Medical professional liability insurers are at a sweet spot intheir underwriting cycle. For insurers, it's a place where lossratios are low, capital is plentiful–and in this case premiums,though under pressure, are only slightly off their peak.

But as any athlete knows, maintaining momentum is a toughproposition, and clear signs of a turn in fortune are alreadyevident. They can be found in the somewhat overlooked corner ofinsurance known as loss reserves.

Over the past five years, MPL insurers have released billions ofdollars in prior-year reserves. Aggregated MPL industry datareviewed by Milliman shows more than $7.5 billion in prior-yearreserve releases from 2005 through 2009, with well over half of theamount booked in the last two years of the period.

As the accompanying bar graph indicates, reserve releases ineach of 2008 and 2009 accounted for an almost 25 percentage pointreduction in the MPL industry aggregate combined ratio, up from a20 percentage point reduction in 2007, and sharply up from 5-to-10percentage point impacts in 2005 and 2006, respectively.

Reserve takedowns, however, arenot a novel phenomenon in the world of MPL, where loss volatilityis a fact of life, the initial estimate of a loss is just that–anestimate–and is revised over time as losses approach their ultimatevalue.

Reserve adjustments are a necessary part of the process inarriving at an accurate picture of an insurer's financial health,but they do not occur in isolation.

As loss trends increase, there is an upward pressure on ratesand insurers see the need to strengthen reserves, which in turninversely affects surplus.

But as insurers gain comfort about their capitalization,reserves may be released and enhance surplus or pay dividends, andwith their release, premiums tend to slacken and policy terms andconditions are often relaxed, giving rise to a soft market wherepolicy terms are favorable to buyers.

The conditions that now dominate the MPL market in many waysresemble the soft market that followed the steep rate increasesthat occurred during the mid-to-late 1980s. Conditions thenresulted in earned premium soaring some 145 percent before insurersstarted to take down reserves that had built up over the period dueto loss trends leveling out before premiums halted their climb.

This period of revenue and capital growth were then followed bya falloff in premium and a release in reserves as insurersreassessed their expected future claims and reevaluated rateadequacy.

In 1989–the advent of the previous soft market–insurers released$1.5 billion in reserves. By 1994, reserve takedowns reached $2.1billion, or 24 percent of net written premium, before tapering offover the next five years when the calendar-year loss and lossadjustment expense ratio soared to more than 130.

At the same time, investment income–a critical buffer to theprofitability of a long-tail line like MPL–also failed to mitigatethe dual devastation of falling premiums and soaring losses, whichhad dragged down industry results by the late 1990s.

From 1998 through 2001, MPL insurers–victims of an extended lowinterest-rate environment that continues today–saw investmentincome topple because of a decline in interest rates on bonds andother fixed-income securities, which make up some 80 percent of theinvestments.

If history is a guide to the future, then current MPL resultsare likely to deteriorate over the next few years. The big questionnow before insurers is this: How long will the industry be able tohead off combined ratios of 130 or more?

If the present cycle were to follow the same trajectory as theprevious one, insurers could expect that reserves will prop upearnings for the next few years.

But following this path, by 2014 the combination of inadequatepricing and shrinking reserves could cause the combined ratio toonce again climb well above underwriting breakeven of 100.

However, the forces that drive the MPL market rarely converge inquite the same way.

Premium increases of the most recent hard market were not aslarge as those of the previous cycle and took longer to develop.Moreover, reserves have been released at a faster pace.

There are also signs that the improvements in claimsfrequency–which happened to occur as insurers started to take heftyrate actions in the early 2000s, and contributed to insurers'recent good fortune–may have started to abate.

If frequency trends were to reverse–a plausible scenario,considering many of the still unanswered questions surroundingtheir improvement–insurers' prior-year reserves could be exhaustedsooner than they were in the previous cycle.

In addition, changes in the regulatory or legal environmentscould tamp down MPL insurers' results in the years ahead.

For example, in February, the Illinois Supreme Court ruled thata 2005 law to cap certain types of MPL awards against doctors at$500,000, and judgments against hospitals at $1 million, wasunconstitutional.

Meanwhile, opponents of a cap on non-economic MPL awards inMissouri have attacked the reform on similar legal grounds, andtort reforms have come under close scrutiny in otherjurisdictions.

A reversal in any one of these factors could increase insurers'claims or operating costs and deplete insurers' reserves soonerthan expected.

If that were to happen, combined ratios of 130 or more may behere even sooner than anyone realizes.

Richard Lord, FCAS, MAAA, is a principal andconsulting actuary in the Los Angeles office of Milliman and may becontacted at [email protected].

Stephen Koca, FCAS, MAAA, is a consultingactuary in the Los Angeles office of Milliman and may be contactedat [email protected].