The Next Hard Market

It may not be time for the curtain to go up on the production known as “The Next Hard Market,” but the opening day may have moved a bit closer.

Some developments over the last year have helped to set the stage. On the liability side, massive catastrophes have led to big underwriting losses that will leave some insurers with no earnings for the year.

The asset side also presented its share of challenges. With interest rates at historic lows, insurers have been unable to make up for their underwriting losses with gains on investments.

A downgrade of the United States’ credit rating in August moved the market another step closer to a hard market by dealing a blow to policyholder surplus as it led to the downgrade of thousands of municipal bonds, which are one of the biggest holdings in insurance company investment portfolios.

“If you ever needed a vivid example that property and casualty insurers are oftentimes viewed by investors as big bond funds, you really got one,” says W. Marston (Marty) Becker, president and chief executive of Bermuda-based Alterra Capital Holdings, in reference to a big drop in the price of insurance stocks on the first trading day after Standard & Poor’s downgraded the U.S. credit rating.

Another key concern is the quality of insurance company earnings. In short, earnings too often come not from underwriting or investments but from the release of the prior year’s reserves. That’s something that can’t go on forever.

Under these circumstances, it’s not surprising there would be talk that a new hard market, in which insurance prices move sharply higher in all lines of business, will be coming soon to a theater near you.

And, indeed, the freefall in U.S. commercial insurance pricing appears to have slowed quite a bit. On average, prices remained stable in the second quarter, with negligible declines, compared with an average 2.9% decline for all accounts reported in the first quarter, according to The Council’s Commercial P-C Market Index Survey, released in late July.

And yet insurance industry sources say they did not believe we’re quite there yet.

“I think we’re still building weight on the camel’s back,” Becker says. “I don’t think it’s broken yet.”

One of the main reasons is that policyholder surplus, a critical component of aggregate capacity, was up 1.4% to a record $564.7 billion at the end of first quarter. When policyholder surplus grows faster than GDP, which is a proxy for demand, that leads to falling premiums.

Dismal economic news, therefore, could forestall any imminent return of a hard market.

While the conditions for a classic hard market may not be right just yet, they will be eventually.

J. Patrick Gallagher Jr., chairman and chief executive of Arthur J. Gallagher, tells the story of a conversation he had with former AIG chief executive Hank Greenberg. It was in the mid-’90s, after nearly a decade of debilitating soft market conditions, and Gallagher asked Greenberg whether they would ever see a hard market again. Greenberg’s response: “I don’t know when it will happen, but no one changed the laws of economics. It will happen.”

As it turned out, it took 13 years.

The last hard market got underway in 2000, picked up steam with the shock loss from the September 11 attacks, and then wound down in 2003. That hard market ran for roughly the same period of time as the hard markets of 1984-87 and 1975-78.

But the interval between the last two hard markets was particularly long. It only took six years between the ’75-’78 hard market and the ’84-’87 hard market. Before that, hard markets used to come about every three years or so, according to retired veteran Wall Street analyst Michael Smith. After 1987, insurers had to wait 13 years.

That long interval took a toll. As year after year went by with insurers cutting prices further and further, some venerable insurers went out of business.

And this is one of the key factors regarding hard markets: Insurance companies often have to endure quite a bit of pain before the market will turn, Smith says.

Both Gallagher and Smith pointed to cash flow as a key indicator.

“The correlation to decreases in cash flow is a pretty tight correlation to when the market has to change,” Gallagher says.

Cash flows are weakening, but they are still positive. “Cash flows are down, but they’re not at pain levels,” says Gallagher.

Another indicator is when insurers start going out of business, as they did during the 1990s. When insurers start getting into financial trouble, Smith says, buyers begin to realize that a great deal on insurance isn’t such a great deal if the insurance company isn’t around to pay claims.

Economist Robert Hartwig, the president of the Insurance Information Institute, says four conditions must be met before there can be a hard market:

• A sustained period of large underwriting losses
• A material decline in industry capacity
• A sharply contracting reinsurance market
• A return to underwriting and pricing discipline.

None of these conditions have been fully met as of yet, he says; although, some have started to move into place.

The biggest shift is taking place in the property catastrophe insurance market, in which prices are beginning to move up as a result of global catastrophe losses, which were estimated by Munich Re at $60 billion in the first half of the year. That’s nearly five times greater than the average since 2001, according to Munich Re.

There may be more big catastrophe losses to come with hurricane season moving into high gear in the second half of the year.

