A reminder of the market forces
Financial marketplace cycles and how they are determined by supply and demand forces, is one of the first lessons in Economics 101. A reminder follows; a change, increase or decrease, in demand or supply, ceteris paribus, will move the market equilibrium and consequently increase or decrease price and quantity. Supply and demand equilibriums tend to move up and down over time, creating cycles.
It will come as no surprise that these forces act on the insurance industry, where we refer to hard and soft markets.
A soft market is characterized by excess supply of capital, also referred to as risk capacity. Underwriting standards are influenced by a business’s need to win incremental business and premiums lowered to stay competitive. However, surplus supply of risk capacity is not a sustainable market state. At some point lower underwriting standards lead to losses in excess of the reserves established to cover losses and the market turns hard.
A hard market is where insurers reduce the amount of coverage they are willing to write, reflecting a decrease in supply and consequential upward move of the equilibrium and higher prices.
Left to ride the rollercoaster of the insurance cycle
As a member of the Alternative Risk Transfer (ART) team, I often find myself in conversations with clients and prospects about the insurance cycle. Our partners understand the forces at play but yet express frustration about unpredictable price fluctuations and the correlated and unwanted volatility on budgets and earnings.
For them, long-term stable and transparent premium charges are desirable. Stability adds certainty to corporate budgeting, cash flows and the loss control/financing processes. This in effect helps to maximize long-term enterprise value.
Our partners feel that they are left to ride the rollercoaster of the insurance cycle, and at times it’s been a wild ride. With the actual risk of underlying assets remaining unchanged, price changes are seen as irrational and outside of their control.
Annual transaction costs are also factors that agitate. I hear that there has been very limited opportunity to invest in solutions that minimize the impact of fluctuations in the cycle and aims to reduce transaction related costs. For some, price swings of ±5% versus ±25% year-on-year are more manageable.
Lessons from other areas of finance
As was established in the introduction, the insurance market cycle is just like any financial marketplace cycle. Insurance is a form of balance-sheet financing, where the supply of capital directly influences the cycle. So a question worth asking is, How is the market cycle managed for other financial products? What is done by buyers to create price stability and limit transaction-related costs?
From my research, I find that in very few cases do companies rely on annually renewed contracts to fulfill their capital needs. Furthermore I seldom find clients renewing a whole financing obligation in one go.
Rather, the capital requirements are divided up with different maturities, in multi-year capital facilities. This allows for a better risk-balanced portfolio and less exposure to cyclical volatility.
Multi-year solutions as a hedge against insurance price volatility
In the ART market there is a trend where multi-year solutions/products are regaining popularity. Markets are comfortable in offering these risk financing solutions and welcome the predictable income over multiple years.
For buyers, locking in insurance capacity to cover the whole or part of a risk can be attractive. The solutions, when efficiently structured, help to deal with many of the above expressed frustrations. More specifically multi-year deals will:
- help guarantee long-term prices and capacity therefore, create stability in budgeting and earnings
- hedge against potential dramatic market and price moves
- reduce cost associated with marketing of the risk portfolio on an annual basis
Another relevant opportunity is the possibility to take advantage of the lows of the insurance cycle. I will not claim that peaks and bottoms of market cycles can be called with 100% accuracy but for those who feel that the market is well capitalized, if not even overcapitalized, it may make sense to bind the current low prices on a longer term than the traditional one year.
Even locking in prices for a fraction of the risk portfolio may help smoothen market cycle effects and make it easier to deal with a hardening market, if and when it comes.
Leaving traditional solutions behind
In conclusion, volatility is created by the way traditional insurance is traded: where annual contracts put 100% of capital needs up for tender each year. A non-traditional alternative which now exists within ART is multi-year contracts.
It should be in the interest of the buyer to not only protect the company´s financials against volatility of adverse loss events but also against the price swings of the insurance cycle. Here’s a chance to build further stability on both sides of the insurance marketplace.