Analyzing U.S. Property & Casualty Commercial Insurance Market Conditions

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1 Analyzing U.S. Property & Casualty Commercial Insurance Market Conditions Introduction November 2014 Albert Risk Management Consultants has been analyzing the commercial insurance market for its United States clients for many years in an attempt to anticipate pricing and coverage terms changes that affect client insurance purchases and retention strategies. We have been publishing quarterly reports for use by our clients and staff. This whitepaper outlines the underlying concepts we use in our analysis and illustrates the elements that are critical to our review. In the following pages, we address the methodology we use and focus on the data we use in our market condition analysis. Obviously, our objective is a macro level appreciation of market forces and how they affect pricing, availability and coverage terms. While the data used in our quarterly reports is updated for each report, the data in this whitepaper dates to the end of the second quarter of We have highlighted those passages that are date specific in grey. We use these sections to illustrate the concepts using our interpretation of real data. If you wish to receive our quarterly reports and summary metrics, please contact us at Albert Risk Management Consultants ( Caveats and Cautions There are fundamental aspects of predicting commercial property and casualty market conditions that are worth stating. These factors influence the accuracy of market forecasts; several are listed below. The market is not monolithic. In fact, at any one time, there may be many segmented markets depending on geography, underwriter appetites, coverages being sought and political concerns. For instance directors and officers insurance may follow an uncorrelated pricing trend when compared with commercial property insurance. The market is global. One hallmark of the modern commercial market is the world-wide reliance on global reinsurers and the speed and depth of the information they share in the marketplace. The market is not always rational. Competitive forces often dictate strategies that are contrary to the approach that financial and economic models suggest are appropriate. The reinsurance market is changing. Underwriting capacity for reinsurance treaties is increasing and coming from non-traditional sources. Increased activity in the catastrophe bond (and other insurance linked securities) and private investment markets is driving pricing and terms improvements for treaty insurance and reducing commercial insurers costs. Access to capital varies. The inflow and outflow of capital within the insurance market comes from several sources which are not always correlated.

2 6/2008 9/ /2008 3/2009 6/2009 9/ /2009 3/2010 6/2010 9/ /2010 3/2011 6/2011 9/ /2011 3/2012 6/2012 9/ /2012 3/2013 6/2013 9/ /2013 3/2014 6/2014 9/2014 Percent (%) An ARMC Whitepaper Market Factors While these variables make predicting the market difficult, there are indicators which help navigate property casualty market trends. There are two major factors affecting insurance market pricing: (1) Supply and Demand, and (2) External Influences and the General Business Environment Supply and Demand Supply and demand economics are translatable to the insurance marketplace. Like most industries, if the change in demand exceeds the change in supply there should be an increase in pricing. Likewise, if the change in demand is less than the change in supply there should be a price reduction. Researchers of the property and casualty insurance market typically use GDP as a surrogate for Demand and Policyholders Surplus as a surrogate for Supply. GDP reasonably reflects the increasing or decreasing need for insurance in a developed economy. Surplus is an appropriate measure of supply because insurers ability to write premiums (capacity) is a function of their surplus (among other constraints). Surplus can be thought of as the insurance markets capitalization. These factors can be helpful when analyzing the U.S. market. Historically, the industry has found that domestic supply and demand are typically in equilibrium when U.S. Policyholders Surplus (hereinafter PHS ) is 3.2% of U.S. Gross Domestic Product (GDP) Surplus as a Percent of GDP Surplus as a Percent of GDP Surplus/GDP Historic Equilibrium As of the second quarter of 2014, U.S. PHS was 3.876% of GDP, rising from 3.695% in the second quarter of Analysts reported PHS at $671.6 billion as of June 30, The ratio decreased modestly from the preceding period (3.884% of GDP in first quarter of 2014) due to a strong 4.6% gain to GDP in the second quarter relative to a proportionately lower surplus increase (1.450% increase to surplus from the first quarter of 2014). PHS relative to the economy demonstrates a highly capitalized insurance market indicating a supply surplus. All other things being equal, this supply surplus should cause downward pressure on rates in the coming quarters. 1 The State of the Commercial P&C Market, Advisen, Apr Table Gross Domestic Product, Bureau of Economic Analysis, Oct Dr. Robert Hartwig, 2013 First half Results, Insurance Information Institute, Oct Page 2 of 10

