So, is middle age the beginning of the end or the end of the beginning?

For humans and hard markets alike, it is necessarily both.

Having made countless tough and often painful underwriting, pricing and organizational decisions over the past two years, most insurers prefer to think of 2003 as a new beginninga wide-open doorway through which they will pass effortlessly into the second stage of hard market Valhalla.

Recent survey results appear to support this optimistic outlook.

Growth in net premiums written is expected to reach 13.6 percent this year, before settling back a bit to 13 percent in 2003. If realized, the gains would be the largest in the past 15 years.

And thats not the end of the good news. The industrys combined ratio is expected to fall to 103.4 in 2003, down substantially from 106.3 this year (and 115.7 in 2001)–the best result since 1997.

The dramatic acceleration in premium growth from their post-war lows four years ago, the similarly impressive improvement in underwriting performance, and the relatively short duration of previous hard markets (three-to-four years) suggest that the end of the hard market must be near.

But lurking just below the surface is a far more disturbing and sobering picture–one that suggests that if the current hard market ends anytime soon, it will end badly. The accompanying chart shows exactly why this is the case.

For at least 12 consecutive years, profitability (as measured by return on equity) in the property-casualty insurance industry has managed to trail the industrys cost of capital–often by a wide margin (see chart). The cost of capital is that rate of return required by investors, given the risks assumed and the alternative investments available.

Frankly, through much of the 1990s investors in p-c insurance enterprises would have done better putting their money in Treasury bills–or, in some years, stuffing it under the mattress.

Why is closing the gap between the industrys cost of capital so critical to the industry? When an individual insurer falls short of its cost of capital it disappoints its investors. When the industry falls short of the mark it risks losing the confidence of investors.

The three-to-four percent return expected in 2002while a marked improvement over 2001s worst-ever performanceis still dreary, even when compared to todays recession-reduced ROE expectations for American industries generally of about 10 percent.

Yet for the insurance industry to fall so grossly short of its cost of capital for so long can only mean that some insurers are living on borrowed time.

Indeed, Economics 101 would suggest that massive amounts of capital should be withdrawn from the industry. That is, in fact, precisely what is happening on a global scale today.

Non-life insurance capacity worldwide is expected to shrink by as much as 25 percent, or $230 billion by the end of 2002 compared to its peak in early 2002 (see chart). In the United States alone, capacity through the first half of 2002 fell by 16 percentmore than $53 billionsince peaking in mid-1999.

This worldwide shrinkage has occurred despite the much-ballyhooed infusion of $53-plus billion in new capital worldwide in the year following the Sept. 11, 2001, terrorist attack.

In short, if the hard market ends anytime time soon (and 2003 is too soon for most and way too soon for many), then the coming year could mark the beginning of the end for some insurers.

While the combination of improved underwriting performance and decreasing capacity will produce better but still sub-par ROEs in 2003, a long list of problems threaten to drain away profits, including:

Significant reserve deficiencies.

Double-digit medical inflation.

The omni-present threat of major natural disasters.

The lack of a satisfactory resolution to the crisis in corporate governance.

A high level of geopolitical instability.

The potential for continued turmoil in the financial markets.

The industrys still-anemic performance in 2003 also owes much to the deep, parasitic relationship that trial lawyers generally, and asbestos plaintiffs specifically have formed with insurersone that will be hard to dislodge in spite of the business-friendly outcome of Novembers midterm elections.

Finally, despite the passage of long-awaited federal terrorism legislation, the now ubiquitous threat of terrorist attacks (exacerbated by the possibility of war with Iraq early in 2003) only adds to the general level of uncertainty.

Can p-c insurers avoid a middle-age hard market crisis?

Men suffering from a mid-life crisis are stereotyped as developing a keen interest in fast cars and young women. The middle-age hard market likewise provides insurers with ample opportunities to be led astray.

Of particular concern is that insurershaving spotted profits on the distant horizonmay abandon disciplined strategies focused on restoring profitability and allow themselves to be seduced by sexier growth-oriented strategies.

For a short time such a strategy will feel good, but insurers will almost certainly live to regret it. Fortune 500 rates of return (12-to-15 percent) are still an ideal for most of the industry, not a reality.

Bottom line: insurers who abandon or reduce their commitment to underwriting and pricing discipline in 2003 do so at great personal peril.

There is no way prices can be reduced (or terms and conditions significantly expanded) in 2003 for any major commercial or personal line of coverage without compromising financial performance in 2004 and beyond. This is especially true in the current slow-growth economy.

Investment by businesses is falling and the overall economy is expected to grow by barely 2 percent next year. Overall employment is falling and payroll growth is stagnant. A growth-oriented strategy in such an environmentwhere exposure growth is virtually nonexistentamounts to little more than a shell game.

The staying power of the hard market will be tested in 2003temptations will abound.

At middle age, the hard market is truly at a crossroads. Choosing the path well-worn means a quick return to high underwriting losses and abysmal profitability. Taking the path less traveledand staying the coursewill produce a stronger industry that can grow into the challenges will assuredly arise in years ahead.

Robert Hartwig, Ph.D., is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at [email protected].

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 8, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.