Hard Market Not Solvency-Driven
London Editor
Vienna, Austria
The current cycle of rate hardening in the United States is mirroring the only other hard-market cycle on record not to be driven by solvency issues–the upturn from 1965 to 1972, according to Douglas W. Leatherdale, chairman, president and chief executive officer of the St. Paul Companies.
During the 1965-1972 period, there was no shortage of capital and price hardening was "driven by 10 years of below-trend premium growth, and, of course, the resulting poor profitability," he said.
Price increases at that time were modest–in the low double digits–and the upcycle lasted for seven years, he noted. "Prices hit adequate levels, but did not significantly overshoot them," he said here during a speech entitled, "The Insurance Revolution–Seize the Day" at the International Insurance Society's annual conference.
He suggested a similar scenario is currently in play and that price increases from 1999 through 2000 are following the example set in 1965-1972. "Since 1987, weve basically operated in a softening market, and in 1999, prices once again appeared to be 20 percent inadequate–the historic turning point for the cycle," Mr. Leatherdale said.
On the other hand, two other hard market cycles–the period between 1975 and 1978, and the years between 1983 and 1987–were driven by the fear among many companies that they teetered on the brink of insolvency, he indicated.
Mr. Leatherdale–who is the new chairman of the New York-based IIS, succeeding Kees J. Storm, the chairman of the executive board of AEGON N.V, said that in 1974, the U.S. stock market was down about 30 percent. "Since most property-casualty companies had more in common stock holdings than they did in surplus, surplus declined by an even greater amount," he recalled.
Many companies "were on the verge of insolvency" and were forced to liquidate their portfolios, he noted. As a result, "the upcycle was sharp and short, lasting three years," he said.
For the next upcycle, beginning in 1983, solvency was again an issue for the U.S. insurance industry, Mr. Leatherdale said, noting that many U.S. insurers were in fact technically insolvent. "Companies had an unknown amount of asbestos and environmental liabilities not yet recorded on their balance sheets," he said.
In addition, interest rates were rising and, as a result, "the market value of bond portfolios was significantly below carrying value," he said, adding that because these factors were not reflected in statutory statements, "we didnt really know on an industry basis how short we were."
"To make up for the lack of real capital, the upcycle was steep and prices climbed to meteoric levels," he said. "By the end of the four-year upcycle, we were 30 percent above [what would have been adequate pricing levels]."
As a result of this over-correction in pricing, new entrants and new capital entered the industry en masse, which was "a significant factor in the subsequent 12 years of soft market," according to Mr. Leatherdale. "This is a lesson we should take to heart: short-run benefits can lead to long-run pain."
Mr. Leatherdale disputed the contention of many industry observers who claim that excess capital in the market today will shorten the cycle, creating a situation thats different from any cycle experienced in the past. The industrys total leverage–the sum of reserve and premium leverage ratios–show that the U.S. p-c industry was undercapitalized in the 1970s, overcapitalized in the mid-1990s, and now is "comfortably in between."
Mr. Leatherdale said it is unlikely that there will be another huge influx of new capital as a result of the current upcycle because industry pricing still is 15-20 percent below adequate levels, "so any market entrant is not going to find an easy time of it." He added that the level of expertise, or human capital "required to effectively deploy the financial capital is very difficult to assemble, as many new entrants have discovered."
Going forward, Mr. Leatherdale said that in the United States the key industry indicators–pricing, growth and profitability–are looking up. The U.S. p-c insurance industry "will reach adequate pricing before the next downward cycle, but will not go much above. That means four years or more of expanding margins," he said.
Premium growth will follow the price increases, he predicted. "We believe premium growth will exceed the current industry forecasts of 7 percent for 2001," he said, noting that reports from the Insurance Services Office in New York indicate that first quarter 2001 premium grew by 10.4 percent.
"Continued industry pricing discipline is mandated by the primary insurers need to replenish understated reserves and to recoup significantly higher reinsurance premiums," he said.
Although the industrys balance sheet is strong, many companies "have reserve holes," Mr. Leatherdale asserted. In the first quarter of 2001, the industry reported an increase in incurred losses of 11.9 percent, which excludes catastrophes. "[W]e believe a significant portion of these loss costs trends industrywide are driven by understated reserves that can only be rectified through continued increases in price and profits," he said.
Because the current earnings recovery will extend longer than the two or three years seen in solvency-driven hard markets, "weak players will not be saved by the cycle," he contended. "Strong companies with strong balance sheets and competitive positioning will be able to capitalize on both the cycle and competitors weakness."
Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 20, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.
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