3 6/2008 9/ /2008 3/2009 6/2009 9/ /2009 3/2010 6/2010 9/ /2010 3/2011 6/2011 9/ /2011 3/2012 6/2012 9/ /2012 3/2013 6/2013 9/ /2013 3/2014 6/2014 An ARMC Whitepaper External Influences and the General Business Environment 4 Many influences on the insurance pricing cycle exist largely independent of insurance industry factors. One external factor is interest rates. Premiums are discounted for future losses, and since insurer investment portfolios largely rely on bond markets interest rates will have some effect on insurance rates. As of June 30, 2014 the yield on a ten year treasury was 2.53%. This low rate is effectively flat from the same time in 2013 (2.50%). 5 In recent years, carriers have had to rely more heavily on underwriting profits as it has become more difficult to offset underwriting losses with investment gains Year Treasury Yield Regulatory factors also affect the insurance pricing cycle primarily on a state level with some lesser federal influence. Changes can occur suddenly and are difficult to predict. Because states have such broad powers, the insurance climate in one state can be vastly different than a neighboring state. Insurance rates, forms, and capital requirements are subject to state approval which can vary depending on the state insurance department. The legal environment also has an impact on insurance premiums and coverages particularly in the liability insurance markets. Similar to regulatory changes, changes in case law, legal theory and judicial practice affect the insurance industry on both a state and federal level. The legal component may be much more prevalent when reviewing insurance premiums and terms with a more narrow scope, such as within a specific industry, e.g. the long-term care or hospital industries. Catastrophe losses are severe losses often from a natural disaster. They may result in a capital event described as substantively decreasing industry capacity (surplus). Super storm Sandy was the last major domestic event with estimated insurable losses in the $18 billion range. Much of the economic losses were due to damages to residences and automobiles insured in the personal lines market. Much of the flood/storm surge loss was be either (i) uninsured or (ii) federally insured or covered in the NFIP/FEMA program. While this makes Sandy one of the top five natural disasters in the United States, 4 Ursina Meier, Francois Outreville, The Reinsurance Price and the Insurance Cycles, European Group of Risk and Insurance Economists. Sept. 15, Daily Treasury Yield Curve Rates, U.S. Department of the Treasury, Jul, Page 3 of 10

4 it is not a so-called capital event 6 for US insurers and it does not significantly affect market pricing of reinsurers. The 2014 U.S. hurricane season has begun with below average losses, further easing reinsurance pricing. Medical inflation has dogged insurance casualty markets for a number of years. As the costs of medical procedures and products increase faster than overall inflation, insurance premiums struggle to keep pace. Accompanied by concentration concerns (i.e. large number of insured employees/persons in one vicinity) casualty lines of business, especially as Worker s Compensation, have demonstrated substantial volatility. It is important to remember that insurers view concentration on their risk portfolios exposure not just the insured entities exposure. The general business cycle has an impact on the property casualty insurance marketplace. One aspect of this is GDP, and its relationship to insurance demand. 6 In contrast to a capital event, the loss resulting from Sandy is generally characterized as an earnings event as the losses affected individual insurer s earnings for the period, but did not significantly affect their capital positions. Page 4 of 10

5 Capacity Constraint Model Introduction to the Capacity Constraints Model Many of the previous principles (supply and demand, external factors, and the business environment) can be merged into what is generally known as the Capacity Constraints Model. This concept suggests as industry surplus (capacity) declines, there is a need for insurers to increase profitability. As profitability increases, surplus begins to grow. With greater surplus, profit requirements decrease and other initiatives (e.g. market share) may come to the forefront. The result of this is increased competition and decreased premiums. Pricing Adequacy Capital Adequacy 7 Research has shown that the model functions in four stages. Anne Gron, an economist focused on insurance markets, concisely describes the four stages in the RAND Journal of Economics as follows: The first stage is marked by several years of low profitability. This is followed by a sudden change to rapidly increasing profitability. This is followed by a sudden change to rapidly increasing profitability. The second stage is often called the insurance crisis, owing to the characteristics described above. In the third stage, profitability remains high but is no longer increasing. Profitability gradually declines during the fourth stage as the industry returns to a 7 Profitability is measured using two principal industry equations, the loss ratio (losses/premiums) and the combined ratio. Capacity adequacy is a function of how much surplus insurers hold relative to their written premiums. When insurers surplus is too low they must increase pricing to restore their balance sheets to an acceptable level. The model can be broken into four quadrants representing various high/low combinations of the two industry characteristics (pricing adequacy, and capacity adequacy). Page 5 of 10

