Underwriting cycle

What Is Underwriting Cycle?

The underwriting cycle refers to the cyclical fluctuations in the insurance industry, particularly within property and casualty (P&C) lines, characterized by alternating periods of abundant capacity and low premiums (soft market) and periods of limited capacity and high premiums (hard market). This phenomenon is a core aspect of Insurance and Risk Management and influences the profitability of insurers and the availability and cost of coverage for policyholders. The underwriting cycle is primarily driven by the interplay of competition, capital accumulation, and claims experience, impacting how insurers assess and price risk.

History and Origin

The concept of the underwriting cycle has been a recognized phenomenon in the insurance industry since at least the 1920s, viewed as an inherent "fact of life" within the sector. It's not attributed to a single invention but rather describes the observed tendency of insurance markets to swing between periods of expansion and contraction. Historically, following periods of significant losses or adverse events, insurers would tighten their underwriting standards and increase rates to restore profitability, leading to a "hard market." Conversely, sustained periods of profitability would attract new capital and intensify competition, leading to a "soft market" with lower premiums and broader coverage. This cyclical behavior is a result of the industry's unique dynamics, where the price of a product (premium) is determined before the true cost (future claims) is known.

Key Takeaways

• The underwriting cycle describes the natural ebb and flow of the insurance market between hard (high premiums, limited capacity) and soft (low premiums, ample capacity) conditions.
• It is driven by factors such as competition, capital availability, claims experience, investment income, and the overall economic environment.
• The combined ratio is a key metric used to gauge an insurer's underwriting profitability and identify its position within the cycle.
• Understanding the underwriting cycle is crucial for insurers, policyholders, and investors to anticipate market changes and adjust strategies.
• While cycles are inherent, their predictability can be challenged by unforeseen events like major catastrophe risk or significant economic shifts.

Formula and Calculation

While the underwriting cycle itself isn't a single formula, its phases are often tracked and measured using key financial metrics, most notably the combined ratio. The combined ratio indicates an insurer's underwriting profitability by comparing incurred losses and expenses to earned premiums.

The formula for the combined ratio is:

Where:

• Incurred Losses: The total cost of claims paid and reserves set aside for future claims.
• Underwriting Expenses: Costs associated with acquiring and servicing policies, such as commissions, salaries, and administrative overhead.
• Earned Premiums: The portion of premiums for which the insurer has provided coverage over a specific period.

A combined ratio below 100% indicates an underwriting profit, meaning the insurer is making money from its core insurance operations. A ratio above 100% signifies an underwriting loss, implying that the insurer is paying out more in claims and expenses than it collects in premiums.

Interpreting the Underwriting Cycle

Interpreting the underwriting cycle involves recognizing its two primary phases: the hard market and the soft market. In a hard market, insurance coverage is less available and more expensive. This typically follows a period of significant losses, a reduction in insurer capital, or heightened concerns about future risks. During this phase, insurers implement stricter underwriting standards, and premiums rise as competition diminishes. Conversely, a soft market is characterized by lower premiums, broader coverage terms, and greater availability of insurance. This occurs when there is ample capital in the industry, strong competition among insurers, and favorable claims experience, leading companies to compete aggressively for market share. The transition between these phases is often gradual, influenced by market participants' collective behavior and their responses to prevailing conditions and future expectations.

Hypothetical Example

Consider "Horizon Insurance," a hypothetical P&C insurer operating within the broader market cycles of the industry. In a soft market phase, perhaps from 2018-2022, Horizon Insurance experiences intense competition. To gain market share, they offer lower premiums and more flexible policy terms, despite their combined ratio hovering near or slightly above 100%. This period of aggressive pricing strains their underwriting profitability.

Then, a series of major weather-related catastrophe risk events in 2023 lead to a surge in claims across the industry. Horizon Insurance, along with many competitors, incurs substantial losses, depleting their capital and forcing some smaller, less capitalized insurers out of business. This marks the transition to a hard market. In 2024, facing reduced capacity in the overall market, Horizon Insurance can now increase its premiums significantly and impose stricter underwriting standards. Their combined ratio improves to well below 100%, reflecting strong underwriting profits. This hypothetical example illustrates how the underwriting cycle directly impacts an insurer's operational strategy and financial performance.

