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What Causes Insurance Cycles?
I do not know in general, but for workers' compensation I have some ideas. A conventional wisdom that investment yields drive the cycle seems doubtful. There appear to be several factors, among them delay and deception. The top of a cycle occurs when insurance is priced at its high point--as in about 1993 and about 2003. The bottoms would be in 1999 and--we're not there yet.
Year One. Our insurer has $100 in premium revenue, $65 in losses, a combined ratio of 100 and investment earnings of $15. Profits are therefore $15. (To simplify matters, ignore taxes.) The insurer has plenty of equity, or policyholder surplus--$100--reflecting the overcapitalized state of workers' comp insurers as a whole. Year Two. The number of injuries will decline by 3 percent annually, but costs per claim will grow at 8 percent, a net $3 increase in loss costs for the current year's injuries. Premiums will automatically rise by $2 to reflect the incremental rise in covered payrolls. Let's say that investment returns improve by 10 percent, or $1.50. Year Two, looking good, is now about to close out with an increase of profits of 50 cents to $15.50. But loss cost inflation affects all open claims, especially in medical outlays. You have to figure on the second spinal fusion on a worker injured years ago, and increases in lifetime pain medication costs for many open claims. At the very end of Year Two, the insurer rolls up all these adjustments into a $5 increase in loss reserves. This reduces profits to $10.50, down 30 percent from the prior year. It then examines the smoky deals it has made to expand market share, and calculates that instead of premiums rising by $2, they declined by $3 to $97. That drives net profit down by $5 to $5.50. Profits actually fell by over half! Year Three. The fog surrounding loss cost inflation clears further. Current-year claims costs increase again by $3, as cost inflation outpaces injury decline. The insurer tacks on an additional $5 reserve increase. Investment yields fail to rise, so investment income increases only by increasing the assets invested. The sales force tries more intensely to beat out other insurers for a fixed amount of customers. (The few that decline to drink the market share Kool-Aid should step back.) Premiums in Year Three drop $7 to $90. Based simply on payroll increases, they should be $104. Insureds now enjoy a 13 percent savings. The insurer closes Year Three with a $3 loss--assuming that all the figures are accurately posted, rather than massaged to push some of the bad news into . . . Year Four. Another year of increases in claims costs on diminishing revenue base. The chief actuary insists on a reserve adjustment of $10 for prior years. (A few years later, a third will be reversed.) Sales, though bridled, still reduces premium to $87. Loss costs plus reserve development are $84, and the combined loss ratio is 137. Insureds now enjoy a 18 percent reduction while the insurer reports a loss of $14. The End. Net profits have declined from $15 to $5.50 to ?$3 and ?$14. The actuary wants to add to reserves. A rating downgrade? Looking at actual ratings practices, one suspects that the agencies may pull their punches, especially with the big players. Insurers collectively push prices much higher very quickly, starting the hard market. The key drivers in my estimation are: idle capital, unrealistic sales plans, and mediocre controls over claims and pricing. PETER ROUSMANIERE is a Vermont-based writer and columnist for Risk & Insurance®. September 1, 2006 Copyright 2006© LRP Publications |
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