As we enter another market cycle of a "hard market" I am reminded that we have a large group of clients and industry associates who have not had firsthand experience of a market cycle and may need some explanation of what is occurring and why.
Most of us understand that a hard market is an effort for insurance companies to return to profitability. Higher premiums and elimination of policyholders that have had high losses is the obvious actions underway but these steps are only part of the actions underway.
A period of unprofitability for the industry is not something that happens overnight, and is a result of many factors, NOT just because we underpriced our product. Our lack of profit is not the only symptom of a "soft market" rather it is a result of a series of events put into place by external factors.
The purpose of this article is to explain how and why insurance companies can "run out of product to sell". Yes, insurance companies can sell out of insurance.
Because insurance is an intangible most people cannot understand or conceive how an insurance company can run out of insurance. The reality is, however, that an insurance company is one of the most heavily regulated industries in the world. The "amount" of insurance an insurance company can sell is limited by a myriad of laws.
The same laws regulating what, when and how insurance companies can write are designed to protect the public by making sure the money is available at the time of a claim.
Insurance company accounting requirements specified in law are extremely complex, boring and completely understood only by attorneys, regulators, and insurance industry accountants. Having explained that, I will NOT bore you to tears with technical requirements that you really do not want to know about.
I will, however, oversimplify this explanation so that you can easily see what is currently happening in the insurance market and how that is driving the changes.
VALUE OF MONEY
Logic and common sense tell us that to be profitable an insurance company must collect more premiums than they must pay in claims and expenses, however, that is not necessarily true. The missing factor is investment income. To ensure solvency of the insurance companies state laws require the insurance companies to establish reserves, or monies that have been identified as liabilities of the insurance company. Insurance companies customarily take your premiums at the time you purchase a policy and do not pay claims until sometime in the future with that money. With the right investments the insurance company can supplement their income by investing those premiums in bonds, stocks, and other investments until it is necessary to pay for the claims. Some claims are not paid for several months, or years, and as such provide the insurance company with a great deal of investment income. With this knowledge you can now understand that during times for high yield investments insurance companies can collect less in premium than they pay in claims as long as the investment income will make up the difference. Simply stated, the investment income supplements premiums and in times of high interest and market yield can enable insurance companies to lower their premiums. Indeed, in times of extreme yield insurance companies compete for premium dollars as a means to enable them to further their investment income.
ROLE OF RESERVES
Remember the intense governmental regulation to ensure the solvency of insurance companies? A huge element of insurance company solvency is "reserves" that are mandated by statute.
I will save you the pain of an 18-week course in insurance company accounting practices, and give you a crash course on reserves and how they relate to the current insurance market.
First, you must understand that an insurance company cannot show dollars collected today for premiums as earned income. The insurance company must show a $365. premium collected today as $1 of earned premium and $364. of unearned premium. The following day the insurance company can show an additional 1/365 of the premium or another $1 as being earned. In reality the policyholder can cancel their policy and request the unearned premium be returned to them. Insurance is a prepaid expense of the policyholder until such time as the policy is "used" at the rate of 1/365 per day on an annual policy.
By statute the unearned premiums is a liability of the insurance until it has been "earned" by the insurance company. These monies are called unearned premium reserves.
Another reserve that insurance companies must establish is for claims that they are aware of, but have not yet been paid. Once a claim has been reported to the insurance company they must establish a reserve for that claim. They must estimate how much money they think will be required to pay their liability for this claim. This is just one of the many reserves they must maintain for claims. The logic behind this tactic is that this money is owed to the future recipient of the claim, and as such has been "spent" or "used". Again…The Insurance Company is holding money owed to others, so this is a liability. This does not, however, prevent the insurance company from investing these sums in the marketplace and making investment income from the fiduciary funds. The interest income goes toward the income of the insurance company.
There is yet another claims reserve that few people know about or truly understand called the "IBNR" reserves or money set aside to pay claims for future claims that have not yet been identified. This is an acronym for "Incurred But Not Reported" claims. An example of a claim of this nature is an injury that has occurred but the injured persons have not been identified – i.e. a vitamin manufacturer that has been producing a contaminated product that has slowly impacted the health of its consumers. The consumers have been injured, but the injury has not been identified yet, and the insurance company has not been informed of the injuries and/or claimants. At the end of every policy the insurance company knows there is the potential for claims yet to be paid which have not been reported to them. By law, the insurance company must establish a "reserve" for these claims, and reflect those as a liability.
In review, there are two major reserves (unearned premium reserves, and claim reserves) which insurance companies must establish. In times of high interest rates and profitable economic investments the income of the insurance company can be greatly supplemented by profits of these fiduciary funds.
