Insurance Industry Resources, Cycles, and Crises

As mentioned, insurance works best for highfrequency, low-severity, relatively stationary, relatively independent events with good data and moderate loss volatilities.6 For such events, insurers can accurately estimate premiums and the equity capital needed to reduce insolvency probabilities to acceptable levels, and the amount of required equity does not lead to excessive prices.

Even for larger, less-frequent, more-risky events such as commercial liability lawsuits, insurance can also be effective most of the time. However, there are significant questions about the ability of the insurance industry to deal with the largest catastrophic events.

For various reasons, it is infeasible and inefficient for the industry to hold sufficient capital to finance losses arising from very-high-severity, low-frequency events (Jaffee and Russell, 1997).

This section provides an overview of the resources of the U.S. propertycasualty insurance industry and the global reinsurance industry to gauge the industry’s capability to sustain losses from mega-catastrophes.

The total resources of the U.S. propertycasualty insurance industry are shown in Figure 4. In 2004, the industry held about $400 billion in equity capital and collected premiums of about $440 billion.

Although this might seem to be more than enough to withstand a catastrophic loss of $100 billion, in fact, most of the premiums represent expected loss payments for high-frequency lines such as automobile insurance and workers compensation insurance.

The premiums for homeowners insurance, the line most exposed to natural disasters, are only about 12 percent of the total. Moreover, the $400 billion in equity capital represents the total amount held by insurers writing all lines of business in all states.

Only a fraction of the total would be available to pay catastrophe losses in high-exposure states such as California and Florida because insurers not writing policies with catastrophe exposure in those states could not be called upon to pay claims.

Cummins, Doherty, and Lo (2002) investigated the capacity of the U.S. property-casualty insurance industry to respond to large catastrophic events during the late 1990s.

They considered the aggregate resources of the industry nationwide and also the resources of insurers writing policies in the catastrophe-prone state of Florida as well as the correlation of losses among companies, another factor in determining the capacity to respond to catastrophic events.

The results indicated that the industry could pay more than 90 percent of the losses from a $100 billion–loss event. However, a loss of this magnitude would have caused the failure of approximate 140 insurance companies.

This would be by far the largest failure rate in the post-1900 history of the U.S. property-casualty industry and would significantly destabilize insurance markets. The aggregate equity capital of the global reinsurance industry is shown in Figure.

The figure indicates that equity capital increased significantly from 1990 to 2003, from about $250 billion to about $340 billion, and increased more modestly in 2004 to $377 billion. The premiums of global reinsurers were about $167 billion in 2004 (Standard and Poor’s, 2005).

However, most of the premiums are for high-frequency lines of business. To put the equity capital totals in perspective, Figure 5 also shows the worldwide catastrophe losses from Swiss Re (2005a) as a ratio to the equity capital of global reinsurers.

Catastrophe losses can amount to a significant proportion of equity, exceeding 15 percent in 1999 and 2001 and reaching 13 percent in 2004. Insurance markets are subject to cycles and crises, which can be triggered by shifts in the frequency and severity of losses as well as investment losses.

The underwriting cycle refers to the tendency of property-casualty insurance markets to go through alternating phases of “hard” and “soft” markets. In a hard market, the supply of coverage is restricted and prices rise; whereas, in a soft market, coverage supply is plentiful and prices decline.

The consensus in the economics literature is that hard and soft markets are driven by capital market and insurance market imperfections such that capital does not flow freely into and out of the industry in response to unusual loss events (Winter, 1994; Cummins and Danzon, 1997; and Cummins and Doherty, 2002).

Informational asymmetries between capital providers and insurer management about exposure levels and reserve adequacy result in high costs of capital during hard markets, such that capital shortages can develop. Insurers are reluctant to pay out retained earnings during soft markets because of the difficulty of raising capital again when the market enters the next hard-market phase, leading to excess capacity and downward pressure on prices.

Hard markets are usually triggered by capital depletions that result from underwriting or investment losses.

The three most prominent hardmarket periods since 1980 resulted from the commercial liability insurance crisis of the 1980s, catastrophe losses from Hurricane Andrew in 1992 and the Northridge earthquake in 1994, and the WTC terrorist attack in 2001.

