Low Prices and Legislation Lead to Insurance Industry Decline

By Beer, Albert J. | American Banker, March 7, 1986 | Go to article overview

Low Prices and Legislation Lead to Insurance Industry Decline


Beer, Albert J., American Banker


Low Prices and Legislation Lead to Insurance Industry Decline

OVER THE PAST 30 YEARS, the United States property/casualty insurance industry has exhibited a fairly regular cyclical behavior. A true understanding of the affordability and availability problems to be discussed during these proceedings requires a basic knowledge of the nature of this cyclicality and the unique factors contributing to the severity with which insurers have reacted.

An insurance company derives its income from two primary sources, namely the premium contributed directly by its policyholders and the investment return generated from accumulated assets.

In this context, underwriting gain/loss is defined as the difference between premiums earned during any specific calendar year and the losses and expenses incurred durign that year. Losses consist of claims payable to, or on behalf of, the policyholders. Expenses include claim adjustment, acquisition, and other overhead costs, as well as policyholder dividends.

By the very nature of the insurance contract, there is a lag between the time when the premium is collected and the time when claims related to the underlying' coverage are ultimately paid. In some lines of insurance where litigation is common, such as medical professional liability, payment may not occur for as many as 10 to 20 years after the plicy has expired. Funds set aside for the ultimate settlement of these incurred claims are referred to as loss and loss expense reserves and appear as liabilities on the insurers' financial statements.

In addition, not all premiums received by an insurance company during a particular calendar year are deemed to have been earned during that period. Therefore, a reserve for unearned premium is also established as a liability at each yearend.

These reserves, along with available capital and surplus funds, may generate a significant amount of investment income for the insurer.

Pretax Operating Income

One common method of presenting insurance results is in the form of statutory pretax operating income. For any given year, this value is derived by combining the underwriting gain or loss with investment income derived from all assets prior to consideration of capital gains and federal income tax adjustments.

The table details pretax operating income figures for the property/casualty industry from 1967. A review of pretax operating results reveals two obvious characteristics: the cyclical nature of the industry's performance and the severity of the decline during the most recent two years. An analysis of the role that each component has played in the overall result will help in understanding the insurers' perception of his problem and the approach they have taken to resolve it.

Historically, the insurance industry has generally performed in a manner consistent with traditional economic theory. During periods when profitability is perceived to be relatively high (e.g., 1972 and 1978), new capacity is drawn into the marketplace, resulting in a highly competitive pricing environment and, eventually, deteriorating underwriting results.

This decline continues as underwriting losses approach and, at times, grow beyond the level of investment income. Eventually, the operating result reaches a level low enough to cause an overall tightening in the marketplace. This market constriction might consist of reduced writings by a number of participants that refuse to compete for business at unprofitable prices, or an actual withdrawal from the market entirely.

This lessening of competitive pressure encourages a strengthening of prices in an attempt to achieve more satisfactory underwriting results. As premiums begin to rise, operating results improve and the cycle repeats itself.

While this pattern has manifested itself repeatedly in the past, a series of unusual factors, both external as well as internal to the insurance industry, have contributed to create the most severe decline and, in turn, the most violent market constriction in the history of the insurance industry.

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Low Prices and Legislation Lead to Insurance Industry Decline
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