DURING PERIODS OF HIGH YEILD INSURANCE COMPANIES CAN SOMETIMES CHARGE LESS IN PREMIUMS THAN THEY PAY IN CLAIMS YET REMAIN PROFITABLE.
This can lead to insurance companies cutting prices knowing that with large investment income they can still be profitable. The competition for access to the policyholders’ dollar feeds competition and as such prices for insurance can decrease. The market becomes "soft" and underwriting standards are lessened. A feeding frenzy can develop for premium dollars, exacerbating the reduction in premiums. In the quest for immediate availability of premium dollars, some insurance companies will seek risks or types of insurance they write that have not always been profitable. Underwriting standards are lessened and premiums reduced in an effort to attract more premium dollars.
When investment income declines because of market conditions, the insurance company will start to recognize losses, and in an effort to curtail those losses, will re-evaluate what type of risks they want to write.
Here is where the CAPACITY issue becomes the driving factor. Remember the requirements for the insurance company to have adequate reserves? An insurance company is only permitted to write a limited amount of insurance or assume a certain amount of "risk" in relationship with the amount of money they have in reserves.
ROLE OF REINSURANCE
If an insurance company elects to share their exposure of risk they usually purchase reinsurance from another insurance company known as a reinsurer". The reinsurer will "insure" or assume some of the insurance company’s risk in exchange for some of the insurance premium. By spreading the risk to another insurance company, the regulators will allow the original insurance company "credit" or a reduction in the amount of reserves necessary. Therefore an insurance company can increase their capacity or amount of insurance they can write by purchasing reinsurance from a reinsurance company. The cost of the reinsurance is an expense that impacts the profitability of the original insurance company. However, in the event of large losses, the reinsurance can assure the profitability and/or continued existence of the original insurance company.
Therefore, the cost and availability of reinsurance is a major component in the profitability of most insurance companies. In addition, reinsurance enables insurance companies to transfer risk, reduce reserves, and the ability to write more insurance. In other words the reinsurance will expand the capacity of an insurance company.
When reinsurance becomes more expensive insurance companies must charge higher premiums to make the same level of profitability.
The cost and availability of reinsurance is a major component in the final cost of insurance to the consumer. When reinsurance costs go up, the original insurance company must charge more because this is part of their "cost of doing business". Another way of viewing this is that reinsurance is part of the "cost of goods" for insurance companies.
The World Trade Center attack in September 2001 is the largest loss for insurers in the history of the industry. No doubt this is exactly the type of event reinsurance was designed to handle. The reinsurance industry will pick up the largest share of the losses and as such the reinsurance industry will take the biggest "hit" in their history. Compound this with the pressure of government to prevent insurance companies from excluding "terrorist acts" from existing and future policies, and you can readily see why the reinsurers become critical to the future certainty and solvency of the industry. Combine the critical need for reinsurance with the uncertainty we are facing for future attacks and you can readily see how reinsurance has become a major component in our current "market condition". Terrorism of this magnitude is new and the reinsurers are unable to predict future losses from past experience, therefore the "cost" is guesswork at best. Logic follows that if you are forced to "guess" at the future costs you are going to error on the side of making sure you have charged enough. Now you can see "what" and "why" reinsurance has become one of the largest components in the cost of insurance for everyone.
ROLE OF UNDERWRITING
In a "hard market" where insurance companies are limited on the "amount' of insurance they can write, they turn to their "underwriting" staff, or those people who determine "what" risks the insurance company will write and advise them to reduce or limit the amount of risks they write.
I like to compare this process with shopping on a limited budget. If you have extremely limited dollars to spend for food you make certain you get the most bang for your buck, or carefully shop prior to buying. If you are an insurance company with limits on how much insurance you can write, and are close to reaching those limits you make sure you are writing only the very best risks. A process known as "cherry picking" - taking nothing but the cherries and leaving the pits for others. This is the underwriter's job. If you are a "risky" policyholder or prospective policyholder in a "hard market" you may find it much more difficult to find an insurance company to sell you a policy. Those insurance companies that take "higher risk" exposures will naturally want to charge a higher premium. This is how "capacity issues" become "availability issues" to the policyholders.
SUMMARY
As you can see, legal requirements for reserves, and the cost of reinsurance compounded with the role of current economics and investment income all impact the availability and cost of insurance. We have gone from a "soft market" to a "hard market". The length and severity of the hard market is unknown, but at least now you understand "why".
Author: Lanny L. Hair, CIC, ARM, AAI, RPLU - Executive Vice President
Independent Insurance Agents and Brokers of Arizona, Inc. - Phoenix