Practical Applications

The underwriting cycle has significant practical applications for various stakeholders in the financial and insurance sectors. For insurance companies, understanding the cycle informs strategic decisions regarding pricing, underwriting appetite, and capital allocation. During a hard market, insurers can focus on maximizing underwriting profitability through rate increases and disciplined risk selection. In contrast, a soft market often necessitates a focus on expense management, market share retention, and optimizing investment income to offset slimmer underwriting margins.⁴

Policyholders and businesses also benefit from recognizing the cycle. During soft markets, they can negotiate more favorable terms and lower premiums, potentially securing broader coverage. Conversely, during hard markets, they must prepare for higher costs and potentially stricter requirements. This awareness allows for proactive risk management and budgeting for insurance expenses. For investors, the underwriting cycle can influence investment decisions in insurance stocks, as different phases present varying opportunities for capital gains and dividend income. The overall economic climate, including interest rate fluctuations, plays a significant role in influencing the intensity and duration of these cycles, impacting insurers' ability to generate investment returns.³ The National Association of Insurance Commissioners (NAIC) regularly publishes market share data, providing insights into the scale and concentration of the insurance market, which are key indicators of market dynamics within the cycle.²

Limitations and Criticisms

While widely recognized, the concept of the underwriting cycle faces limitations and criticisms, primarily regarding its predictability and the influence of external factors. Some research challenges the consistent existence and predictable length of these cycles, noting that they can be irregular.¹ Factors such as large-scale catastrophe risk events (e.g., major hurricanes, earthquakes), significant regulatory changes, or broader economic shifts can disrupt traditional cyclical patterns, making forecasting difficult. For instance, a series of unexpected, severe claims can abruptly shorten a soft market phase, or prolonged low interest rates can intensify competition during a soft market by reducing insurers' investment income.

Furthermore, the increasing sophistication of data analytics and risk management tools, as well as the growing role of alternative capital and reinsurance markets, can influence the cycle's amplitude and duration. Some argue that while the underlying competitive dynamics remain, these external pressures and internal industry advancements can make past cyclical patterns less reliable for predicting future market conditions. The variability of capacity infusion and withdrawal also plays a critical role, as new capital can enter the market quickly, dampening the hardening phase, while sustained underwriting losses are required to drive capital out and truly reset the cycle.

Underwriting Cycle vs. Insurance Cycle

The terms "underwriting cycle" and "insurance cycle" are often used interchangeably to describe the periodic fluctuations in the insurance industry. However, some distinctions can be made. The "underwriting cycle" specifically emphasizes the ebb and flow of insurers' core underwriting profitability—how much money they make from charging premiums versus paying claims and expenses. This term highlights the direct operational decisions around risk acceptance and pricing.

The broader "insurance cycle" encompasses the underwriting cycle but also includes the influence of investment income. Insurance companies generate significant income by investing the premiums they collect before paying out claims. Therefore, the overall "insurance cycle" considers both underwriting results and investment returns when assessing the industry's total profitability and capital fluctuations. While the underwriting cycle focuses on operational performance, the insurance cycle provides a more holistic view of the industry's financial health, incorporating the impact of broader financial market cycles.

FAQs

What causes the underwriting cycle?

The underwriting cycle is primarily driven by the interplay of supply and demand for insurance coverage, influenced by factors such as the availability of capital in the industry, competitive behavior among insurers, and the frequency and severity of claims. When profits are high, more capital enters the market, increasing competition and lowering premiums (soft market). Conversely, significant losses or reduced capital lead to higher premiums and stricter underwriting (hard market).

How long does an underwriting cycle typically last?

The duration of an underwriting cycle is not fixed and can vary significantly, often spanning several years. Historically, cycles have been observed to last anywhere from 3 to 10 years, or even longer. The length and intensity of each phase are influenced by numerous factors, including major catastrophic events, economic conditions, and the response of global reinsurance markets.

What is a "hard market" in the context of the underwriting cycle?

A hard market is a phase within the underwriting cycle characterized by rising premiums, reduced capacity, and stricter underwriting standards. This typically occurs after a period of significant losses, a decline in industry capital, or increased perceptions of catastrophe risk. During a hard market, insurance coverage may be more difficult to obtain, and policyholders face higher costs.