4a External Environment and the Insurance cycle Flashcards
Inflation and economic factors affect insurance business in various ways:
In times of low economic growth and high unemployment, there is a greater number of claims on mortgage indemnity guarantee insurance, theft, arson, and fraudulent/exaggerated claims.
Increased demand for pecuniary loss cover as businesses become more concerned about the risk of suppliers, debtors, etc. becoming bankrupt.
Claims inflation:
Claims inflation:
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General levels of inflation in the economy impact the cost of providing insurance and are reflected in premiums.
Different types of insurance are affected by different types of inflation, such as household contents insurance, buildings insurance, medical expenses, motor property damage, and fixed benefits
Types of claims inflation:
Household contents insurance claims are affected by general consumer goods inflation, although not entirely accurate due to the inclusion of items not relevant to claims.
Buildings insurance claims are linked to the cost of building materials and labor, which tends to increase more than general prices.
Medical expenses inflation is often higher than the most quoted indices due to advanced treatments, longer patient survival, and salary increases for doctors/consultants.
Motor property damage claims are related to wage indices and can vary depending on factors like market competitiveness and vehicle type.
Fixed benefits insurance policies are immune from inflation as they provide fixed benefits.
The underwriting cycle:
The underwriting cycle is a cycle of high and low premiums in the insurance industry.
It involves periods of high profitability (hard market) attracting new entrants, leading to increased competition and lower premiums (soft market) until insurance becomes loss-making.
Insurers then leave the market or reduce business, leading to restricted availability and increasing premiums, eventually returning to a hard market.
Economic influences on the underwriting cycle:
Economic factors, such as recessions, can impact the frequency of losses in different insurance lines.
The underwriting cycle is driven by profitability and competition in the insurance market.
Expense Inflation and the Underwriting Cycle:
Expense inflation in insurance: Expense inflation refers to the increase in costs associated with providing insurance coverage. The insurance industry is labor-intensive, and although technology can improve productivity and reduce unit costs, expenses are still subject to inflation. This means that the cost component of insurance policies may increase in line with wage inflation.
The underwriting cycle: The underwriting cycle, also known as the insurance cycle, is a cycle of high and low premiums in
the insurance market. It follows a pattern where insurance premiums are high during profitable periods, leading to increased competition and subsequent premium reductions. Eventually, premiums fall to a level where insurance becomes unprofitable, leading to insurers struggling and potentially leaving the market. This reduced competition results in an increase in premiums, and the cycle continues.
Observations of the underwriting cycle:
In the past, insurance premium rates have varied in ways that do not reflect the underlying cost of providing insurance. This pattern is most common in large commercial and industrial insurance but can affect all classes of insurance. The underwriting cycle is observable not only in large commercial and industrial insurance but also in personal lines products such as household and private motor insurance, especially in competitive markets.
Stages of the underwriting cycle: The underwriting cycle can be described in the following stages, although the starting point may vary:
a. Highly profitable market (hard market): Insurance premiums are high
Stages of the underwriting cycle: The underwriting cycle can be described in the following stages, although the starting point may vary:
a. Highly profitable market (hard market): Insurance premiums are high, and it is challenging for policyholders to find affordable insurance.
b. Increased competition and market expansion: Profits attract new entrants to the market, leading to more insurers writing business.
c. Premium rate reduction: To fill the increased capacity, insurers reduce premium rates to attract more business (soft market).
d. Loss-making market: Premium rates fall to the extent that insurance becomes unprofitable, leading to insurers struggling or becoming insolvent.
e. Insurers leaving or reducing business: Insurers respond to losses by leaving the market or reducing the amount of business they write.
f. Restricted availability and rising premiums: With fewer insurers and restricted availability of insurance, premium rates start to increase again.
g. Highly profitable market (return to stage 1): Premium rates rise, and the cycle begins anew.
Why companies don’t enter/leave at the top/bottom:
Why companies don’t enter/leave at the top/bottom: The underwriting cycle affects different classes of insurance business at different times. Profits from one class of business may subsidize another less profitable class. Therefore, companies may enter the market during the expansion phase to take advantage of profitable opportunities, and they may be reluctant to leave during the unprofitable phase to maintain market share and avoid future costs of reacquiring business and loss of reputation.
