The property/casualty insurance industry is cyclical, continually fluctuating between a hard and soft market. These fluctuations affect the availability and price of business insurance, so it is helpful to understand why they occur.
Hard and Soft Markets
A hard insurance market is characterized by a high demand for insurance coverage and a reduced supply. Insurers impose strict underwriting standards and issue a limited number of policies. Premiums are high and insurers are disinclined to negotiate terms.
A soft insurance market is the opposite of a hard one. When the market is soft many insurers are competing for business and premiums are generally low. Insurers relax their underwriting standards and coverage is widely available. Underwriters are generally flexible and willing to negotiate coverage terms. Broad coverage is available with some extensions available for free.
How Insurers Make Money
To comprehend why the insurance market fluctuates between hard and soft, you must first understand how insurers make money. Insurance companies have two main sources of revenue: underwriting profit and investment income.
The term underwriting profit means the difference between the premiums an insurer collects and the money it pays out in claims and expenses (including agent and broker commissions). An insurer that collects more in premiums than it pays out in claims and expenses will earn an underwriting profit. Conversely, an insurer that pays more in claims and expenses than it collects in premiums will sustain an underwriting loss.
Insurers also generate income by investing in assets. Property/casualty insurers normally hold an assortment of stocks, bonds, mortgages, and real estate investments. Their largest asset group is typically bonds, including corporate, municipal, and U.S. government bonds. Bonds are "safe" assets that can be converted into cash quickly.
State insurance regulations limit the types of assets in which insurers can invest. These regulations are designed to protect policyholders. They ensure that insurance companies will remain solvent and have funds available to pay claims.
Because insurers have two sources of income, they can lose money on one and still generate a profit. For instance, suppose an insurer earns $50 million in investment income and sustains a $40 million underwriting loss. The insurer has earned a $10 million profit. When interest rates are high, insurers can rely on investment income to make up for underwriting losses. However, when interest rates are low, insurers must pay close attention to their underwriting results.
Insurers can't use premium income right away. They must hold premiums they haven't earned in an unearned premium reserve. This reserve is a liability on an insurer's balance sheet. It represents the amount of money an insurer would have to return to policyholders if they all canceled their policies on the date the balance sheet was prepared.
An insurer earns premium on a pro rata basis throughout the term of a policy. For example, if a business owner buys a policy and pays the premium in advance, the entire premium is unearned on the policy inception date. After six months have passed, the insurer has earned 50% of the premium. The insurer has earned the entire premium when the policy expires.
Besides the unearned premium reserve, an insurer must set aside money for loss reserves. Loss reserves are used to pay losses that have already occurred, including those that have not yet been reported. Loss reserves are also a balance sheet liability.
Factors Affecting the Availability of Insurance
There are several factors that can affect an insurer's capacity to issue policies. As noted above, a significant portion of an insurer's money is tied up in reserves. To issue new policies, an insurer must have an adequate financial cushion in the form of policyholder surplus (assets minus liabilities).
Catastrophic events like hurricanes, earthquakes, and gas explosions can generate huge property insurance losses. Insurers that have paid large claims for certain risks may stop insuring those risks in order to protect their financial resources. Moreover, insurers may have shared large losses with reinsurers, which may now be unwilling to renew reinsurance contracts. Without access to reinsurance, insurers may lack the capacity to write new policies.
The legal climate can also affect insurers' willingness to issue policies. In a litigious environment, insurers may be hit with many large lawsuits. Poor loss experience may cause an insurer to sustain an underwriting loss. A liability insurer's capacity may be further reduced if reinsurers are unwilling to renew the insurer's reinsurance contracts.
Insurers' ability to write new policies is also affected by general economic conditions. In recessionary times businesses may purchase less coverage or forgo insurance altogether. Businesses' sales and payroll (on which premiums are often based) may decline. The result is less premium income for insurers. Recessions can also trigger low-interest rates, which reduce insurers' investment income.
Perpetual Soft Market?
Since the early 2000s, a soft market has prevailed in many lines of commercial insurance. Prices have remained relatively low despite numerous disasters that have been costly for insurers. Examples are Hurricanes Harvey, Irma, and Maria that occurred in 2017, and huge wildfires that burned in 2015 and 2016. In years past, such events would have triggered a significant increase in insurance rates. Yet, rates have remained largely flat. Rates did rise in 2019 but the increase was modest (about 2% as of April 2019).
The insurance market has remained soft despite costly disasters because insurers have easy access to capital from non-traditional sources.
The insurance market has remained soft despite costly disasters because insurers have easy access to capital from non-traditional sources. After Hurricane Katrina destroyed much of New Orleans in 2005, insurers needed a new source of capital. Hedge funds, mutual funds, pension funds, and other investors responded by pouring money into catastrophe bonds, and other types of "alternative capital." This trend has continued. According to the Insurance Information Institute, much of the alternative capital has been concentrated in catastrophe business, protecting insurers from disasters. This has enabled insurers to continue writing policies without raising premiums significantly.