Is The Soft Market Over?

Recent weeks have seen no shortage of market forecasts that will impact insurers and brokers inside and outside the E&S/specialty insurance sector. Two of the latest, published in January, predict the soft market could end this year.

In early January, the chief executive of online insurance exchange MarketScout said the decline in insurance prices will halt this year because rates have become inadequate to cover losses and expenses. Richard Kerr, CEO of Dallas-based MarketScout, said the expected increases that should follow may not be seen for months, however.

Separately, a few days earlier, Advisen Ltd. predicted that the commercial insurance premium market cycle is near a bottom and general that prices will start to rise by the fourth quarter of 2009 or the first quarter of 2010.

“In years past, insurance companies recouped underwriting losses with investment income, but in 2008 the combination of underwriting losses and material investment losses means a five-year soft market is coming to an end,” said David K. Bradford, Advisen executive vice president and chief knowledge officer, in a statement.

“The global recession may delay the return of hard market conditions by keeping demand for insurance down, but once the hard market sets in, it is likely to last longer than was the case in recent cycles,” he added.

A chart released by Dallas-based MarketScout illustrating rate adequacy, shows soft market conditions have pushed property-casualty rates down 7 percent below adequate levels in 2008.

The chart revealed that rates have increased only 13 percent since 2001, while inflationary costs–as measured by the consumer price index, have grown 22 percent since 2001.

Assuming that rates were adequate in 2001, rates should have grown by the same 22 percent simply to keep pace with inflation. With rates actually growing on 13 percent, they are now 7 percent below adequate levels.

Specifically, the chart showed that a $100 premium rate in 2001, adjusted for inflation, would stand at about $122 in 2008. However, that base $100 property-casualty rate in 2001, adjusted for rate changes measured on MarketScout's monthly barometer rate survey, rose to a high of $163 in 2004 and dropped to $113 in 2008–$9 below adequate rate adjusted for inflation.

MarketScout noted that in addition to inflation, there are dozen of other actuarial factors that go into determining adequate premiums, suggesting that the analysis gives just a rough estimate of the degree of rate inadequacy.

“At the end of every year we calculate the rate adequacy of the property and casualty industry,” said Mr. Kerr, “According to our calculations, the property and casualty rate index fell below 'rate adequacy' in the fourth quarter of 2008.

“Therefore, we believe this signifies the beginning of the end of the current soft market. It may take as much as a year for rates to actually start increasing but the soft market trend has turned.”

The Advisen report explained that the commercial insurance pricing cycle is a function of the law of supply-and-demand. When the supply of insurance–as measured by the capital held by insurers to support underwriting–grows faster than the growth in demand for insurance, rates fall.

Between the fourth quarter of 2003 and the second quarter of 2008, capital to support underwriting grew rapidly, driven by underwriting profits and strong investment returns. The rapid accumulation of risk capital fueled competition, driving down rate levels.

Advisen experts said they estimated that the p-c insurance industry was roughly $100 billion overcapitalized as of the end of 2007. According to Advisen, policyholders' surplus–statutory accounting terminology for the capital supporting underwriting operation–needed to be reduced by about $100 billion through losses, dividends, share buy-backs or other means to bring insurance supply in line with demand.

Advisen said that U.S. policyholders' surplus declined $36.8 billion, or 7 percent, for the 12 months ended Sept. 30, 2008, citing results from A.M. Best.

Consultancy Towers Perrin forecasted as much as an $80 billion decrease in surplus by the end of 2008. Advisen added that while $80 billion represents a significant sum of the $100 billion in excess capacity–moving the market much closer to the bottom of the soft market cycle–the demand side of the equation also has changed since the end of 2007.

According to the International Monetary Fund, Advisen said, the global economy is now in a recession, with growth projected at 2.2 percent for 2009, down from 3.7 percent projected for 2008. The IMF projected that advanced economies as a group will contract 0.3 percent, with the U.S. contracting 0.7 percent.

Advisen said that in mature economies, such as the United States, Canada and Western Europe, the demand for insurance grows about the same pace as the overall economy. Until the collapse of the U.S. subprime mortgage market threw the global economy into a recession, economic growth was robust–although the increase in insurance supply far outstripped the growth in insurance demand.

The economic crisis impacts both the supply of and the demand for commercial p-c insurance, Advisen said. On the supply side, plummeting stock markets, frozen credit markets and in some cases, investments in “toxic” mortgage-backed assets caused many insurers to post investment losses in the third quarter.

These investment losses are on top of underwriting losses driven by five years of price cutting, higher-than-average catastrophe losses, and reserves for directors and officers liability and errors and omissions liability claims resulting from the subprime mortgage meltdown and the subsequent credit crisis.

The subprime/credit crisis will produce $9.6 billion in ultimate losses for the D&O and D&O lines over accident years 2007, 2008 and 2009, according to Advisen forecasts.

According to Advisen, as companies downsize, the demand for insurance not only decreases, it decreases at a pace faster than the contraction of the overall economy.

While going without insurance is not an option for most companies, many will look for ways to slash their insurance bills. An obvious option is to raise retentions–which will increase the use of captives and other alternative risk financing mechanisms.

Advisen said that more companies will also gravitate to low-cost providers, even if it is necessary to loosen financial security criteria. Although these are typical responses to hard market conditions, it is likely that companies will resort to them even before the market turns as they are squeezed by a deteriorating economy. All these factors will help prolong the current soft market, Advisen said.

