Capacity constraints and the dynamics of underwriting profits

PAUL D. THISTLE [*] The presence of an underwriting profit cycle in property / liability insurance has become a stylized fact. Models of this "underwriting cycle" imply that the insurance market is governed by two regimes, as capacity is constrained or not. We apply the smooth transition regression model to insurance industry data for 1934-1993 to test for a regime shift. We find a rapid shift between two distinct regimes with different dynamics. When capacity is not restricted, we find no evidence of a cycle. The cycle is present in periods when capacity is restricted, immediately following World War II and after 1968. The underwriting cycle appears to be a recent phenomenon. (JEL G22, C32) I. INTRODUCTION It is well known that the property-liability insurance industry is subject to cycles in premiums and underwriting profits. The main features of the "underwriting cycle" are also well known. In a soft market, coverage is readily available while premium revenue and underwriting profits are low. In a hard market, coverage becomes difficult to obtain while premium revenue and profits increase. The onset of a hard market is typically quite rapid, and is followed by the erosion of premium revenue and profits as market conditions return to a soft market. [1] It is also generally accepted that the cycle has a period of approximately six years, although there is some variation across lines and among countries. This approximate period for the underwriting cycle is based on time series estimates of second-order autoregressive models (e.g., Venezian [1985] and Cummins and Outreville [1987]). Understanding the causes of the property-liability underwriting cycle is important for public policy and insurance regulation. Sof t markets may contribute to insurer insolvencies if firms price and underwrite too aggressively, while high prices and restrictive underwriting in hard markets may disrupt the flow of goods and services. A number of alternative theories have been proposed to account for the cycles in premiums and profits in the property-liability insurance market. Initially, attention focused on aspects of the process for determining insurance rates (e.g., Harrington and Danzon [1991, 1994]; Simmons and Cross [1988]; Stewart [1981]; Venezian [1985]; and Wilson [1981]). More recent research has developed equilibrium models of the underwriting cycle. Financial pricing models, based on discounted cash flows, imply that insurance prices are equal to policy expenses plus the expected present value of future claims under the policies issued. [2] Financial pricing models implicitly or explicitly assume perfect capital markets. In the absence of capital market imperfections, there should be no cycles, and prices and profits should vary inversely with interest rates. Cummins and Outreville [1987] and Doherty and Kang [1988] argue that if insurers have rational expectations, then, as a result of insurance accounting practices and inst itutional features of insurance markets, underwriting profits follow an autoregressive data-generating process which gives the appearance of a cycle. The capacity constraint hypothesis, developed by Cummins and Danzon [1991], Gron [1994a, b] and Winter [1988; 1991a, b; 1994] is based on the fact that an insurer must have sufficient policyholders' surplus (capacity) to support the policies it writes. [3] Capital market imperfections lead firms to rely on internal capital as the source of underwriting capacity. This in turn implies that hard markets must be temporary and that soft markets will persist. The capacity constraint hypothesis implies that premiums and profits will depend on interest rates and are negatively correlated with surplus or capacity in the short run. In the long run, capital enters the industry until the constraint is not binding, so profits and surplus are not correlated in the long run. Cagle and Harrington [1995] and Cummins and Danzon [1997] add the assumption that policyholders are willing to pay more for policies with higher financial quality (lower insurer default risk) and that insurer default risk is endogenous. …