The Underwriting Cycle - Don’t Be Taken for a Ride
March 15, 2015| By Tad Montross | P/C General Industry | English
The underwriting cycle is an abiding feature of our industry. It’s mostly accepted as inevitable, being driven by external economic factors, such as the availability of capital. But is that really the case? While it’s true that economic factors, such as interest rates and underwriting results, have an effect on pricing, they are not the only thing driving cycles. Cycles are created and perpetuated in large part by the actions and behavior of management and underwriters.
Management behavior in turn is heavily influenced by analysts’ expectations, owners’ short-term (vs long-term) time horizons, share prices and the growth imperative. Management ultimately informs the way underwriters act - meaning that well-intended underwriting controls will fail if the message or the system of compensation is wrong.
As long as senior management teams are setting premium volume goals and undermining underwriting decisions, the underwriting cycle will keep repeating. The same goes for underestimating parameter and model risk.
Unless underwriters make rational economic decisions consistently on each and every risk they underwrite, as well as making rational portfolio decisions, the industry will remain a slave to the cycle.
Confidence has a lot to do with it.
Underwriters need to be confident about making rational decisions in the face of global uncertainties, external pressures and management inconsistencies. Confidence will help the industry sell a more consistent product that is appreciated by consumers.
Of course, building confidence isn’t easy in this complex world. But it can be done by improving the quality of decision making. A strong emphasis on both feedback and accountability helps ensure the quality of decisions is understood and managed.
The discipline of behavioral science has identified important factors regarding decision biases in finance, and managing those inherent biases in our decision making is especially important in a softening market where external negative stimuli weigh so heavily on the confidence/overconfidence balance.
Soft markets are characterized by the volume of noise that either undermines confidence or stimulates over-confidence. The different pictures painted by calendar year vs accident year results, for example, must be clearly understood if appropriate confidence is to be maintained while avoiding overconfidence.
Linked to that, it’s important to remember that actual loss experience often bears little resemblance to “normalized” experience, where we define normalized as the “correct” technical price for the insured risk. Actual results can be misleading, so a “walkaway” technical pricing discipline can help counter the urge to follow the market down.
Soft markets also influence underwriters’ thinking in the context of experience rating, compared with exposure pricing. Underwriting is a mix of science and art. The challenge is to get the mix right and not allow the “art” side to dominate in a soft market. My own view is that good underwriting is 80% science and 20% art.
Wordings and contract documentation tend to suffer in a soft market in a way that has no parallel in the financial services sector. Contracts, terms and conditions and breadth of coverage are integral to structuring an economically rational transaction. Contracting language and drafting is the responsibility of underwriters and shouldn’t be left to brokers.
If we can instill a culture of confidence in fundamental underwriting principles, we can at least stay consistent throughout the cycle - because, in the end, consistency is what clients of insurance and reinsurance companies value most.