April 6th, 2009

Manage the Cycle, Part I: What Cycle?

Posted at 1:00 AM ET

venter_gary_thumbGary Venter, Adjunct Professor, Statistics, Columbia University

The insurance and reinsurance industry often talks about cycles. Although not as regular as the term “cycle” might imply, there are indeed systematic fluctuations of insurer and reinsurer underwriting results. Periods during which reinsurer capital positions are strong favor cedents, although they too might be hurting from their own market problems at such times. Then, a market-changing event occurs, and the market for reinsurance cover tightens. The cost to transfer risk climbs, as balance sheets are depleted, coverage becomes harder to find, and competition becomes less intense. Over time, of course, carriers replenish their coffers, and reinsurance rates come down again.

Yet, this is not truly a cycle. It may feel like one, as conditions persist for a few years, but the drivers behind it are not beholden to the clock. Given the role of uncertainty in protecting capital from external events, insurers and reinsurers need to manage to prevailing market conditions rather than hoping for an up-tick. A long-term plan recognizing the competitive nature of the industry is what is needed.

Cycles are defined by time, with market events anticipated according to a reasonably predictable schedule. The trip the Earth takes around the sun, for example, exhibits cyclicality. The path is consistent and the results expected. The insurance and reinsurance industry does not adhere to this type of behavior. A mega-catastrophe can occur at almost any time, and carriers must be prepared. For larger firms that write several lines of business, predictability plunges: there is more opportunity for uncertain-and remote-events to enter the system, surprise risk-bearers, and erode capital.

The notion of cyclicality is comforting. If one expects an event, preparation is easy. Thus, people look for cycles as a way to reduce uncertainty and anchor their plans for the future. Once a cycle is identified, it can be followed. This tendency is reinforced by the consideration of average durations between major events. If an above-average amount of time has passed, carriers feel the market is “due for an event.” Averages, however, mask the underlying conditions. They create the appearance of cyclicality, despite a much different underlying reality.

Country Time Between Events
Australia 5.18
Canada 5.79
France 10.19
Italy 4.84
Japan 7.07
Netherlands 12.03
Malaysia 12.01
Spain 5.73
United States 7.39
Source: Guy Carpenter & Company, LLC


One historical study found quite different average return times for sellers’ market conditions for different companies during the period they studies. Consider the average time between catastrophes for the United States, for example. Using this number (7.39), one could expect the next mega-catastrophe to hit in 2012 or 2013, with Hurricanes Katrina, Rita, and Wilma in 2005 as the most recent instance. Based on this thinking, the previous disaster would have hit in approximately 1998, which overlooks the terror attacks of September 11, 2001 completely. This approach also fails to account for the many casualty catastrophes that have occurred over the past decade, such as the accounting scandals that followed the collapse of the “dotcom economy.” To see the notion of cyclicality fall apart, one can look back on the past decade. Clearly, there is no standard period that elapses from one event to the next.

For insurers and reinsurers, the challenge is to mange capital effectively in the gaps between events, in order to be ready for the next occurrence, regardless of how long the wait is. There is no way to tell how long these periods of calm, with their rising levels of competitive pressure, will last, as a result of the outside factors that cause catastrophes and influence carriers’ responses.

Over the next five days, we’ll take a look at what is commonly called “the cycle” — i.e., the periodic changes from peaks to valleys in reinsurance pricing. The drivers (capital levels, information lags, and macroeconomic conditions) will be explored, as well as how carriers can optimize their use of capital before and after mega-catastrophes.

Instead of watching the clock, we’ll explore the advantages of watching capital and making it as effective as possible.

Gary Venter was previously a Managing Director in Guy Carpenter’s Instrat® Unit

This is the first in a six-part series. To have the next installment delivered directly to your inbox, register for e-mail updates.

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