Why insurers should act now, before the market hardens

24 October 2016

Insurers should start thinking more creatively about capital management and take measures to protect their balance sheet.

Though the soft market has continued for many years, I think it will harden.

There have been peaks and valleys in prior (re)insurance market cycles. This time I don’t expect market hardening to be so severe – just as the hard market in the 2000s was less severe than it was for property insurance in the 1990s or for liability insurance in the in the 1980s.

In large part, this is because information exchange, and the technology behind it, continues to improve. (The previous hard markets were so severe because of a lack of good information, which led to companies taking on more risk than they realised.)

Capital flow

The superior information we have today has also resulted in many more types of entities being comfortable investing in insurance (hedge funds, pension funds etc). This had led to the industry being well capitalised and allowed capital to flow in quickly in response to market opportunities.

This is positive because hard markets can have long-term destructive consequences. Specifically, they lead to companies foregoing (re)insurance; when this happens, it can be a long time before they return to the market (if they ever do).

For example, in the 1980s liability hard market, companies started using captive insurers more. Similarly, after the post-KRW hard market, many insurers raised retentions. In many cases, some of that business left the (re)insurance market permanently.

Tipping point

There are definitely themes – or a confluence of themes – to hard markets, which lead to the identification of previously unknown correlations and a recalibration of risk (as happened after Hurricane Katrina, 9/11 or Hurricane Andrew).

One indicator of a market about to turn is reserve inadequacy. When reserves are upside down, it changes the landscape – fear creeps in, and trust diminishes between different counterparties in the chain of risk transfer.

Reserves seem to be at some kind of tipping point: they are generally adequate but not ‘super adequate’. When the reserves do tip, it will invariably lead to a hardening market environment.

All that said, I’ve given up trying to predict when the market will harden. In the late 1990s it felt like it would never happen – then it did.

Back then there were underwriters that had never dealt with hard markets. But those underwriters learned, and so will today’s generation of young underwriters.

Get creative

So what can insurers do to prepare for a possibly harder market?

Think less linearly about capital definitions. For example, capital can sometimes be too narrowly defined (eg, long-term deficits, equity), when actually capital comes in many other forms (eg, reinsurance) which can be more subtle, but still provide protection.  This protection is not just with respect to the book value of the enterprise, but the franchise value as well.

Insurers are wary about being overcapitalised and their ability to service their capital bases. However, in any future hard market capital will be scarcer, by definition, so it may very well be self-defeating to believe that one can raise capital in that environment.

So think more creatively about capital management and take measures now, while there is more lassitude, to protect your balance sheet and franchise value.

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For more information, please contact Ed Hochberg on +1 215 246 1681 or ed.hochberg@jltre.com