earnings down with them. If the past is any guide, we can expect a particularly sharp deceleration in premiums in 2006. That’s because cash flow historically rises one to two years before cycles hit bottom and premiums flatten. The last peak in cash flow took place in 2004.

The timing of industry slumps varies somewhat more than its peaks. In four instances, cash flow rose one year before the closing of a cycle. In three instances, the updraft occurred two years before the cycle’s end. The two-year gap occurred in three of the last four cycle-ending points. In each of these cases, there was a significant cash-flow drought preceding the cycle upturn.

Now, looking at end of the 2000 to 2003 hard market: At the close of 2002, cash flow showed that the up cycle would end in 2003. Cash flow began to improve in 2001 and hit an “inflection point” in 2002. The inflection signals that premium growth likely will slow down within 12 to 18 months.

Cash flow to premium typically approximates 20 percent as a prelude to the end of the up cycle. The ratio crossed the 20 percent level in mid-2002 and continued to rise thereafter. Based on this we predicted that premium growth would decelerate in 2004–and it did. In 2004, premium growth was less than half the level of 2003.

One crucial forecast we are making is that going forward, the industry will see shorter cycle durations. If the p-c marketplace is a melody of ups and downs, it is growing decidedly more up-tempo. We believe that the pricing cycle’s pace is quickening. The time from cycle peak to trough should fall from an average of eight years to two to three years for the current cycle.

This is because the increasing difficulty to use finite reinsurance, heightened scrutiny by rating agencies and an overall emphasis on transparency all contribute to hastened shifts from pricing peak to trough.

The continuing investigations into finite reinsurance play a big role in all of this. As insurers begin to use less finite reinsurance, that should hasten the shift from pricing peak to trough.

Finite risk transactions are based on the premise of transfer of financial risk but limited transfer of insurance risk. Finite reinsurance covers are sold by reinsurers and purchased by insurers. A reinsurer’s exposure to loss is traditionally capped by an aggregate limit that usually meets minimum requirements for risk transfer (defined by FASB 113).

The coverage provides an insurer with temporary earnings and/or surplus relief from major loss events or reserve deterioration. However, the differential between actual and contractual loss/reserve deterioration is eventually refunded through a variety of mechanisms (that is, multi-year premiums, commutations, and/or profit commissions).

Finite reinsurance was used by insurers in the late 1990s to manage the high level of losses stemming from the poor underwriting environment. These covers helped to mask the level of adverse loss development from 1997 to 2001 and were one of the factors that extended the soft pricing cycle into the 2001 underwriting year.

However, going forward, the ability to extend the cycle with finite re likely will not be an option. As a result, it will be more challenging to mask the expected significant deterioration in results in 2006 and 2007. Inability to prop up balance sheets, therefore, should translate into pressures to raise prices potentially by 2008.

Looking ahead to 2006, industry cash flow now is showing an early warning signal that “real industry earnings” (which exclude material reserve swings) are on the edge of a big deterioration. Operating cash flow is a good precursor for real industry earnings, as cash-flow trends usually show movements in industry earnings 12 to 18 months in advance.

Growth in our Cash Flow Index slowed rapidly and actually fell for the first time in the 2004 fourth quarter. The growth rate for the index has slowed from an average of 60 percent for 2003 down to 16 percent for 2004 with an actual decline of 6 percent in the 2004 fourth quarter. (Only a portion of the decline was caused by a high level of hurricane activity.)

Our data project that industry cash flow will drop to between $40 billion and $45 billion in 2006, down from about $75 billion in 2004. The fall is caused by a post-hard-market pattern in which heightened competition drives down premium rates, loosens underwriting standards and ultimately results in higher paid loss levels.

Historically, two years after a hard market, paid losses rose by an average of 12 percent to 13 percent. This suggests that the paid loss ratio will likely rise from an estimated 65 percent in 2004 to 72 percent to 73 percent in 2006, which, in turn, should lower cash flow by almost 50 percent from 2004 levels.

Another factor that indicates there will be a severe inflection in “real earnings” levels in 2006 is a relatively low historic cash buildup.

In the up part of the pricing cycle, the industry normally develops a cushion where cash flow exceeds reported earnings by a significant margin. This cushion provides for a good base to grow investment income, protect against accelerating claim costs, and ultimately serve as a source of earnings when underwriting results in future years turn negative.

However, this cushion between cash flow and earnings is at historic lows for a post-hard-market period. The cushion has averaged 17 percent of premium in the 1975-1978 hard market and 22 percent in the 1985-1987 hard market. In contrast, however, the cushion built up in the most recent up cycle of 2001-2004 averaged only 11 percent of premium.

So, all this means that the current cycle could hit bottom in 2007.

The expected sharp drop in operating cash flow–combined with a relatively low cushion–means that the underwriting cycle will likely go from peak to trough in a mere two to three years’ time frame (2004 to 2006/2007). As we said before, this is in contrast to the eight-year duration from peak to trough of the last two underwriting cycles.

The p-c industry is on a course to return to 1997 operating levels. By 2006, underlying fundamentals of the business should be on par with those experienced in 1997–10 years after the last peak.

Cash flow divided by paid losses is a good measure of underwriting health and financial flexibility. In robust periods, cash flow equals 30 to 40 percent of paid losses. We expect the ratio to decline to 13 to 15 percent by 2006, in line with the 1997 level.

Additionally, investment income should represent 100 percent of cash flow, as it was in 1997. By 2007, cash flow has the potential to drop to 5 percent of paid losses and investment income should represent more than 200 percent of cash flow.

Adam Klauber is an analyst at the New York-based investment research firm Cochran, Caronia Securities LLC.

“Going forward, the ability to extend the cycle with finite re likely will not be an option. Inability to prop up balance sheets, therefore, should translate into pressures to raise prices potentially by 2008.”

==Adam Klauber

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“As insurers begin to use less finite reinsurance, that should hasten the shift from pricing peak to trough,” says Mr. Klauber.