6 period of low profitability. Anecdotal evidence suggests price and quantity movements accompany the changes in profitability. In the first stage prices are relatively low and quantity is abundant. Prices rise rapidly and quantity available drops sharply during the crisis stage. High prices and slowly increasing quantity follow. Falling prices and relatively abundant quantity accompany the falling profitability of the fourth stage of the cycle. 8 The opposed market types described above can be categorized as a hard or a soft market. It should also be noted that at the time of this publication (RAND Journal of Economics), the U.S. property casualty market was only a few years past a major liability crisis. The model can function with less dramatic circumstances. In other words, the insurance crisis stage could be considered a hardening market. In summary, soft markets are characterized as having increased competition and decreasing rates. A major risk in soft markets is insurer insolvency due to inadequate premiums. Hard markets are characterized as having decreased competition and increased pricing. A major risk in hard markets is large rate increases, restricted terms and conditions, and policy cancellation. Understanding the insurance market cycle can help organizations make more informed insurance purchasing decisions and provide insight in shaping their overall risk management strategy. Conditions for a Hard Market The general consensus of commercial market analysts is that four conditions in the insurance market are necessary for a hard market turn. The following table describes these conditions. Condition Precedent to a Hard market A continuous period (possibly 3 quarters or more) of large underwriting and/or net income losses as measured by combined ratio, net loss and loss adjustment expenses, and catastrophe losses. This precedent condition would be evidenced by (i) poor accident year loss ratios and/or (ii) prior year reserve shortfalls. Present Market Condition These measures are acceptable at this time. The combined ratio 9 for the second quarter of 2014 was 99.9%, up a few points from the year prior ratio of 97.9%. Return on surplus fell to 7.8% (down from 8.1% Q2 2013) despite an increase in net income due to a proportionately larger increase to the denominator, surplus. 10 While these results show a modest deterioration from recent quarters, they are still solid figures. These profitability measures are more in line with the industry norm than the five preceding quarters few quarters (which have been extraordinarily profitable). 8 Anne Gron, Capacity Constraints and Cycles in Property-Casualty Insurance Markets, RAND Journal of Economics, Spring As the combined ratio rises, profitability falls. 10 Dr. Robert Hartwig, Insurance Information Institute, Oct Page 6 of 10

7 Condition Precedent to a Hard market A material decline in capacity or surplus relative to demand as measured by policyholder surplus, which for the first half of 2014 is at a record high for private US property and casualty insurers. Concerns in this area would focus on (i) withdrawal of surplus capital or (ii) destruction of capital by catastrophic capital event losses. A hard (reduced capacity and increased pricing) reinsurance market as measured by rate changes and comparative rate on line data. A return to disciplined underwriting and pricing of risks as measured by year over year rate and premium comparisons. Present Market Condition Capacity continued to rise to $671.6 billion 11 (up from $614.0 billion Q2 2013). Supply relative to demand was 3.876% of GDP/Surplus. 12 In addition to organic surplus growth, the industry has experienced been injections of capital from CAT bonds and other insurance linked securities. Despite the aforementioned decrease in industry profitability, results were still sufficient to continue attracting alternative capital. Reinsurance pricing indices suggest rates are decreasing, especially in the United States. Additionally, increased capital infusions from non-traditional sources are providing capacity and downward pricing pressure has experienced below average reinsurance losses (on a global scale) leading some analysts predict a soft reinsurance market into Here we are seeing a real tempering of rate increases. The average rate increase according to third party surveys was 0.9% for the second quarter of 2014, down from 5.1% the year prior. 14 Insurance premiums are experiencing modest increases at a decreasing rate. We expect this will moderate increases and drive some decreases depending on coverage and risk characteristics. At this time we are not seeing conditions indicative of an impending hard market. Carriers have ample surplus and have shown acceptable results over the last several quarters. Surplus capital is not being withdrawn currently and catastrophe experience has been favorable. Barring any extreme event, it is unlikely underwriters will sharply raise rates or reduce/deny coverage on a macro scale in the near future. 11 Dr. Robert Hartwig, Insurance Information Institute, Oct Bureau of Economic Analysis 13 Schneider, Brian, Fitch Ratings, Oct See below to Lagging Indicators and Other Market Features. Page 7 of 10

