An inquiry into the existence of underwriting cycles in the South African reinsurance market 1964-2005.

An inquiry into the existence of underwriting cycles
in the South African reinsurance market 1964-2005.

Tebogo Leshilo

A research report submitted to the Faculty of Commerce, Law and Management
of the University of the Witwatersrand, Johannesburg in partial fulfilment of the
degree Bachelor of Commerce (Honours)
December 2007

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Declaration
I hereby declare that this is my own unaided work, the substance of or any part
of which has not been submitted in the past or will be submitted in the future for
a degree in to any university and that the information contained herein has not
been obtained during my employment or working under the aegis of, any other
person or organization other than this university.

---------------------------------------------------

------------------------------

(Name of candidate)

Signed

Signed this ------------- day of --------------------------------- 2007 at Johannesburg.

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Acknowledgements

I would like to thank the people instrumental to this report:

1. My mother and family for their understanding and support. Without them, I
would not have made it this far.
2. Mr Frank Liebenberg, my supervisor who has been a beacon of light
throughout this process. Thank you for the time and effort you have devoted
to this research report and most importantly for letting me realise that I
always had it within me to succeed.
3. Prof R.W. Vivian for his continued help and support.

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Contents

Abstract
1

Introduction

Page 1

2

Types of Insurance

Page 3

3

2.1

Direct

2.2

Reinsurance

2.3

Retrocessions

Underwriting Cycles

Page 8

3.1

Definition

3.2

International underwriting cycles

3.3

Factors that can influence underwriting cycles

3.4

Reinsurance underwriting cycles

4

Empirical analysis on South African Data

Page 49

5

Conclusion

Page 60

6

Future Research

Page 60

Reference list

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List of Figures

Figure 1 ‘The stabilising effect of reinsurance on French non-life insurers’
underwriting results’
Figure 2 ‘Stages of the short-term insurance pricing cycle’
Figure 3 ’United States Combined Ratio: 1957-2001’
Figure 3 ‘United States Combined Ratio: 1957-2001’
Figure 4 ‘Underwriting result of U.S. Property-Liability Insurers 1915-2000’
Figure 5 ‘South African Underwriting Cycle for the period 1974 to 2005’
Figure 6 ‘UK Underwriting Results (1983-2001)’
Figure 7 ‘Underwriting Margins of Hong Kong direct insurers (1992-2004)’
Figure 8 ‘Gross Combined Ratios in China, 1999 to 2005’
Figure 9 ‘Combined Operating Ratio for Australia (1977 to 2004)’
Figure 10 ‘U.S Direct Insurers’ Underwriting Profit or Loss 1991-2003’
Figure 11 ‘The Comparison of Loss Ratios from Four Countries’
Figure 12 ‘U.S. reinsurance cycle and its influencing factors’
Figure 13 ‘Underwriting Result - U.S. Reinsurers from 1980 to 2003’
Figure 14 ‘Unsmoothed South African Reinsurers’ Loss Ratio’
Figure 15 ‘3 Year Smoothed South African Reinsurers’ Loss Ratio’
Figure 16 ‘5 Year Smoothed South African Reinsurers’ Loss Ratio’
Figure 17 ‘South African Reinsurers’ Underwriting Profit as a Percentage of
Net Written Profits’

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Figure 18 ‘Comparison of Gross and Net of Retrocession Underwriting Profits
for S.A. Reinsurers’
Figure 19 ‘Comparison of South African Direct Insurers’ and Reinsurers’
Underwriting Profits as a Percentage of Net Written Premiums’
Figure 20 ‘Comparison of U.S. Underwriting Losses and S.A. Profit Ratio
(1980-2005)’

Figure 21 ‘Comparison of U.S. Underwriting Losses and S.A. Loss Ratio (19802005)’

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Abstract
This research report attempts to establish if underwriting cycles exist in the
South-African reinsurance market and discusses the factors most frequently cited
as the cause of underwriting cycles.

JEL Classification:
Keywords: insurance cycles, reinsurance cycles, underwriting cycles, South
African short-term reinsurance market.

