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 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 Acknowledgements I would like to thank the people instrumental to this report: My mother and family for their understanding and support Without them, I would not have made it this far 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 Prof R.W Vivian for his continued help and support Contents Abstract Introduction Page Types of Insurance Page 3 2.1 Direct 2.2 Reinsurance 2.3 Retrocessions Underwriting Cycles Page 3.1 Definition 3.2 International underwriting cycles 3.3 Factors that can influence underwriting cycles 3.4 Reinsurance underwriting cycles Empirical analysis on South African Data Page 49 Conclusion Page 60 Future Research Page 60 Reference list List of Figures Figure ‘The stabilising effect of reinsurance on French non-life insurers’ underwriting results’ Figure ‘Stages of the short-term insurance pricing cycle’ Figure ’United States Combined Ratio: 1957-2001’ Figure ‘United States Combined Ratio: 1957-2001’ Figure ‘Underwriting result of U.S Property-Liability Insurers 1915-2000’ Figure ‘South African Underwriting Cycle for the period 1974 to 2005’ Figure ‘UK Underwriting Results (1983-2001)’ Figure ‘Underwriting Margins of Hong Kong direct insurers (1992-2004)’ Figure ‘Gross Combined Ratios in China, 1999 to 2005’ Figure ‘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’ 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)’ 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 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 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 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 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 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 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 The multinational parent companies may follow a strategy of wanting to be the largest or most diversified African reinsurer - in spite of the losses incurred by the African market; Reinsurers’ retrocession programmes are dependant upon financial strength and the cost of reinsurance South African reinsurers have relatively strong financial positions and this may therefore limit the amount of retrocessions purchased This may be observed in figure 19, where the 1994 net underwriting loss of 17% (vs the 19% gross loss) implies that reinsurers purchased limited retrocessions Based on the figures 14 to 19 presented above, representing the South African reinsurers’ underwriting profits based on the net loss ratio and as a percentage of net written premiums, it is evident that an underwriting cycle does not exist in the South African reinsurance market An area for future research could be a study to establish whether the United States reinsurers’ underwriting cycle drives the South African reinsurance market through the international reinsurance market The U.S market serves as a proxy for the international market, given that the U.S accounts for 42% of the global market (Sigma, 2007) 60 Figure 20: Comparison of U.S Underwriting Losses and S.A Profit Ratio 1980-2005 Source: Berger et al (1992), Hartwig (2003) and Financial Services Board (1964-2005) The profit ratio for South African reinsurers is compared to the United States reinsurers’ underwriting losses in figure 20, so as to observe trends between the two reinsurance markets over the 1980 to 2005 period The profit ratio can be defined as 100 percent minus the loss ratio Underwriting losses as a performance measure takes expenses and commission into account; however, the profit ratio takes no cognisance of these factors due to unavailability of adequate data for the South African reinsurance market over the 1980 to 2005 period Therefore, it is obvious that while loss ratios and underwriting losses cannot be compared; it is possible to compare the trends of the two measures Whilst there does not appear to be a South African reinsurers’ cycle; it can be seen from figure 20 that both markets follow a remarkably similar trend from 1980 to 2000 After 2001, it is evident that the effects of the World Trade Centre attacks are observable only in the United States’ The trend is the same until 2001, possibly, due to the fact that both the United States and South African 61 markets are dominated by the same multinational reinsurers The 9/11 attacks were a domestic catastrophe for the United States market; hence the trend, from 2001, between the two reinsurance markets is no longer similar The effect of the 2001 World Trade Centre attacks on underwriting results persist in 2002 partially due to reporting lags by cedents; leaving reinsurers to adjust reserves and prices only as information became available and not at the time of the loss event Catastrophe cover is used by reinsurers to diversify substantial risks However, an effect known as the ‘London market spiral’ arises when a many reinsurers reinsure portions of each other’s catastrophe covers The effect of the spiral is that while direct insured losses are settled fairly quickly after a catastrophic event, the gross reinsured loss amount increases as risk carriers receive additional claims and submit additional claims to their own catastrophe covers, therefore generating further reinsurance claims and recoveries (Stanard and Wacek, 1991) This spiral can thus be said to be partially responsible for the persistence of losses experienced in 2001 during 2002 62 Figure 21: Comparison of U.S Reinsurers’ Underwriting Losses and S.A Loss Ratio Source: Berger et al (1992), Hartwig (2003) and Financial Services Board(1980-2005) Figure 21 depicts a comparison of the United States reinsurers’ underwriting losses and the South African reinsurers’ loss ratio for the 1980 to 2005 period Recalling the description of the loss ratio in section 3.1, an increase in the loss ratio signifies an increase in losses to the reinsurer; the converse is true The United States liability insurance crisis of the mid-1980s was characterised by substantial price increases, reductions in coverage and unavailability of coverage at any price for certain segments of the market The sharp declines in insurer underwriting profitability produced the significant losses for the U.S reinsurance industry that can be observed in figure 21 over the 1983 to 1985 period Berger et al (1992) state that the U.S liability insurance crisis led to similar developments in international reinsurance markets, where reinsurance was characterised by high losses and low premiums Observing figure 21, the 1984 and 1985 increases in the South African reinsurers’ loss ratio reflects high losses 63 relative to prices; this can be attributed to the U.S liability insurance crisis’ adverse impact on the South African insurance market Conclusion The purpose of this study is to establish whether or not an underwriting cycle exists in the South African short term reinsurance market It is concluded that there is no clear evidence of such cycles Future Research In order to delve further in this field, it is suggested that research be conducted to determine which, if any, of the factors hypothesised in the insurance literature as the causes of direct underwriting cycles, are applicable to reinsurance cycles in South Africa Meier and Outreville (2006) cite external shocks, such as catastrophic losses, as a factor that may cause to underwriting cycles Unexpected claims payments in the event of a catastrophic loss are a shock to capital that may deplete the insurer’s capital and reserves Should it not be possible to raise sufficient capital at a relatively low cost, insurers have the option of increasing the probability of insolvency or reducing the amount of coverage supplied at a given price This situation is temporary and adjustments create shocks that could induce an underwriting cycle (Harrington and Niehaus, 2000; Meier and Outreville, 2006) 64 In the context of the South African short term insurance market, the significant underwriting losses experienced in 1994 and 1999 are attributed to external shocks i.e a surge in motor vehicle theft (Geldenhuys, 1998), fire claims (Montagnani, 2007) and flooding (FSB, 2000) According to Meier and Outreville (2006), reinsurers’ adjustments to these events should have generated an underwriting cycle; however, a reinsurance underwriting cycle does not exist in the South African short term market Doherty and Kang’s (1988) hypothesis that unexpected changes interest rates may generate external shocks which could stimulate an underwriting cycle, may not be valid in the South African reinsurance market as there does not appear to be evidence of a reinsurance underwriting cycle Further 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