The Big Question For 2002: Will Hard Market Last Long?
Following over a decade of declines, the price for commercial lines insurance began to increase in 2000. Price increases accelerated with 2001 renewals. Following the horrendous losses to commercial lines insurers as a result of the events of Sept. 11, businesses are expecting even higher rates of increase in 2002.
As opposed to prior hard markets, businesses in 2002 have a lot more options to manage exposures than through the pure transfer of risk by insurance. In considering these options, businesses need to assess when the current upturn in pricing will peak, and when pricing will return to rates that clients consider acceptable.
As shown in Chart 1, prices for commercial lines insurance began to increase in 2000, following 12 years of decline. Below, I examine how general liability performed in the last major cycle and suggest what factors are likely to shape the nature and duration of the current hard market. (A similar analysis on the property side–too long to include in this article–leads to the same results.)
Chart 2 shows net written premiums for general liability, using premiums as an indicator of price movements in this period. While there is a volume component of written premiums–an increase or decrease in the number of businesses buying insurance, and changes in the amount of insurance purchased–such volume changes were miniscule compared to the price fluctuations over this period.
As shown in Chart 2, the upturn in the market basically began in 1985, and continued for three years. We can then ask if the current upturn is likely to last longer or shorter than the mid-1980s cycle. Below are arguments that suggest a longer cycle:
The market is more concentrated and hence less competitive than in the mid-1980s. A number of commercial writers have disappeared since the mid-1980s, including household names like Aetna and Continental.
Management is more bottom-line oriented. This reflects increased institutional shareholder activism and the more general concern about share values among all equity holders. An increased emphasis on the bottom line by shareholders would suggest that any company identified as an early price cutter might find its stock price punished and its management excoriated by institutional owners.
The arguments that suggest a shorter cycle versus the 1980s include:
Insurers and reinsurers have a clearer target rate of return in mind for pricing than they had in the mid-1980s. This reflects the increased technical nature of risk assessment by insurers and the increased financial orientation of decision-making.
Given the events of Sept. 11, the psychology of the marketplace seems to be that fairly sizeable price increases will be experienced in 2002, implying that insurers will achieve their targets early in this cycle vis-a-vis prior cycles.
Capital is moving much faster into the insurance industry in this hard market than in prior upswings. Transactions valued at more than $13 billion have already been announced, far exceeding the capital that entered the industry in the hard property catastrophe market cycle of 1993/1994.
Commercial lines insurance clients have a lot more options available to them than in the mid-1980s. The use of alternative risk-transfer vehicles is well developed. As insurers see that their customers are walking away, self-insuring rather than paying directly for risk transfer, they might be more inclined to decrease prices.
In sum, the weight of argument seems to favor a shorter upturn than in the mid-1980s. Since the upturn in commercial lines began in 2000, this analysis would suggest that price increases would level out some time in 2003.
The analysis above addresses the issue of when prices might start to decline. However, commercial lines customers are not interested in when prices start to fall as such, but rather when prices might return to a fair level.
As businesses consider whether to move to the ART market, such as setting up or joining a captive, they are asking how many years will they be facing "exorbitant" pricing. This is a critical factor in their consideration of the financial implications of a move to an ART option.
To address this issue, Chart 3 shows the rate of return for capital allocated to the general liability line over the 1980s cycle. As shown in Chart 3, the general liability line returned to profitability in 1987. The rate of return swelled in the succeeding years to 1992.
If we take 13 percent (equal to the rate of return for the Fortune 500 over this period) as an indicator of fair pricing, then policyholders were probably paying too much for general liability insurance in the years up to 1991. One might then conclude that a business considering moving to ART in the mid-1980s was facing a market of exorbitant pricing of four or five years.
However, there is another message from this chart. A policyholder that opted for self-insurance over the whole of this period would miss all the good years preceding the crisis and the good years following the crisis, beginning in 1992. Given the competitive nature of the insurance business, profit levels tend to be sub-par. This implies that over the long term it will be hard for a business to beat insurance as a risk-transfer mechanism in terms of price.
Other factors–stability, cash flow and control–are more likely to be the deciding factors in self-insuring.
This analysis suggests that price increases in commercial lines might have run their course by 2003. Above-average rates of return might persist for three-to-five years. These conclusions are highly tentative and are presented more in the spirit of providing a framework for decision-makers than as definitive projections.
The outlook for 2002 is extremely cloudy. Future terrorist activities, natural catastrophes and the recession in the U.S. economy–developments in all of these areas will make a critical difference in the cycle.
Sean F. Mooney, CPCU, is senior vice president, research director and economist at Guy Carpenter & Company in New York.
Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, January 7, 2002. Copyright 2002 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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