Turn of the cycle: evidence suggests property/casualty's hard market is ending, but changes in the way the industry writes business may be of more lasting significance.

Property/casualty insurance's soft market lasted so long that it may not seem fair its hard market is already losing steam. The facts indicate that it is, however, though industry news remains generally upbeat.

According to a December report by the Insurance Information Institute on last year's first nine months, the industry was "on the threshold" of its best profit performance in five years. The recovery was broad based with significant improvement noted in every key financial statistic, wrote Robert P. Hartwig, senior vice president and chief economist. Premiums-a primary measuring stick of hard and soft markets--were racking up another stellar year with 10.1% growth through September.

The premium-growth trend, however, is down, prompting several industry analysts to speculate just when the hard-market cycle will end. Spurred by several factors--with the terrorist attacks of Sept. 11, 2001, the major catalyst--net premiums grew in 2002 by 14.3%. That rate fell to 12.7% in last year's first quarter, 9.3% in the second quarter and 8.4% in the third. Hartwig estimated growth for "all of 2003 would fall to 9.8%, surprisingly lower than the 10.8% average that analysts at the beginning of the year had expected.

Rate growth, a more significant measurement of hard markets, has been higher than premium growth. The Council of Insurance Agents & Brokers reported that in commercial lines, rate increases peaked in the fourth quarter of 2001 at more than 30% for mid-sized and large accounts. The increases have fallen steadily since then to the mid-to-high single digits in last year's third quarter. The council's survey of agents and brokers showed that in the third quarter, nearly a third of the small and large accounts, and 27% of medium-sized accounts, experienced no change in premiums or a drop of up to 10% for renewals and new business.

R. Neal Pomroy, managing director at worldwide consulting firm Mercer Oliver Wyman, said it is "wishful thinking" that the market will stay hard through 2004. Commercial property rates have softened, and the pace of increase in casualty lines has moderated. This year, he expects that some casualty rates will drop. Specialty lines will hold because there is "sufficient chaos" and "not yet a capitulation" by underwriters, but he added that customers and brokers are starting to look for ways to reduce the cost of insuring risk. Pomroy said rate softening began earlier in personal lines with some rate givebacks. "No one anticipates capitulation there, hut certainly price competition has returned," he said.

Richard Fein, a principal at PricewaterhouseCoopers, said the hard market is not at an end. Property rates appear to be rising at a slower pace, and casualty rates should continue to rise, he said. Fein is PwC's practice leader for U.S. actuarial and insurance-management solutions. Fred Donner, a partner at KPMG LLP and the insurance sector leader, said the industry is still in a hard market, but he is seeing a leveling of rates and is starting to see buyers look to alternative methods of handling risk, which has the effect of capping how high rotes will go.

Other assessments came at December press briefings. Peter R. Porrino, Ernst and Young's director of insurance services, said 2004 may be the "last great year" for disciplined underwriting and pricing in commercial insurance. He expressed doubts for 2005, noting that the industry has a history of being unable to resist reducing prices. In his report, Hartwig identified loss of pricing discipline or a sharp loss in pricing momentum as "among the biggest downside risks for 2004." Executives at Swiss Re were decidedly optimistic, saying that the industry's hard market will last through 2005 and beyond. Patrick Mailloux, head of U.S. direct business, said Swiss Re sees "favorable trends in many lines that support that outlook." Among them have been a tightening of underwriting terms and conditions and the fact that the industry has had to focus this past year on its core problems and address the concerns of rating agencies and investors, he said.

Some factors likely to moderate aw rate declines in the general commercial market are a still-weak economy, low yields on investments and the continuing need for insurers to build reserves and strengthen their overall financial condition, said Ken A. Crerar, president of the Council of Insurance Agents & Brokers, in its third-quarter press release.

Are Cycles Shortening?

Pomroy said this hard market was shorter than usual "and certainly shorter than insurers wanted it to be." He said there is lots of evidence that this hard market was not sufficient for a number of insurers to reload their capital. He questioned whether currently there is capital sufficiency across the board in the industry, and he said there is probably undercapitalization among a number of key companies and key lines.

Three major reasons account for the shortened hard-market cycle, Pomroy said. One is that the industry--particularly reinsurers--raised capital at the beginning of the hard market "at an unprecedented quickness." That capital rapidly found its way into the market in areas insurers believed were strategically mispriced, he said.

Second, companies with "Swiss cheese covers'--those unable to find the coverage and coverage forms they wanted--turned to alternate risk facilities and self-insured programs. This occurred only on the margin, Pomroy said, but it came at a time when companies were familiar with and comfortable with pursuing those options, particularly in the upper-middle and large market tiers. "It's not a huge trend, but it was meaningful nonetheless," he said.

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Estimates are that some 80% to 95% of the biggest 500 or 750 companies in the United States use alternative-risk or self-insured programs in some of their lines, said Pomroy. "There are indications the middle market is somewhere between 50% and 70%, so there's opportunity for the utilization of these kinds of programs there," he said.

Third is the emergence of some industry leaders. Those leaders are a little more sophisticated in the way they segment and price risk, measure and manage their capital, and take an aggressive stance in the way they'd like to create value in the future, said Pomroy. "We're starting to see those companies step up, and that's enough to turn the market a bit, where they're being selectively more competitive," he said.