1 Introduction
Several major studies about insurance cycles have been conducted over the past
twenty years by Venezian (1985), Cummins and Outreville (1987), Doherty and
Kang (1988), Fields and Venezian (1989), Danzon and Harrington (1991), Winter
(1991) and Gron (1994). Studies demonstrating the existence of underwriting
cycles in the South African short-term insurance market have been conducted by
Ambaram (2002) and Markham (2006). Berger et al. (1992) and Cummins and
Weiss (2002) studied the impact of reinsurance on insurance prices and profits,
while Meier and Outreville (2006) determined the role of reinsurance on the
cyclical behaviour of underwriting cycles. In South Africa, Joe (2006) studied the
impact of global reinsurance cycles on the South African short-term insurance
market. The purpose of this paper is to demonstrate the existence of reinsurance
underwriting cycles in the South African short-term insurance market and to

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give a review of the factors most frequently cited as the causes of underwriting
cycles in short-term insurance markets.

The causes of underwriting cycles are based on several different theories: (1) the
extrapolation

hypothesis

by

Venezian

(1985);

(2)

the

rational-

expectations/institutional-intervention hypothesis by Cummins and Outreville
(1987); (3) the fluctuations-in-interest-rates hypothesis suggested by Doherty and
Kang (1988) and Doherty and Garven (1992); the capacity-constraint hypothesis
by Winter (1988,1989), Cummins and Danzon (1991) and Gron (1994); and the
changes-in-expectations hypothesis by Lai and Witt (1990,1992). Additional
factors related to disequilibrium between supply and demand, external shocks
and general business influences are also cited as causes of the underwriting
cycle.

Despite the significant amount of research conducted about insurance cycles, no
single factor in isolation has yet been attributed as the cause of underwriting
cycles.

Underwriting cycles in direct insurance markets have been demonstrated in
several international markets other than the United States, such as Europe, Asia,
Australia and Africa. In spite of this, the available literature draws heavily upon
research conducted in the United States. The lack of research about reinsurance
underwriting cycles, limits the scope of this report and the causes or otherwise of
possible South African reinsurance cycles are not examined.

This report begins with an overview of the forms of insurance offered within the
industry, in order to gain an understanding of the market. It is then followed by
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an analysis of underwriting cycles and the factors believed to cause them. The
next section studies reinsurance underwriting cycles, followed by an analysis of
data from the South African short-term reinsurance market in order to establish
if reinsurance cycles exist. This report is then concluded and recommendations
made for future research.

2 Types of Insurance
The established principle for the informed use of insurance is to retain
predictable frequent losses up to the point where one has the financial means to
do so, and insure those losses that are unpredictable, infrequent and severe. In
the same manner that purchasers of insurance select deductibles and a selfinsured individual purchases excess insurance above a self-insured retention
level, most direct insurers transfer a portion of the risk they assume from
policyholders to reinsurers. In turn, reinsurers may transfer some of that risk
onto other reinsurers, namely retrocessionaires (Emery, 2002).

The following section provides insight into the activities and functions of the risk
carriers in the insurance industry.

2.1 Direct Insurance

Stettler, Eugster and Kuhn (2005:13) define insurance as “an operation by which
one party, the insured, obtains from another party, the insurer, the promise to
indemnify the insured or a third person in case of a loss. The payment for this

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service is called premium. The insured accepts a totality of risks and
compensates the insured or a third person according to statistical laws”.

An insurance policy cannot protect an individual or corporate entity against fire,
a traffic accident, potential legal liability or the loss of a motor vehicle; rather the
subject of insurance is a person, benefit or property exposed to loss or damage or
some potential legal liability the insured may incur. Direct insurers offer their
services through independent agents or brokers, insurance consultants or banks.
The insurer is a commercial entity who will take some part of the insured’s risk
and bear the financial loss sustained by such events, subject to the terms and
conditions of the insurance policy. This provides the insured with greater
security for which they agree to pay the insurer a premium (Stettler et al., 2005).

Risk management, a managerial function involving measuring risk and
developing strategies to control the risk, is aimed at protecting the insurer
against the financial consequences of event risk. Reinsurance is a risk
management tool employed by insurers to transfer some or all of an insurance

risk to another insurer, namely the reinsurer. There are several motivations for
primary insurers to reinsure: professional reinsurers have specific skills in risk
management; the direct insurer has undiversified risks; the direct insurer may
realise some tax advantages by ceding premiums, and reinsurance can increase a
primary insurer’s surplus thus enabling them to write new policies (Chen,
Hamwi and Hudson, 2001; Stettler et al.,2005).

