The title of this article is offered with apologies to James Carville and with a slight modification to the quote he made famous during the 1992 presidential campaign: "It's the economy, stupid." With numerous complicated strategic forces influencing a national election, back in 1992 it was the economy that ruled the day, just as it seems to be today.
In the professional lines arena of the insurance industry, numerous forces at work affect the market between the ebb and flow of the hard and soft cycles. Though hardly an exhaustive list, some factors influence these cycles:
o Interest rates: When interest rates rise, a carrier's investment income grows due to higher yields in the portfolio. This allows "breathing room" and underwriting profit margins can be reduced (or in some cases eliminated) because the higher interest rate yields allow investment return to pick up the profitability slack. Conversely, when interest rates fall, there also is an upside, as this increases the mark to market value of the bonds within the carrier's investment portfolio. For the purposes of this example, lower interest rates equal lower investment yields, which equal less breathing room on underwriting profitability.
o Inflation: The long-tail nature of professional lines makes these products particularly susceptible to inflationary trends. If inflation spikes between the time the premium is collected and the loss is paid, the cost of paying the claim (be it medical costs, lawyers' fees or anything else) is higher than the dollar-for-dollar comparison of what was collected. Rising inflation puts pressure on underwriting profitability.
o Excess capital: In insurance circles, excess capital is heralded as a good thing because it is an indicator of strength and solvency relative to liabilities. But excess capital actually equals excess equity. With return on equity (ROE) being a key performance factor, too much "E" in the ROE equation (E is the denominator) creates a performance drag in the calculation. This creates the incentive to put capital to work lest a carrier be compelled to return that capital to shareholders. Putting capital to work often translates into writing more business, so excess capital can, in fact, equal a more competitive landscape.
o Developing loss activity: The impact of loss activity in the market is clear. However, the cascade of events that occurs before it materially affects carrier behavior is not short. First, direct writers need to confess to loss development. Then they need to inform their reinsurers. After that, reinsurers need to confess to the development. Finally, reinsurers reduce capacity lent to direct writers based on the performance slippage. Armed with less of "other people's money," direct writers have less capacity with which to deploy. What goes around eventually comes around, but the trip isn't always short.
In the end, all of these factors influence the behavior of markets at different times and in different ways. But even with all of the external forces driving these complex financial instruments, what seems to matter most is the same formula that sets market rates for apples selling on the side of the road: the more people selling apples, the lower the price per apple. The market seems to be enjoying an abundance of capacity, i.e., more people selling than buying. Interest rates, inflation, capital surplus, and developing loss concerns from subprime and credit activity all matter, but their effects are more subtle–at least today–than the raw impact of capacity supply in the market.
To be sure, any one factor, or any combination of the above, could fundamentally shift the pricing curve. But a more certain and immediate turn in the market seems to be elusive due to current capacity levels. The economic crisis may be contributing to over-capacity in the marketplace by making capital-raising and M&A more challenging, and also by increasing government intervention in the private sector, particularly for financial institutions.
Insurance can be complex, but what drives the overall market is not. It's supply and demand. It's capacity available versus capacity in demand. What the market seems to need isn't more capacity, but smarter capacity.
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