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21 Cards in this Set
- Front
- Back
Overview of underwriting cycle
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A cyclical pattern of insurance pricing. Consists of periods of increasing premiums and profits followed by periods of decreasing premiums and profits. Insurance cycles actually have very similar characteristics to general business cycles. However insurance cycle and business cycle do not move together. At any one time, the state of the insurance industry is based upon the cumulative result of actions taken over prior cycles. |
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Reasons for underwriting cycle
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Reasons why cycles occur: Structural change (cumulative change that occurs in cycles over a period of years or a long period of time. Change in society and business. Change in industry). Demand for products (insurance demand is fairly stable compared to other products). Supply of products (insurance supply can change rapidly). |
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Profit cycle |
More appropriate description of the underwriting cycle. The cycle is driven by expectations of profit. Cycle is measured by the operating ratio which measures underwriting and investment income. Includes a hard market and soft market. At any one time the state of the insurance industry is based upon the cumulative result of actions taken over prior cycles. |
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Hard market |
When the profit cycle reaches a trough the market begins softening. Is a sellers market. |
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Insurer strategies during a hard market include |
Increase premiums, review and evaluate current reserves, restrict coverage, restrict producers representing the insurer, increase staff, reunderwriting (imposing deductibles, non-renewals and surcharges to existing policies).
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Soft market
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When cycle reaches a peak, new hard market begins. |
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Insurer strategies during soft market |
Lower premiums, loosen underwriting standards, expand coverage, offer specialized products or rate credits, reduce staff, maintain existing premium levels and sustain a loss in market share.
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Influences on underwriting cycle |
Profitability influences underwriting cycle. Financial factors include: investment income, insurer capacity, return on equity and cash flow. |
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Investment income |
If insurer investment income declines, insurer profitability declines. Profitability declines will need to be offset with improved underwriting results. At some point declining profits will bottom out, at which point the cycle will turn from a soft market to a hard market. Insurers that loosen underwriting standards in a soft market could be highly susceptible to reductions in investment income. Insurance industry experienced underwriting losses from 1978-2004. |
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Capacity
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Excess capacity is considered one of the factors that helps contribute to an extended soft market. |
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Return on equity
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Insurers will use available capacity if expected return exceeds their return on equity target. Return is generated through underwriting and investment operations. If return on equity is too low, insurers often increase premiums or restrict coverage. If many insurers increase premiums, a hard market will begin. Insurer will most likely take on expansion if the return-on-equity threshold is exceeded. |
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Cash flow |
Insurers cannot survive with negative cash flow. Typically leads to insolvency. May be caused by inadequate reserves. Usually results in increased prices, expense reduction and more strict underwriting. When majority of insurers experience a negative cash flow it may lead to a hard market. Cash flow underwriting relies on investment income to offset underwriting losses. Often used to achieve competitive premiums in a soft market. |
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Supply and demand theory
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Supply and demand principles applicable to other products also apply to insurance. Demand is inversely related to price, (the higher the price, the lower the demand). Supply is directly related to price, (the higher the price, the more supply offered). Supply and demand are equal at the market equilibrium price. |
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Supply and demand theory pt.2 |
If there are no constraints of prices, market equilibrium will be attained in a free market. If prices are higher than equilibrium, supply will be too great, causing price reduction. If prices are lower than equilibrium, demand will be too great, causing price increase. |
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Insurance supply |
With property/casualty insurance, losses are not known when the premium is established. Supply can change dramatically over a short period of time. |
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Insurance supply pt.2
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Reinsurance (purchase increases insurer capacity and can provide surplus relief, usually results in increased supply, however, insurance supply may decrease if reinsurance supply decreases or reinsurance prices increase). Ease of entry (entry of new competitors increases the supply of insurance). |
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Insurance supply pt.3
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Difficulty of exit (the difficulty of an insurer exiting the market keeps capital committed to the market, which tends to increase supply). Regulatory environment (regulatory constraints may reduce supply of insurance, minimum financial requirements may cause insurer to choose not to sell particular line, rate increase regulations may cause insurer to choose not to sell particular line). |
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Insurance supply pt.4 |
Dedicated capital (insurers must support written policies with dedicated capital, capital can't be moved to other areas, contributes to increase supply). Underreserving (artificially inflates surplus, increases capital and supply). Profit expectations (High profit expectations usually result in decreased supply b/c insurers tend to tighten underwriting standards and increase premiums.). |
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Insurance demand |
Represents the ability and desire to purchase a product. Elastic demand is willingness to purchase a product declines if price increases. Inelastic demand is willingness to purchase a product remains constant if price increases. If demand for a product is elastic, the demand (and revenue) will increase after a drop in price. E.x. if demand decreases and supply remains the same, equilibrium price will fall. This is reflected in a leftward shift of the demand curve. Insurance demand has both elastic and inelastic characteristics. |
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Insurance demand pt.2 |
Inelasticity of insurance demand: may be requires to purchase insurance. Insurance must be renewed regularly. |
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Underwriting cycle |
Changes in supply cause the rise and fall of profitability. Insurance cycles typically do not match general business cycles. Most non-insurance business cycles are controlled by demand. |