To succeed in this new environment, insurers need to "achieve the next level" of underwriting insight, segmentation and pricing discipline, said Pomroy. He suggested they use scoring models, improve their underwriting processes in ways that help local underwriting decisions to be taken in more of a global context, and beef up research and development. Successful insurers also will become more adept at deploying capital in a more sophisticated framework that reaches lower and lower levels of the company, where the risk actually is taking place. Lastly, he expects successful companies will become more focused in order to achieve a level of differentiation. Such companies might sell lines in which they are subscale, or business in regions in which they are subscale, but buy into lines or regions when such purchases would create better brand awareness among the customers or channel partners. Such purchases also would be prudent if they increase an insurer's information and knowledge within select areas.

"Scale through size alone is a myth," said Pomroy. "Scale through a valuable brand with customers and channel, and scale through information knowledge and use, is very real"

The hard market blossomed after the 2001 terrorist attacks as huge amounts of capital flowed into insurance entities willing to write property business, according to Fein. With great uncertainty in the market, reinsurers in particular reacted very quickly, he said. The law creating a federal backstop for terrorism insurance has since reduced uncertainty, but there is still plenty of uncertainty about the chances of more terrorism, he said. The hard market in casualty began even before the Sept. 11 terrorist attacks due to a recognition that premiums were out of line with costs, he added. After Sept. 11, directors and officers and surety lines led the upsurge in rates.

Matching Prices and Risks

Fein also disagreed that this hard market has been shorter than most. In addition to the pre-Sept. 11 start in casualty lines, directors and officers covers rose after Enron's collapse and scandal. "This one has gone on for a while, a little longer than others," he said. "In the 1980s, it was the level of availability that was driving the hard market. Today, it's that our prices and risks are not well matched." He also cited the accounting issues, how companies stated their financials and low investment returns. "These factors have made this hard market into something very different than what I've ever seen," said Fein, who has more than 31 years of experience in the insurance industry. "It's astonishing all these economic engines have adapted themselves to all of the extraordinary changes."

One would expect hard markets to be shorter because the information technology employed by the business has improved so much, Fein said. The "additional shots" to the economy, however, prevented it from happening. But technology is still working to help insurers better know what they're writing and to write it profitably, he said.

Technology can tempt companies to try to gain market share, but as Pomroy mentioned, Fein said the better companies will have an established strategy with technology in place and shared by everyone so that all involved in key decisions know what risks the company is putting onto the books and what business it is declining. Such a strategy also can help in soft markets, he pointed out. He also said companies will sometimes write business at a loss in order to "establish a beachhead somewhere."

Donner said the present hard market began when the reinsurance marketplace hardened right after Sept. 11 and the capital markets declined. "Low interest rates forced insurers to rethink their underwriting philosophies," he said. "Before that, weakness in underwriting discipline had really become exposed."

Every hard market is different, and one of this one's differences is that it started so quickly, Donner said. "I don't think there's another hard market that we can attribute to one or two events like this," he said. "Usually, it's a series of things."

Soft markets start with a leveling of rates, but this is still a hard market because the industry is still seeing rate increases, said Donner. "Once competition starts to heat up, companies may start chasing premium dollars, but I'm not seeing things now that cause a soft market--greater competition and lowering of rates," he said.

However, Donner said he is starting to see buyers look more closely at alternative risk methods and risk-retention groups. "What that does is put a cap on how high rates will go, when buyers reach the breaking point and say 'enough is enough,' and we're seeing that," he said. "That's why you see this trend of rates leveling."

Keeping Options Open

The industry does get such customers back when there's a soft market, however. "We see that all the time" Donner said. "Commercial buyers are price-sensitive, and they go with traditional insurance coverages when rates are right for them." Pomroy said they often come back to traditional insurance because very few completely stop buying insurance even when they use alternate programs." If you set up a big structural captive, there is a bit of an exit barrier to going all the way back to pure risk transfer," he said. "If you've used self-insured programs, the exit barrier to flip back out to a traditional cover is actually modest. You're just moving your attachment point down and firing your third-party administrator." But he added that the industry will not see "a complete capitulation" of the different kinds of alternative risk management and a return to traditional insured levels of 2001.

Most people would argue that the use of alternative facilities is more an effect than an indicator of market cycles, said Pomroy. Insurance customers and their brokers are almost constantly evaluating the best ways to manage the cost and nature of risk management, he said. During hard markets, alternative facilities are more attractive, and during soft markets, their relative economic attractiveness is less.

Fein said the use of alternative facilities and self-insurance in commercial markets does not serve as an indicator of the direction of the personal lines market. Commercial buyers are in a better position to engage in risk shifting, he said. "They have capital flow and can withstand losses," he said. "Personal has a limit in this, and regulatory edicts sometimes say they need a minimum amount of coverage."

Personal and commercial lines also are sold differently. Since personal lines are sold to lots of different people, underwriting must be very expense-conscious, Fein said. Commercial lines can offer a lot more pricing options and flexibility, and parties can react faster in commercial lines to pricing changes than in personal lines.

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