One thing that could keep market conditions competitive in some sectors is a weakened American International Group battling for renewals, Advisen said. Because AIG is perceived by its competitors as vulnerable, competition for its clients will remain intense. This heightened level of competition could keep price levels in some segments of the commercial lines market depressed after economic factors indicate the market should be hardening.

Advisen added that one or more very large catastrophe losses could trigger a sudden and sharp increase in insurance prices. If catastrophe losses are mild-to-moderate in 2009, average commercial insurance prices will begin to creep higher in the fourth quarter of 2009 or the first quarter of 2010.

Looking ahead, not every line of business will increase at the same pace, Advisen said. The reinsurance market will firm up sooner than the overall primary insurance market, placing upward pressure on heavily reinsured lines such as excess liability, Advisen observed.

Looking back, MarketScout's December 2008 barometer registered few changes by line or size of account from November. Overall insurance rates showed an average decrease of 9 percent in December, MarketScout said.

By account size:

o Small account rates (up to $25,000 premium) remained down 8 percent.

o Medium-sized accounts rates ($25,001-$250,000 premium) were down 9 percent compared to down 8 percent in November.

o Rates for large accounts ($250,000-$1 million premium) were down 9 percent in December, compared to down 10 percent in November.

o Jumbo accounts (over $1 million in premium) were unchanged from November to December, down 10 percent.

Examining coverage classes, there were no dramatic developments in December, with nine of 14 classes of business exhibiting a change of 1 percent compared to drops reported on the November barometer, but all classes remained down in December, ranging from 10 percent down (commercial property and general liability) to 5 percent (surety).

The complete MarketScout barometer report is available at www.marketscout.com.

Advisen, which publishes a quarterly survey of risk managers–the RIMS Benchmark Survey (in conjunction with the Risk and Insurance Management Society)– had a different take on changes for the last quarter, reporting that rates for property, general liability and D&O “all decreased at a materially slower pace.”

In its fourth-quarter survey report released last week, Advisen reported:

o The average general liability premium fell more than any other line at 5.9 percent in fourth-quarter 2008. The third-quarter decline was greater, however, at 9.6 percent.

o Property premiums were off by 3.8 percent, compared to the 8.5 percent decline in the third quarter.

o D&O rates fell 1.2 percent in the fourth quarter, down from 2.1 percent in the third quarter. Excluding financial institution buyers of insurance, the drop was 4.5 percent in fourth-quarter 2008, as compared with 7.5 percent in the third quarter.

D&O continued to show two trends–an increase for financial institutions buying insurance in the face of a meltdown in that sector and falling average premiums for commercial business in other sectors, Advisen said.

Focusing specifically on the D&O line, an earlier report–released by Aon in late November–revealed that pricing for directors and officers liability insurance continued to fall in the third quarter, dipping below a low level of prices buyers experienced during the last soft market

Aon's Quarterly D&O Pricing Index report also said that as stock prices fall, D&O rates can be expected to head upwards.

Aon Financial Services Group said that when inflation is factored into the analysis, its third-quarter 2008 analysis marked the first time the broker had seen pricing drop below that of the index's base year of 2001, which was a year when firms enjoyed a very soft market.

The pricing index, as charted on a graph displaying a downward sloping line broken up by only a few minor quarter-to-quarter price hikes, was actually 13 percent higher than the 2001 base year in nominal terms–not adjusted for inflation. Factoring in inflationary effects, however, Aon estimated that third-quarter D&O pricing was 8.8 percent lower in real terms than 2001.

Aon also noted that third-quarter 2008 was the 20th consecutive quarter for which D&O pricing fell year over year. In other words, when each quarter's price level index is compared to the same quarter a year earlier, the pricing index for the more recent quarter is lower.

The year-over-year decline for third-quarter 2008 was 5 percent, Aon reported.

As noted in prior reports, the overall nominal pricing index of 1.13 reflects continued price declines for D&O insurance buyers outside the financial institutions sector (non-FI risks) across all industries as a whole. But the index shows there were price hikes for financial institutions (FI risks), which started in late 2007.

Without adjusting for inflation, the separate indices were 1.02 for non-FI risks and 1.58 for FI risks. This means that non-FI prices were only 2 percent higher than 2001–without an inflation adjustment, which would indicate a double-digit decline in real terms. FI prices were 58 percent higher than 2001 without an inflation adjustment.

Aon said it expects D&O pricing to start moving up for everyone in 2009.

“Historically, D&O pricing moves in the opposite direction of the equity markets,” the report said. “The predominantly negative volatility of the markets over the past year in general, and the past three months in particular, would indicate that D&O pricing and coverage characteristics are going to change.”

“As stock prices fall, shareholders become increasingly disgruntled and eventually look for someone, or something, to blame,” the report said.

Noting that there is typically a lag between the drop in stock prices and the rise in D&O pricing, Aon forecasted a shorter lag this time around than history would suggest “given the abruptness with which the [stock] markets have fallen.”

The report included, for the first time, a chart comparing D&O pricing, claims frequency and stock market indices to provide a historical perspective.

The Aon Quarterly D&O Pricing Index is compiled using the proprietary policy data of Aon's Financial Service Group.

According to a report footnote, the D&O Pricing Index is currently comprised of policy information on over 5,000 D&O programs for publicly traded companies–predominately U.S. insureds–between Jan. 1, 2001 and Sept. 30, 2008. The Index represents the weighted average cost of $1 million of D&O insurance.

According to the report, this average “rate per million” of limit includes full D&O placements and Side-A (non-indemnifiable loss) placements. Programs with blended coverage (such as a shared limit for D&O and fiduciary liability combined) are excluded from the Index.