Understanding Cycles and Shocks in the Property and Casualty Insurance Industry: Lessons Learned from Experience
Shuford, Harry, Business Economics
The experience of the property and casualty (P & C) insurance industry provides insights into the nature of financial shocks and cycles. The evidence indicates that:
* Shocks do not contribute to the underwriting cycle because they are random and, hence, taken as not being truly representative of the future of "business as usual."
* Shocks do affect underwriting practices by initiating efforts to eliminate or mitigate a newly perceived risk from interfering with "business as usual."
* Shocks in the P & C industry have been more psychological than financial due to the protection of diversification.
* Cycles in premium income and underwriting can be attributed to underwriting decisions driven by the anticipated profitability of writing P & C insurance.
Changes in economic and financial activity largely reflect one of three phenomena: long-term trends, intermediate-term cycles, and short-term shocks. This paper examines the specific experience of the property and casualty (P & C) insurance industry. In this case, shocks are defined as major underwriting losses resulting from a single event, typically referred to as a "catastrophic loss." The "underwriting cycle" is measured by the deviation from trend of the industry's premium income, underwriting results, and total operating gains. The paper's intent is to describe how the industry responds to exogenous shocks, to try to identify the factors that drive the largely endogenous swings in the underwriting cycle, and to determine the extent to which shocks may trigger cyclical changes.
The Scope of the Analysis
The analysis begins by examining the impact of Hurricane Andrew on the market for homeowners insurance. Next, the analysis is expanded to examine the impact of a series of catastrophic events during the 1980s and 1990s on the entire P & C industry. In addition to Andrew, the Northridge earthquake and the September 11 terrorist attack on the World Trade Center stand out as shock-loss events.
This examination of the impact of shocks is followed by a discussion of the underwriting cycle and the key factors that appear to drive the long-term financial performance of the P & C industry as a whole. The paper concludes by reviewing the key observations on the nature of shocks and cycles in the P & C industry and speculating on what they suggest about gaining a better understanding of economic shocks and cycles in general.
Shock Losses in Property Insurance--How the Industry Responds
The first part of the analysis focuses on Hurricane Andrew and the market for homeowners insurance as a case study of an underwriting shock loss. Some observers may argue that natural catastrophes pale in comparison to the events of September 11. However, the actual and potential consequences of natural catastrophes and terrorist events are comparable. Thus, Hurricane Andrew is a reasonable case study.
Hurricane Andrew vs. Sept. 11 losses at the World Trade Center
In March 2002, the Property Claims Service of the Insurance Services Office (ISO) estimated that the insured property losses from the September 11 attack on the World Trade Center in New York totaled $20.3 billion. This estimate (Table 1) barely exceeded the inflation-adjusted estimate of $19.6 billion of insured property losses generated in 1992 by Hurricane Andrew. Moreover, if Andrew were to happen today ISO estimates that the property losses would exceed $23 billion because economic growth in the region means that more properties would be at risk.
ISO also indicated that the WTC property losses are associated with approximately 49,000 claims. In contrast, ISO reports that the property losses from Andrew were generated by more than 680,000 claims. (Insurance Information Institute, 2002). Moreover, the Insurance Information Institute stated that "the enormity of the World Trade Center has overshadowed what is still the greatest threat to insurers and their policyholders: natural disasters. …