Influences on the underwriting cycle:
a. Capital availability and market expansion:
Influences on the underwriting cycle:
a. Capital availability and market expansion: An insurer’s ability to write insurance is limited by the capital it holds. A profitable market attracts new capital, allowing existing and new insurers to expand their business.
b. Mechanisms reducing market size during unprofitable phases: During unprofitable periods, mechanisms such as company insolvency, companies withdrawing due to losses, and reduced availability of reinsurance can decrease the size of the insurance market.
c. Major disasters and soft market endings: Soft markets often end when significant disasters cause severe losses that exceed the normal level of claims. These events, such as Hurricane Andrew in 1992 or the September 2001 terrorist attacks, can trigger a change in the market.
Reasons for the underwriting cycle:
a. Low barriers to entry: Insurance markets
Reasons for the underwriting cycle:
a. Low barriers to entry: Insurance markets have low barriers to entry, allowing new companies to enter quickly if they meet capital and competence requirements. This ease of entry contributes to the cycle’s progression.
b. Delay in profitability assessment: There is a delay between writing insurance business and knowing its profitability. This delay adds to the existence of the cycle.
c. Simplistic regulatory capital requirements: Simple capital requirements, such as basing the required capital on premiums, can encourage insurers to write more business during falling premium rates and less business during rising rates.
d. Economies of scale: Insurers’ overheads, though not entirely fixed, are less variable than premium rates. This means that even marginally profitable business can be written during soft markets to cover fixed expenses. Insurers may be reluctant to lose market share and incur future costs by not writing business.
Importance of understanding the underwriting cycle:
Impact of expense inflation:
Importance of understanding the underwriting cycle: Insurers must be aware of the position in the underwriting cycle for each class of their business when making strategic decisions. This understanding helps in managing profitability, evaluating risk, and avoiding adverse effects of market fluctuations.
Impact of expense inflation: Expense inflation affects the cost loading of insurance policies, potentially leading to increased policy costs. As the industry becomes more labor-intensive and wages increase, expenses rise, contributing to overall inflationary pressures within the insurance market.
Investment conditions: Insurance companies invest the premiums they receive from customers and their capital in financial investments. The investment conditions of these assets, such as equity investments, can impact the insurance company’s exposure to market value changes.
Capital categorization:
Importance of investment decisions
Relationship between business characteristics and investment income:
Cashflow underwriting approach:
Sophisticated pricing and underwriting:
Investment conditions: Insurance companies invest the premiums they receive from customers and their capital in financial investments. The investment conditions of these assets, such as equity investments, can impact the insurance company’s exposure to market value changes.
Capital categorization: An insurance company’s capital can be divided into two categories: the capital required to meet liabilities (statutory reserves) and the free assets, which represent the excess of the company’s assets over its liabilities. Insurers have more freedom in how they invest their free assets compared to non-financial companies.
Importance of investment decisions: Since insurance companies have a small proportion of their assets tied up in fixed assets, such as office buildings, the investment decisions and returns on invested securities are crucial for their profitability compared to other types of companies.
Relationship between business characteristics and investment income: The amount of investment income generated by an insurance business depends on the characteristics of that business. Longer-tailed business, which takes longer for claims to be paid out, tends to generate more investment income compared to short-tailed business.
Cashflow underwriting approach: In the past, some insurers adopted a “cashflow” underwriting approach, where premiums were set below the level required to cover claims and expenses. The underwriting loss was expected to be offset by investment returns earned on the premiums before claims were settled. However, this approach led to significant losses when investment returns were lower than anticipated.
Sophisticated pricing and underwriting: A more sophisticated approach considers the expected level of investment income under current investment conditions in the pricing calculation. The discount rate used should reflect the current investment conditions on the assets backing the policy.
Currency movements: The impact of currency exchange rate movements on insurers depends on where their business is written and where claims are made. Insurers writing business in multiple territories and dealing with various currencies are more exposed to currency risk.
Analyzing business by currency:
Currency hedging:
Relationship between investment conditions and pricing:
Currency movements: The impact of currency exchange rate movements on insurers depends on where their business is written and where claims are made. Insurers writing business in multiple territories and dealing with various currencies are more exposed to currency risk.
Analyzing business by currency: Insurers may analyze their business by currency to avoid distortions caused by changes in exchange rates. Converting premiums and claims into the insurer’s domestic currency can create misleading results and affect profitability assessments.
Currency hedging: Currency movements can cause challenges in reserving and financial analysis. To mitigate this risk, insurers may use currency hedging strategies to protect against adverse exchange rate movements and ensure more accurate reserve calculations.
Relationship between investment conditions and pricing: Investment income and required profit loading should be taken into account in pricing calculations. The discount rate used may be based on the risk-free rate of return, considering that insurers themselves assume the investment risk and should receive appropriate additional income.
