Is the Insurance Market Hard or Soft?
The insurance market can fluctuate from hard to soft or from soft to hard. Because these fluctuations affect the availability and price of business insurance, it is helpful to understand why they occur.
How Insurers Make Money
To comprehend how the insurance market operates 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 that it collects in premiums will sustain an underwriting loss.
Insurers also generate income by investing in assets. State insurance regulators limit the types of assets in which insurers can invest. Generally, insurers may invest only in "safe" assets that can be converted into cash quickly. Examples are government and municipal bonds. The rules 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 but generate a gain from the other. If their gain exceeds their loss, they will generate a profit. For instance, suppose an insurer has earned $50 million in investment income and sustained a $40 million underwriting loss. The insurer has earned a profit of $10 million. When interest rates were high, insurers relied on investment income to make up for underwriting losses. Interest rates have been low since the Great Recession began in late 2007.
This has reduced insurers' investment income, forcing companies to pay closer attention to their underwriting results.
While premiums are a major source of insurers' income, they cannot use that money right away. Insurers must hold premiums they haven't yet earned in an unearned premium reserve. This money is used to pay future claims (claims that have not yet occurred).
An insurer earns premium on a pro rata basis throughout the term of a policy. For example, suppose a business owner buys a policy and pays the premium before the coverage takes effect. On the policy inception date, the entire premium is unearned. Six months later (halfway into the policy period) the insurer has earned 50% of the premium. The insurer has earned the entire premium when the policy expires.
In addition to the unearned premium reserve, an insurer must maintain loss reserves. Loss reserves consist of money the insurer has set aside to pay losses that have already occurred, including those that have not yet been reported.
Because a significant portion of an insurer's money is tied up in reserves, it may lack the financial capacity to issue new policies. Fortunately, an insurer can increase its underwriting capacity by purchasing reinsurance. When an insurer buys reinsurance it transfers some of the risk of future losses to the reinsurer. The transfer of risk reduces the amount of money the insurer must hold as unearned premium reserves. With less money held in reserves, the insurer has a greater capacity to issue new policies.
Factors Affecting the Availability of Insurance
There are several factors that can affect an insurer's capacity to issue policies. Catastrophic events like hurricanes, earthquakes, and gas explosions can generate huge property insurance losses. Insurers that have paid large claims for certain risks may be reluctant or unwilling to insure those risks in the future. Moreover, insurers may have shared large losses with reinsurers, who may now be unwilling to renew reinsurance contracts. Without access to reinsurance, insurers have limited capacity to write new policies.
The legal climate can also affect insurers' capacity. 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' capacity 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.
Characteristics of Soft and Hard Markets
A strong economic climate, a favorable legal environment and/or few catastrophic events can increase insurers' capacity, creating a soft insurance market. 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.
A series of catastrophic events, a litigious legal environment and/or a poor economy can reduce insurers' capacity to write new policies. The result can be a hard insurance market. A hard insurance market is the opposite of a soft one. When the market hardens, insurers tighten their underwriting standards. Some coverages may be difficult to secure as fewer insurers are competing to write policies. Premiums are relatively high and insurers are disinclined to negotiate terms. Broad coverage may be costly or unavailable but some coverage extensions may be available for an additional premium.
Perpetual Soft Market?
Since the early 2000s, much of the commercial insurance industry has experienced a soft market. Prices have remained relatively low despite numerous disasters that have been costly for insurers. Examples are Superstorm Sandy in 2012, massive tornadoes in Missouri and Alabama in 2011, and huge wildfires in Colorado in 2012 and 2013. Such events would normally have triggered higher insurance rates but rates generally remained flat. In 2017, three major hurricanes (Harvey, Irma, and Maria) occurred.
Property rates increased a bit in early 2018 but then leveled off.
Why has the insurance market remained soft despite all the costly disasters? The answer is that 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.