2.2 Reinsurance

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Reinsurance is a mechanism used by the direct insurers to spread the risks and
hazards assumed from policyholders; it serves as insurance for direct insurers.
Since reinsurance covers part of the risks assumed by direct insurers, the direct
insurers’ exposure to liquidity problems or the threat of financial ruin after a
catastrophe is reduced. Reinsurance absorbs the direct insurance industry’s
losses and distributes them among a group of companies so that no single
insurer is overburdened by the financial responsibility of offering coverage to its
policyholders. Reinsurance moderates the effect of primary insurer losses in
unprofitable years; however, reinsurers expect to receive adequate compensation
in years with favourable results. The portion of risk that primary insurers
transfer to reinsurers is that which exceeds their underwriting capacity and
which would negatively affect the balance of their retained portfolios (Enz, 2002;
Baur and Breutal-O’Donoghue, 2004; McIsaac and Babel, 1995).

A reinsurance treaty is an insurance contract by the reinsurer to the direct
insurer, usually referred to as the ceding company, cedent or reinsured. Based on
the terms of the reinsurance treaty, the reinsurer agrees to indemnify the cedent
against all or part of a loss that may be incurred under a policy initially issued by

the cedent. The reinsurer is only liable to the direct insurer, as no legal
contractual relationship exists between the reinsurer and the policyholder. The
ceding company is fully liable for claim payments to its policyholders even if its
reinsurance contracts cannot be enforced. Although reinsurance protects the
cedent against frequent or severe losses, it does not change the original policies
or any obligations created by those policies (Stettler et al., 2005; McIsaac and
Babel, 1995; Chen et al., 2001).

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A primary insurer is willing to forego some of its expected profits to a reinsurer
in exchange for several benefits. Reinsurance enables the primary insurer to
expand its underwriting capacity and flexibility in underwriting risks that would
normally be too large or for types of business that would normally not be
written; i.e. it increases the insurer’s capital. Adequate reinsurance stabilises
earnings and limit fluctuations in underwriting results by significantly reducing
the probability of a capital depleting loss event. Access to reinsurer’s advice in
the areas of product development, pricing, underwriting and claims
management gives a direct insurer a competitive edge in the market. Primary
insurers use reinsurance as a financial risk management tool to diversify risks,
optimise capital allocation, reduce capital cost, maintain solvency, manage
investment risks, realise tax advantages and circumvent international insurance
trade barriers (Baur and Breutel-O’Donoghue, 2004; Stettler et al, 2005; McIsaac
and Babel, 1995, Meier and Outreville, 2006; Chen et al, 2001; Thomas, 1992).

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Figure 1: The stabilising effect of reinsurance on French non-life insurers’ underwriting

results
Source: Baur and Breutel-O’Donoghue, 2004

One of the fundamental reasons that insurers purchase reinsurance is to protect
their capital base against large deviations from expected losses, especially in the
event of major catastrophes. The smoothing effect of reinsurance for an
individual insurer can amount to at least 50% of its premiums. Figure 1
demonstrates the stabilising effect of reinsurance on the net underwriting results
(after reinsurance) of French property and casualty insurers from 1990 to 2003.
The effect of reinsurance was most pronounced in 1999, the year of the Winter
Storm Lothar; reinsurance cover protected the French insurance industry from
severe distress and possible insolvencies. It can be seen from figure 1 that during
the Winter Storm Lothar in 1999, the underwriting result before reinsurance was
8 percent but it decreased to 4.25 percent after the introduction of reinsurance
(Baur and Breutel-O’Donoghue, 2004).
Should a reinsurer not want to keep the full share of ceded risk or have
inadequate capacity to retain the risks, it is possible to reduce underwriting and
investment risks by transferring the risks outside of the company using
retrocession (Fitt, 1982; Baur and Breutel-O’Donoghue, 2004).

2.3 Retrocessions

The insurance ceded to a reinsurer is called the cession. Should the reinsurer
accept more of that risk than it desires, the reinsurer may reinsure a portion of
that risk with yet another reinsurer (McIsaac and Babel, 1995). Retrocession is the
transfer of ceded premiums by reinsurers to other reinsurers or insurers.