8 Combined Ratio (%) Surplus/GDP (%) An ARMC Whitepaper Industry Metrics and the Capacity Constraint Model As noted above, insurer supply is adequate and the highest it has ever been ($671.6 billion in surplus and 3.876% surplus to GDP ratio). This indicates an excess in supply. The industry metric used to measure the profitability side of the equation (referring to the Capacity Constraint Model) is the combined ratio. The lower the combined ratio, the higher the profitability, essentially a combined ratio below 100% indicates the firm/industry is operating at a profit. The industry combined ratio has been steadily dropping over the past few years from a high of 110.5% in the second quarter of The second quarter of 2014 saw a combined ratio of 99.0% Combined Ratio (%) 85 6/2008 6/2009 6/2010 6/2011 6/2012 6/2013 6/2014 Profitability and surplus measures tend to move opposite one another. The chart below shows the combined ratio (profitability) at various points in time with the corresponding surplus/gdp ratio (market capacity). Combined Ratio to Capacity (Surplus/GDP) Combined Ratio (%) Surplus as a Percent of GDP 15 Dr. Robert Hartwig, Insurance Information Institute, Oct 2014 Page 8 of 10

9 With profitability (combined ratio) and capacity (surplus) isolated, the market forecast suggests rates will decrease in the near future. We have been experiencing increases at a decreasing rate (see the below Third Party Market Survey chart). To the right is a red x reflecting where the market is on the Capacity Constraint Model. Surplus is on the high side, and profitability has improved but begun to fall modestly from prior quarters. Additionally, Return on Surplus (currently 7.8%) has been healthy over the past ten quarters or so. 16 In the coming quarters rates should begin to soften according to these isolated variables. Lagging Indicators and Other Market Features Third Party Market Surveys To confirm a change in market direction, we look at some lagging indicators of pricing. Here we find that current premium levels as reported by carriers, brokers and agents continue to show increases, but at sustainably falling percentages. Towers Watson, in their Commercial Lines Insurance Pricing Survey (CLIPS) 17, reported rate increases of approximately 4.0% for the first quarter of This is down from 7% the prior quarter. Towers Watson has yet to release second quarter 2014 results. See chart below. A similar lagging indicator, Market Scout, reports a similar deceleration in pricing increases with a 2.3% increase on average for the second quarter of 2014 versus a 5.0% increase in the first quarter of See chart below. The Council of Independent Agents and Brokers found commercial rates to decrease 0.5% on average for the second quarter of 2014 versus a 4.3% increase one year prior. 19 See chart below. 16 Dr. Robert Hartwig, Insurance Information Institute, Oct Commercial lines insurance Pricing Survey, Towers Watson, Oct Market Scout Market Scout, Oct Council of Independent Agents and Brokers (CIAB), Oct 2014 Page 9 of 10

10 10.0% Third Party Market Rate Surveys 5.0% 0.0% % -10.0% Towers Watson CLIPS CIAB Average Market Scout Average General Reinsurance Climate Reinsurance market strength also plays a role in insurance pricing. Worldwide reinsurers indicated increases in policyholder surplus positions and improved catastrophe losses signaling some price decreases on renewal. U.S. reinsurance demand from primary insurers was flat year on year. The Reinsurance Association of America (RAA) reports member US reinsurers increased PHS from $ billion to $ billion for the second quarter of 2013 and 2014, respectively. The RAA member average combined ratio for the second quarter of 2014 increased to 92.3% from 86.0% for the second quarter While this recent result was not nearly as notable as the year prior, the low interest rate environment has pushed alternative capital into the reinsurance market. Overall, the increase in reinsurance capacity (from both favorable results and alternative capital) is expected to continue causing downward pressure on primary rates, and loosening contract conditions. 20 Quarterly Report Reinsurance Association of America, Oct Page 10 of 10