Goodbye, Soft Market

The soft-market cycle has come to an end, at least according to Dallas-based insurance exchange MarketScout—which declared so in its November Market Barometer.

Several other market analyses also show that, for many lines, rates are beginning to creep upward after seven years of decreases.

But insurers should probably hold off on popping the corks on celebratory bottles of champagne. Although the era of falling prices may be over, few observers are ready to predict that the start of a true hard-market cycle is close at hand.

Even those who are forecasting improved profitability in 2012 will not say the industry is on a path to a genuine hard market—at least not yet.

For example, in a Dec. 15 report, Fitch Ratings gave the P&C industry a “stable” rating, citing the prospect of a return to underwriting discipline and improved earnings in 2012. Fitch said that—barring any “shock events”—reduced losses and healthier premium growth could produce a return on surplus this year as high as 5.4 percent, compared to 2.7 percent in 2011.

However, in a conference call discussing the report, James Auden, managing director for P&C insurance for Fitch, said that while the ratings agency expects the market to gain some near-term benefit from rate increases, “a return to a true hard market is less likely.”

What Causes a Market Turn: The Hard Facts

In Auden’s view, the critical factors working against a market turn: Capital levels and capacity remain strong.

Dan Thomas, principal for PricewaterhouseCoopers’ U.S. Financial Services Sector, also points to the level of capital hindering a market turn.

“Hard markets generally are driven by a sudden contraction of capacity, yet industry capital levels today remain very high—and companies may be reluctant to return capital in the current financial climate, lest they find it hard to recapture,” he tells NU.

Noting that PwC monitors industry rate-change information very closely, Thomas adds, “In the third quarter we certainly saw encouraging, albeit modest, rate signs on selected lines of business after a long period of rate reductions. However, I don’t think we have seen enough signs yet to confirm that we are entering the start of a hard market.”

Thomas says it’s difficult to say when a market will turn, or has turned, unless there is a “clear, large catastrophic loss with a consequent large contraction in capacity” that forces the market’s hand.

Steve Weisbart, vice president and chief economist for the Insurance Information Institute, predicted a market turn four years ago—incorrectly, as it turns out.

When he made his call in 2008, Weisbart says he looked then at the freezing credit markets and the fall in value of stocks and other assets, as well as a sharp drop in industry surplus. 

“In the past, according to my research, when there were significant drops in surplus, a hard market followed,” Weisbart explains. But surplus recovered quickly and a hard market did not ensue, he adds, “so my prediction was wrong.”

One lesson Weisbart drew from his too-quick call that the market was hardening: No single factor—whether a drop in surplus, or in today’s case, modestly rising rates—is likely enough to precipitate or definitively signal a market turn.

   Weisbart says he now looks at four factors to gauge the market, and  that “probably at least three of these factors need to be in place in a really strong way to be confident we’re talking about an imminent hard market.”

The four factors he cites:

• Substantial and significant underwriting losses. According to Weisbart, until recently, insurers hadn’t been suffering too severely. The industry’s combined ratio up to 2011, he says, has been around 100—“not making money, but not losing much on insurance activity.” In contrast, he notes that in 2001 the combined ratio was 115.8—and a hard market set in within a year of that (see chart on page 16).
• A sharp decline in surplus. While this factor was briefly in play in 2008, Weisbart says surplus has been on the rise in recent years.
• Significant tightening in the reinsurance market. Weisbart says reinsurance rates are up slightly, and a hard reinsurance market would create harder pricing in direct sales. But he says reinsurance cannot yet be classified as a true hard market.
• Underwriting discipline. Companies have to be more focused on properly pricing risks rather than preserving and increasing market share, says Weisbart. He notes that this is the most difficult of the four factors to measure. While there is anecdotal evidence of increasing discipline in the marketplace, Weisbart says it is not clear enough.

So of Weisbart’s four factors, the firming that is occurring in the reinsurance arena would seem to possibly put one check in the hard-market column. And in 2011, many carriers did report substantial underwriting losses—a second factor pointing to a hard market.

But surplus is hardly declining sharply—so that’s one for the “not turning” column.

That leaves the wild card of underwriting discipline. If carriers get tough on rates, that could be the third factor that causes a turn.

Weisbart’s own take? He doesn’t believe a hard market is imminent, but opines, “Are we heading for one in the next several years? The answer is: quite possibly.”

Loss Costs and Pain Gauges

Other industry observers have their own benchmarks—generally involving one or a combination of the four factors Weisbart cites—to gauge when the market can most definitively be considered to be turning.

After Towers Watson released its third-quarter Commercial Lines Insurance Pricing Survey (CLIPS) on Dec. 13, Bruce Fell, managing director of Towers Watson’s P&C practice in the Americas, said,  “We will not be in a market where insurance-company results can improve, and start to enter a real hard market” until rate increases exceed loss-cost inflation.

Analyst firm ALIRT Insurance Research uses a proprietary scoring method to determine when a market may turn—and its latest results do not pour as much cold water on the prospect of a pending hard market as some other analyses.

David Paul, a principal for the firm in Windsor, Conn., explains that ALIRT scores—derived every quarter from an analysis of operating and investment ratios, as well as other financial-strength measures—range from 0-100, with higher scores assigned to stronger insurers. The 10-year median industry score is right in the middle, at 50.

A composite, industry-wide score below 50 may act as a leading indicator of a turn, Paul says, explaining that the score can be viewed as a “pain gauge” that can highlight the point when insurers “begin to get fearful about balance-sheet deterioration.”

The P&C commercial-lines score has been trending downward since early 2007, but it had been above 50 since the middle of 2005—until 2011’s first quarter. Since then, it dipped further below 50 throughout the year.

“If such composite-score deterioration is sustained...this could precipitate harder-market conditions,” ALIRT says in its most recent industry report, released Dec. 9.

Yet the firm notes that the industry is not quite there yet: “One broker opined that rates are ‘firming but not hardening.’ While this may at first appear an equivocation, it actually captures the current environment quite well: Broad rate decreases are coming to an end, but conditions remain competitive, especially for new business, and therefore no pronounced hard market is in sight.”

Broker/Carrier Divide

ALIRT points to interesting differences in market observations between carrier executives and brokers. During third-quarter analyst calls, management at large publicly traded insurance companies declared that the pricing environment is improving and that the market is hardening.

Brokers, on the other hand, have issued studies saying that rates will continue to be flat to slightly lower.

NU has taken note of this carrier/producer split as well. For example, W.R. Berkley CEO William R. Berkley, speaking on Dec. 6 at the Goldman Sachs U.S. Financial Services Conference 2011, said the industry is now “definitively in a hardening market.”

Conversely, a Dec. 22 report by insurance-broker Marsh says that while loss-affected geographies and classes of business continued to see rate increases in fourth-quarter 2011, “rate decreases are still achievable in many lines of business” that are not in catastrophe-exposed areas.

(As a response to the cat losses, however, almost half of Marsh’s clients did experience rate increases in 2011’s second half, compared to 31 percent in the first half.)

“The global-insurance market remains well capitalized and generally competitive,” Dean Klisura, U.S. risk-practices leader for Marsh, says in the report.

“This year’s record catastrophic losses are resulting in price-firming around catastrophe and loss-driven accounts, but there has been no overall change in market pricing,” he adds.