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A retrocessionaire is defined as any insurer or reinsurer accepting retroceded
risks, while a retrocedent is a reinsurer purchasing reinsurance for his portfolio.
Unlike primary insurers and reinsurers, retrocession companies as such do not
exist; retrocession business is written either by direct insurers or reinsurers
(Stettler et al., 2005). Therefore, the retrocession of risks occurs in a chain-like
fashion, diversifying exposure to risks throughout the international reinsurance
industry (McIsaac and Babel, 1995). Retrocession ensures that risks are spread
among a large enough group of insurers and reinsurers that a single catastrophe
can be absorbed better without causing insolvencies among those carrying the
risks (McIsaac and Babel, 1995).

3 Underwriting Cycles

3.1 Definition

Short-term insurance markets alternate between rising and falling prices and
supply of coverage in a persistent and pervasive process that is referred to as the
underwriting cycle (Klein, 2003).

An underwriting cycle has been defined by Harvey Rubin in the Barron’s
Dictionary of Insurance Terms (1995) as:

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“The tendency of short-term insurance premiums, insurers’ profits and the
availability and quality of coverage to rise and fall with some regularity
over time. A cycle can be said to begin when insurers tighten their
underwriting standards and sharply raise premiums after a period of
severe underwriting losses. Stricter standards and higher premium rates

often bring dramatic increases in profits, attracting more capital to the
industry and raising underwriting capacity. On the other hand, as insurers
strive to write more premiums at higher levels of profitability (following a
hard market), premium rates may be driven down and underwriting
standards relaxed in the competition for new business. Profits may erode
and then turn into losses if more lax underwriting standards generate
mounting claims. The stage would then be set for the cycle to begin again”
(Fitzpatrick, 2004:256).

Cyclicality is not unique to insurance; upturns and downturns in prices and
profits, as well as variations in product supply and quality are present in many
industries. Fluctuations in the overall business activity are referred to by
economists as the ‘business cycle’ (Markham, 2006). Stewart (1984) states that
cycles in the property-casualty industry do not coincide with the general
business cycle, nor are they reliably contra-cyclical. According to Webb (1992),
not only does the underwriting cycle not synchronise with the general business
cycle, it is much more regular (Chen et al., 1999). Insurance cycles actually reflect
more volatility than other business cycles, in that they display higher ‘highs’ and
lower ‘lows’. It is this volatility that is responsible for the regular crises in
insurance markets (Fitzpatrick, 2004).

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Figure 2: Stages of the short-term insurance pricing cycle
Source: Parsons (2003)
The insurance underwriting cycle is divided into four phases based on
movements in price, quantity and reported profits (Gron, 1994). The first stage,
known as the ‘soft market’, is illustrated by several years of low profitability
until it reaches a trough. Prices and profits are relatively low, quantity is

abundant and underwriting standards are loosened. Thereafter, there is an
abrupt transition to rapidly increasing profitability. This second stage, called the
‘hard market’, is characterised by substantial price increases and restricted
supply. The rise in insurance premiums and the reduction in availability can be
so abrupt and severe that hard markets are often referred to as ‘liability crises’;
which are crises in availability, adequacy and affordability. The third stage sets
in, where although profitability stays high, it is no longer increasing. This stage is
characterised by relatively low availability, high premiums and high
profitability. In the final stage, profitability gradually declines as the industry

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returns to a period of low profitability. The decline in profitability during the
fourth stage is accompanied by falling prices and eased availability restrictions
(Gron, 1994 a, b; van Fossen, 2002). The phases of the insurance pricing cycle are
summarised in figure 2.

It is widely believed that the American underwriting cycle spans a period of
about six to eight years from peak to peak (Venezian, 1985; Cummins and
Outreville, 1987; Doherty and Garven, 1995; Chen et al., 1999). There is no
regularity to the underwriting cycle; the current cycle will not end simply
because its 2001 starting point plus six equals 2007 (Stewart, 1980). The length of
the cycle may be shortened somewhat by ease of entry and exit in the insurance
market; while reserve management may extend the cycle by causing profits to be
reported when the business is no longer profitable (Boor, 1998).

