April 7th, 2009

Manage the Cycle, Part II: Behavior Drivers

Posted at 12:30 AM ET

venter_gary_thumbGary Venter, Adjunct Professor, Statistics, Columbia University
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What most people in the insurance and reinsurance business call the “cycle” is really only the space between market-changing catastrophe events. Disaster strikes, and capital evaporates. Then, time passes, and carriers recapitalize. Reinsurance rates follow capitalization, typically spiking post-event and dropping during quieter periods. The spaces “in between” are not always the same. Several factors can accelerate or impede the return to stability, with the three major drivers being capital levels, information lags between an event and industry (and regulator) reaction, and macroeconomic factors.

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Since Hurricane Andrew hit the Florida coast in 1992, the reinsurance market’s reaction to shock losses has changed. The price increases that followed Hurricane Andrew were sharp, but subsequent disaster events - such as the terror attacks of September 11, 2001 and Hurricanes Katrina, Rita, and Wilma — triggered significant but less severe reinsurance rate increases. There were critical differences in the markets that followed each of these events. Capital levels (and the means by which capital could be acquired), regulatory and market responses, and macroeconomic conditions varied, resulting in different situations from one mega-catastrophe to the next.

The role of capital levels in reinsurance rate trends is intuitive. An abundance of insurer and reinsurer capital leads to lower demand and increased competition, which in turn lead to lower cost. As a result, reinsurance rates trend lower as the industry recapitalizes following a mega-catastrophe. Further, we have seen from recent catastrophe events that post-disaster recapitalization is taking less time, and the effects of these events on reinsurance rates are becoming less severe. With alternative sources of capital (such as sidecars and catastrophe bonds) available to supplement traditional reinsurance, sufficient capital levels have become easier to maintain, muting the implications of mega-catastrophes. There will still be peaks and valleys, but they are likely to become narrower over time.

Though capital level is probably the first factor that comes to mind in insurance and reinsurance company management between catastrophe events, it does not stand alone. Time also shapes the period between events. An event and its response, by definition, are not simultaneous. The former must precede the latter. Again, we look to the space in between — i.e., the lag. A longer lag can frustrate the industry’s attempts to recover post-event, as we saw in the United States in the 1950s and 1960s, when regulators wouldn’t grant rate increases before solvency problems occurred. Insurance companies have been described as underwriters driving a car blindfolded with actuaries shouting directions while looking out the rear window. The element of truth is that insurers can only look at past events to determine their strategies, and these events take time to come into focus.

Insurance companies have been described as underwriters driving a car blindfolded with actuaries shouting directions while looking out the rear window.

The problems with lags can be based on market factors, as well. Following a mega-catastrophe, it takes time to figure out the implications for insureds, individual carriers, and the industry as a whole. Reactions are rarely immediate, as conditions are digested and prudent responses are developed and executed. A longer time to react exacerbates the implications of the cause, delaying the market’s recovery.

Prevailing macroeconomic conditions will influence how carriers manage between disaster events. Factors such as gross domestic product (GDP) growth and inflation can influence investment asset returns, which flow through to the availability of capital for underwriting and ultimately company profitability. Also, catastrophe losses — short of market-changing events — will also affect the management of risk and capital during quieter periods. Years with above-average frequency can erode primary insurers’ balance sheets, particularly when retentions are high.

These factors — capital levels, information lags, and macroeconomic conditions — are at play in today’s market as well. The decimation of capital in 2008, the result of the subprime market collapse spreading to broader credit and equity markets, occurred during the second most active catastrophe year since at least 1970. The availability of capital under these conditions will shape the market in 2009, and possibly beyond. The information lags will have an impact as well, particularly as regulators and rating agencies explore the capital levels and methodologies necessary to mitigate the effects of future financial crises.

Gary Venter was previously a Managing Director in Guy Carpenter’s Instrat® Unit
This is the second in a six-part series. To have the next installment delivered directly to your inbox, register for e-mail updates.
 
 
 

 

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