26.2 Theories of the Cycle

Different researches findings below are often contradictory due to:

  • Research typically focused on different LoBs

  • Often focus on just one stage

26.2.1 Institutional Factors

Lags in data can lead to cycles

Reporting and regulatory delays leads to 2nd order autoregression

26.2.2 Competition

Competition drives prices down:

  • Players might not behave rationally

  • Someone might underestimate the expected loss (winner’s curse)

Companies strategy is either aggressive growth (through price reduction) or price maintenance

  • Once a large portion of the market is dropping prices, price maintenance is not sustainable

  • Incumbents drop price so as to convince the aggressive players that they should focus on profits, rather than market share and thus get back to higher prices sooner

Dowling’s 4 phases of cycle

  1. Cheating (optimistic reserve levels)

  2. Pain

  3. Fear

  4. Restoration

26.2.3 Supply and Demand, Capital Constraints and Shocks

Capital determines the available supply of insurance

  • Losses that reduce capital will reduce the supply \(\Rightarrow\) Increase price

Capital is not replaced quickly once reduced (debatable now with ILS)

\(\therefore\) Market does not rebound quickly

Best clients may leave first when capital \(\downarrow\) \(\Rightarrow\) anti-selection

\(\therefore\) Declining profits exacerbated by anti-selection

26.2.4 Economic Linkages

Profitability of firm links to the economy

  • Investment income, cost of capital

  • Expected losses may impacted by: inflation, GNP growth, unemployment

  • Price of risk (may be set by the market)

    • Is generally ignored by insurers

26.2.5 All of the Above

No single theory can explain the u/w cycle completely