Underwriting results are most commonly expressed in a measure called the
combined ratio or in a measure known as the loss ratio. The percentage loss ratio
is calculated as claims incurred divided by net written premiums. The

percentage combined ratio, which measures the growth rate in premiums and
the ratio of losses and expenses to premiums, is calculated as claims incurred
plus expenses and commission divided by net written premiums. Therefore, the
combined ratio is an extension of the loss ratio that signifies underwriting profit
or loss. A ratio above 100 for an operating period signals an underwriting loss,
while a ratio below 100 signifies an underwriting profit. The combined ratio
decreases if premium growth exceeds the growth in losses and expenses (Long,
1986; Berger et al., 1992).

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Simmons and Cross (1986) assert that risk managers ought to observe the
underwriting cycle when developing risk management programmes. In the
rising phase (combined ratio increasing) of the cycle, increasing profitability
means underwriters can relax underwriting standards and reduce effective rates.
The risk manager may depend more heavily on insurance, a risk financing tool.
In the downward phase (combined ratio decreasing) of the cycle, underwriters
tighten underwriting standards and raise effective rates, whilst relying on risk
retention and utilising captives. The use of these non-insurance tools may impact
the cycle. The use of captives during the rising phase of the cycle can increase the
steepness (increase combined ratio) of the cycle by reducing the demand for
insurance. The industry’s increased capacity together with the reduced demand
leads to even more lenient underwriting standards and greater reductions in
rates; resulting in even higher combined ratios. As the combined ratio reaches
the peak of the cycle, the industry’s low profitability leads insurers to tighten
underwriting standards and raise rates. This causes the combined ratio to decline
until it reaches the trough again and the cycle begins again (Simmons and Cross,
1986).

3.2 International underwriting cycles

Although the characteristics of the cycle such as its length and amplitude vary
between lines of insurance, geographical markets and over time, cycles are a
universal feature of insurance markets (Schnieper, 2002). Cycles are not limited
to the United States; they are also observed in many countries (Cummins and
Outreville, 1987; Lamm-Tennant and Weiss, 1997; Chen et al., 1999). The growth
of international reinsurance services and the deregulation of global financial
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markets suggest that insurance cycles will be present in parts of the world other
than the United States and developed countries (Cummins and Outreville, 1987;
van Fossen, 2002). Underwriting cycles exist in South Africa (Markham, 2006),
Morocco, Tunisia, Kenya, Egypt, Nigeria (Ambaram, 2002), Asia (Chen et al.,
1999), Switzerland, Japan, Germany (Leng and Meier, 2002), and Australia
(Australian Competition and Consumer Commission, 2003; Chidgey et al., 2005).

Figure 3: United States Combined Ratio: 1957-2001
Source: Klein (2003)

Figure 3 presents the United States underwriting cycle depicted by the combined
ratio from 1957 to 2001. Six distinct cycles can be observed when measuring from
peak to peak: 1957-1964; 1964-1969; 1969-1975; 1975-1984; 1984-1992; and 19922001. One can observe that the individual cycles range between 5 to 9 years,
however on average, the length of the cycles is equal to 7 years. The United
States short-term insurance industry reported its first underwriting profit in
2004, twenty five years after the last reported profit in 1978 (Pressman, 2005).

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Figure 4: Underwriting result of U.S. Property-Liability Insurers 1915-2000
Source: Ambaram (2002)

It can be seen in figure 4 that cyclicality in United States underwriting results
dates back to the early 20th century when data first became available (Long, 1986).
According to Ralph (1991), the insurance cycle appears to be increasing in
amplitude; it can be seen in figure 4 that the cycle has become more pronounced
over the time (Ambaram, 2002).

Figure 5: South African Underwriting Cycle for the period 1974 to 2005
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Source: Markham (2006)

Figure 5 depicts the South African underwriting cycle expressed as a percentage
of earned premiums for the period 1974 to 2005. Six distinct cycles can be
observed from figure x: 1978-1982; 1982-1987; 1987-1991; 1991-1995; 1995-2002.
The South African cycles appear to be of a shorter length than the U.S. cycles,
with an average length of 4 years. Ambaram (2002) provides evidence that
although the South African cycle generally followed the same trend; it lagged
behind that of the international cycle.