The 1980s liability crisis was triggered by an unexpected increase in the frequency and severity of commercial liability claims, accompanied by a sharp decline in interest rates in the early 1980s, and the catastrophe and terrorist crises were driven by catastrophe losses of unexpected magnitude.

Each crisis not only depleted insurer capital but caused insurers to re-evaluate probability of loss distributions and reassess their exposure management and pricing practices. The U.S. property-casualty insurance underwriting cycle is illustrated in Figure 6.

The figure plots two important operating ratios for the industry—the underwriting profit ratio and the overall profit ratio.

The underwriting profit ratio is the difference between 100 and the industry combined ratio, which is the sum of the loss ratio (losses incurred divided by premiums) and the expense ratio (operating expenses divided by premiums), expressed as percentages.

If the underwriting profit ratio is positive, the industry is collecting more in premiums than it is paying out in losses and expenses—it is incurring an underwriting profit; and if the ratio is negative, the industry is incurring an underwriting loss.

The underwriting profit ratio is a useful indicator of underwriting performance, but it is not a very good indicator of overall profitability because it does not consider investment income.

The overall profit ratio corrects for investment income by adding the ratio of investment income to premiums to the underwriting profit ratio. If the overall profit ratio is positive, the implication is that insurers are making profits when both underwriting and investment results are considered; and if the overall profit ratio is negative, insurers are realizing overall losses.

Figure 6 reveals the impact of the liability crisis of the mid-1980s and the catastrophe crises of 1992-94 and 2001. The underwriting loss in 1984 was about 18 percent of premiums, and the overall profit ratio indicated a net loss of about 7 percent of premiums in that year after considering investment income.

In 1992, the underwriting loss, mainly due to Andrew, was 15 percent and the overall profit ratio showed a loss of about 4 percent of premiums. The underwriting loss due to the WTC attack was also about 15 percent of premiums, and the overall loss was about 6.5 percent.

With losses of this magnitude and volatility, it is not surprising that insurers restricted supply and raised prices following these events.9 Another indicator of recent underwriting cycle activity in the United States is provided by survey data collected by the Council of Insurance Agents and Brokers.

The Council conducts a quarterly survey of its members to determine the changes in commercial lines insurance prices, based on policies renewing in each quarter. The average rate changes from 1999 through 2005 are shown in Figure 7.

The figure shows that prices had been increasing significantly even before September of 2001, and the prices in umbrella liability and commercial property insurance spiked after 9/11. However, beginning in early 2002, commercial insurance prices began to decline sharply, reflecting a softening of the market caused by inflows of new capital and improved underwriting profitability.

The underwriting cycle interacts with the level of capitalization in the industry. A relative measure of capitalization is provided by the premiums-to-surplus ratio, the most widely used measure of leverage for this industry. 10 The premiums-to-surplus ratio since 1980 is graphed in Figure 8.

The ratio was about 1.5 in the early 1980s and then declined steadily to less than 0.7 in 1999, before increasing again as a result of the hard market and 9/11 claims in the early 2000s.

The sharp decline during the 1990s has been attributed to over-capitalization in the industry as well as the need for additional capital brought about by higher loss volatility, particularly in liability and property catastrophe insurance (Cummins and Nini, 2002).

Deterioration in the premiums-tosurplus ratio is often associated with the onset of a hard-market phase of the cycle. Because profitability in reinsurance markets mirrors the results in primary insurance markets and because underwriting cycles also exist in most other industrialized countries, the global reinsurance market is also subject to underwriting cycles.

The cycle in the worldwide catastrophe reinsurance market is shown in Figure 9, which plots the rate-on-line index in this market. The rate-on-line is a price measure defined as the premium for a reinsurance policy divided by the maximum possible payout under the policy.

The index increased from 100 in 1990 to approximately 375 in 1993, primarily due to Hurricane Andrew. The index then declined steadily until 1999 and increased sharply following the WTC attack and a general hardening of insurance markets into the early 2000s.

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