Most of the losses in the first half came from an earthquake and tsunami that hit Japan in March. Other large losses in the first half included an earthquake in New Zealand, floods in Australia and a record outbreak of tornadoes in the U.S.

The property catastrophe market is also reacting to a major update to a widely used hurricane model from risk modeler RMS, which has prompted some insurers and reinsurers to reassess their hurricane loss estimates. Hartwig cited other factors, such as a tightening reinsurance market and a return to pricing and underwriting discipline, that are beginning to be reported in the property catastrophe market.

Ironshore, for instance, cut back underwriting in its property business by about 20% to 25% in the first six months of the year, says Chief Executive Kevin Kelley. The Bermuda-based company cut back capacity because of catastrophe losses in the first quarter and a determination that the company wasn’t getting paid for the risk it was taking, Kelley says. The result is that prices on its property business were up in the 9% to 10% range in April and May and up about 11% in June.

“We are in effect reducing effective capacity and getting rate increases on accounts that we’re binding,” Kelley says.

Other insurers have been raising prices on property catastrophe business.

“The areas where the rates are going up is all pretty logical,” says James Vickers, chairman of Willis Re International & Specialty. “It’s the areas where there have been losses.”

Outside of the property catastrophe market, however, it’s a different story. While prices in the U.S. commercial insurance market may be stabilizing, they’re not making a real move up yet.

“I think we’re in a classic soft environment,” Gallagher says. “We’re at a point in time now where underwriters are trying to be much more strategic in how they price.” But underwriters that hold the line on price are still at risk of losing business.

It is true that catastrophe losses are a factor driving up prices in the property catastrophe market, but the property market makes up less than 25% of the premium in the overall U.S. insurance market, Gallagher says. The U.S. is primarily a casualty market.

Underwriting losses that have an impact on the broader market typically come from business that has been mispriced or under-reserved, Hartwig says. Not only must underwriting losses be big, they must be sustained—quarter after quarter for at least a year and usually longer.

Policyholder surplus, meanwhile, has certainly not seen a material decline—yet.

The downgrade of the U.S. credit rating will have an impact, though, as the related downgrades of municipal bonds drive the price of those bonds down. As the price of the bonds goes down, yields will go up. A 1% increase in interest rates, Becker says, would probably take away about 10% of industry surplus.

The impact of this is likely to be more long lasting than the decline in asset values in 2008.

“The question this time is: Will assets recover as quickly, given the broad-based systemic issues, particularly among sovereign debt around the world?” Becker says. “Because the fix is not quick.”

The other conditions that have to be met before there can be a new hard market—tighter reinsurance pricing and discipline in both pricing and underwriting—are not yet taking place in the market outside of property catastrophe. With these conditions unfulfilled, insurance prices are unlikely to make a major move higher in the very near future, barring some unforeseen development.

Could what’s happening in property catastrophe begin to spill over into the rest of the market? There are those who think that the last hard market was too moderate to truly rebuild insurers that had been weakened by the lengthy soft market of the 1990s.

One sign that all is not well is the quality of insurance industry earnings. Rather than making money on underwriting or investments, a lot of the industry’s earnings have come from the release of prior year reserves. A. M. Best estimates that insurers released $10.3 billion in 2010 and $10.5 billion in 2009, says Richard Attanasio, a vice president at the rating agency.

“That’s not a great business model,” Kelley says.

With the accumulation of stresses that have been building, Becker says he believes the insurance market is nearing a point that is more akin to 1999 or 2000 than 2005 or 2008.

“All lines of business are showing stress,” he says. “Therefore, if there is a major event, it would probably add some pricing power across the board.”

That’s different from 2005 and 2008, when insurers were hit with big losses from Hurricanes Katrina and Ike but there was no significant impact on the price of insurance in the overall market.

Others see a different scenario playing out. Rather than a return of a traditional hard market, market cycles may simply flatten out, Vickers says.

“We are tentatively putting forward a hypothesis that the days of a general market turn where all rates go up, in all classes, all over the world, which is what happened historically, are unlikely to happen again,” he says. “The peaks and the troughs are slowly being ironed out.”

Vickers points to improvements in the way insurers segment their risks and in risk modeling, which prevents pricing from going too low during soft markets. There also are new techniques to gain access to capital, which keep price increases more muted during hard markets.

Others, however, see history repeating itself.

“We will eventually see a firming of the market,” Gallagher says. It may take a while for the right conditions to build, but it all comes down to supply and demand. “When the supply of capital is pinched,” he says, “it will go up.”