1. Insurance cycles Robert W Vivian Professor of Finance & Insurance School of Economic and Business Sciences University of the Witwatersrand

2. What cycles? Underwriting profits? Insurance premiums? Rate of increase and decrease Aggregate lines or specific lines Premium growth Combined ratio Operating income (Profits before tax) Etc? Was clear but no longer clear Let us settle for underwriting profits

3. American Insurance Cycle Risk Management January 2006

4. South African Insurance Cycle Gerrit Sandrock Critical Factors for the Financial Success of South African Short-term Insurers (DCom Thesis Unisa 1996)

5. Theories explaining the causes of insurance cycles Enormous body of literature – at least 50 articles have been written and recently two PhD theses awarded Forms part of most US university curricula

6. Causes Interest started in 1979, within the industry with a firm of brokers sponsoring research into the issue. Conference was held to discuss the findings and the rest as they say history Liability crisis of the 1980s. –Liability crisis of the 1980s –Forgotten Commission of Inquiry – Willard

7. Causes – insurers system of ratemaking Venezian, Emelio (1985) ‘Ratemaking Methods and Profit Cycles in Property and Liability Insurance’ Journal of Risk & Insurance 52, 477- Muliti-line study Reflected the industry view, competition forces rates to unprofitable levels, crisis, then sudden turn back to profitability, and so on. More conferences, more papers

8. Reactions to the ratemaking theory Economists do not like one-sided stories. Economists believe in the equilibrium between supply and demand. Ratemaking deals with the supply side only. Cummings and Outreville (1989) ‘An International Analysis of underwriting cycles in property and causality insurance’, Journal of Risk and Insurance –Mulit country study –Placed the blame on regulatory environment –US has a strange system for historical reasons –Insurers must file to change policy rates and policy conditions Econometric models

9. Capital markets to blame? Financial economists have for a long time trying to apply Capital Market theory to insurance problems (Financial Risk Management) More about equilibrium theory –Doherty (1988) ‘Interest rates and Profit margins in the PC insurance industry – an equilibrium approach’ (Journal of Banking and Finance 1995 Journal of Business Academics assume insurers do not know how to price insurance products. If only academics could teach insurers how to do this, their problems will be solved

10. Profits and insurance Profit = Underwriting profit + Investment profits Attainable profits in mature markets = market returns (Adam Smith next slide) If excessive profits are generated, additional competition will be attracted to the market Bermuda capital after September 11 Economists (Frank Knight) Risk Uncertainty and Profit 1922 predicted a long time ago that profits will tend to zero in mature markets. Several of his pupils are the current Nobel Laureates General Motors, Coca-Cola, Mercedes, HP etc

11. Adam Smith on insurance Wealth of Nations In order to make insurance, either from fire or sea-risk, a trade at all, the common premium must be sufficient to pay the expense of management, and afford such a profit as might have been drawn from an equal capital employed in any common trade. The person who pays no more than this, evidently pays no more than the real value of the risk, or the lowest price at which he can reasonably expect to insure it.

12. Low profits are to be expected As long as insurers make a net profit they will survive Underwriting profit = Net Profit – Investment income Underwriting profit can equal zero Net profit = Investment income Investment income = r (Cs + Pr) Value added to shareholders = r * Pr

13. Does regulatory capital adequacy requirements cause insurer ‘insolvency’? Underwriting profits at the lower side of the cycle, when the problems occur, are negative Market rate are then set by Cs. Where this is excessive less capitalised companies fall short of the statutory requirements are shut down – crisis in the market place and rates increase – sacrificial lamb?