Figure 6: UK Underwriting Results (1983-2001)
Source: Sears (2004)

Figure 6 depicts the underwriting results in the United Kingdom insurance
market. Underwriting cycles of differing lengths and frequencies are depicted for
the property, accident and health, and motor lines for the period 1983 to 2001.

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Figure 7: Underwriting Margins of Hong Kong direct insurers (1992-2004).
Source: Chye (2005)

Figure 7 provides evidence of the underwriting cycle in Hong Kong which has
been through one complete cycle of underwriting profit-loss-profit in the past
decade. The Hong Kong cycle has been found to be correlated with the economic
cycle; economic downturns are characterised by slower premium growth, lower
premium rates and increased competition among insurers in the insurance
market (Chye, 2005).

Figure 8: Gross Combined Ratios in China, 1999 to 2005

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Source: Tucci and Baker (2007)

Figure 8 depicts the gross combined ratios 1 for China from 1999 to 2005; it
appears that the overall underwriting performance of the Chinese insurance
industry has been quite profitable in recent years. However, Tucci and Baker
(2007) state that the combined ratios shown suffer from deficiencies; if corrected,
the estimated true combined ratios would be higher than shown. This would
translate to underwriting losses instead of profits for 2003 and 2004.

Figure 9: Combined Operating Ratio for Australia (1977 to 2004)
Source: Chidgey et al. (2005)

Figure 9 depicts the Australian underwriting cycle expressed as the combined
operating ratio. The industry experienced underwriting losses between 1997 and
2000; managing to write business profitably at the underwriting level only after
2001 (Chidgey et al., 2005).

A gross combined ratio is defined as the gross claim payment ratios adjusted to include an
estimate for acquisition and operating expenses.
1

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3.3 Factors that can influence underwriting cycles

During the past decade or more, a substantial body of literature has developed in
explaining the cyclical nature of insurance rates and profits in the propertyliability insurance market. Although Meier and Outreville (2006) acknowledge
that there is no generally accepted view of what the causes of the underwriting
cycle may be, they consolidate the literature into three main schools of thought:
1. disequilibrium between supply and demand;
2. external shocks; and
3. general business influences.

These three views are not mutually exclusive as the rational expectations
hypothesis implies that prices are influenced by many factors other than the
present value of expected losses. Therefore, one cannot test the theories against
each other, nor can a single theory explain the cause of underwriting cycles
(Meier and Outreville 2006). Some theories do not explain the cause of the cycle
itself, but merely the symptoms thereof; hence, some theories are less valid than
others. However, once the cycle starts its depth and length can be affected by the

response of insurers, such as increasing supply when premium profits are rising
(Rose et al. 2004; Markham 2006).

3.3.1 Disequilibrium between Supply and Demand

Stewart (1980) explains disequilibrium as the imbalance between the supply of
insurance and the demand for insurance. Demand for insurance varies over time
as a result of fluctuations in the flow of business directed to insurers, such as
18


changes in the marketing or distribution strategy. However, one must remember
that insurers are price takers rather than price makers; should there be excess
supply within the market, prices will face downward pressure towards the
equilibrium price level (Markham, 2006).

3.3.2 External Shocks

a. Interest Rates

Myers and Cohn (1987) and Cummins (1991) suggested that in a rational
expectations framework, insurance premiums reflect the present value of
expected losses and expenses. Thus, higher discount rates imply lower
premiums, other things being equal. This prediction is consistent with Doherty
and Kang (1988) who hypothesise that fluctuations in interest rates cause
insurance price cycles. Unexpected changes in interest rates may generate
external shocks which could stimulate an underwriting cycle (Doherty and Kang,
1988; Fields and Venezian, 1989; Doherty and Garven, 1992; Fung et al., 1998,
Lamm-Tennant and Weiss, 1997).

The intuition behind Doherty and Kang’s (1988) hypothesis is that higher interest
rates generate greater investment income, which lowers premiums; the converse
is true. As a result, premiums are inversely related to interest rates (Fung et al.,
1998). Insurers suffering from diminishing investment returns will have to
increase underwriting margins by increasing prices or toughening underwriting
standards so as to generate earnings. Thus, interest rates can significantly
contribute to the ‘hardening’ phase of the underwriting cycle. Conversely,
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