The insurance cycle is something that is well known to general insurers (property and casualty, if you are in the US). For many classes of business, the price of insurance fluctuates much more than the underlying cost. The general consensus is that it is about availability of capital. If the insurance market as a whole has suffered substantial losses recently (think 2005 and the nightmare Hurricane year in the US) then all the capital that is generally available for insurance companies will have been used up paying claims. So companies will have to pay much more for capital, reinsurers will charge higher premiums, and the market as a whole will charge much higher premiums for the next few years. This is, of course, completely contrary to the Efficient Market Hypothesis that would suggest that the premium should reflect the best forward looking view of the risk, but it is a well known phenomenom.
But in my view, there is a different (closely related) reason. Insurance cycles generally happen in “long tail” business – that is business where the claims are paid a long time after the premium is received. Think workers compensation insurance, or (for an extreme) asbestos insurance. And this means that the company is deciding on the premium rate to charge a long time before they know what the ultimate claims will be. Of course, they will get it wrong (that is the only certain thing about insurance). If the insurance companies charge too high a premium for that year’s risk, capital will come flooding into the market because there are superprofits to be made. And the price will come down substantially. And if they charge a premium that is too low, the opposite occurs. The problem with this approach is that it is happening a long time later. So inevitably there is an overcorrection – hey presto – an insurance cycle where insurance companies make super profits some of the time, and diabolical losses (if they are still in the market) the rest of the time.
If you know what you are doing, the way to make good profits on this kind of business this is to hold your nerve on price. You need to charge the higher prices that the market generally is charging just after a disastrous year, but when the prices start going too low, you need to be able to hold your nerve and refuse to participate. That takes a long term, patient, shareholder, and a company where the pricing power is nowhere near the marketing team (which will have sales targets they are expected to meet). Of course, you won’t know whether you were right until many years later.
A colleague of mine recently described the group life insurance market as a commoditised business – low margin high volume. It would be, if the ultimate cost of the product was known up front. But the insurance cycle (group life claims, particularly for disability are paid up to 10-15 years after the premium) changes this dynamic. Instead, I think it is a business where the way to make money is through disciplined and very superior pricing. Which is not very common in any financial services business, and may be the reason not much money has been made in this business historically.
This is the season for industry events, so I’m musing on what I’ve seen on this blog. It feels quite strange to be doing professional blogging here, but that’s why I originally started this blog after all!