Similar to how the broader economy shifts from expansion to recession, the insurance market has a cycle as well.
There are two distinct periods of the cycle, known as the “hard” and “soft” markets.
While you would need an advanced degree in insurance to understand the concept completely, we’ll do our best to present the basics of the concept to give you a general idea of how it all works.
And more importantly, we’ll explain how the cycle affects the cost (and availability) of insurance coverage.
It is important to understand how insurance companies make money in order to further grasp the explanation below.
In short, insurers can make money using our insurance premium dollars to invest for return in the stock market and/or simply by generating more premium dollars than what they pay out in insurance claims over a specified period.
The latter is referred to as an “underwriting” profit (or loss if more is paid in claims than brought in from premiums).
Soft Insurance Market Basics
In a soft market, which we have been in for several years now, insurance companies have a broader appetite for “risk” and compete with one another by (generally) lowering premiums to attract more customers.
This is generally a period of time when insurance companies have high-dollar reserves and can make money in the stock market. Thus, they can lower their premiums to a point where they either don’t make money or even lose money on the “underwriting” side of the equation.
For example, an insurer may bring in $100,000,000 in premium, pay out $105,000,000 in claims, but generate $15,000,000 in investment returns in one year. The overall result? The insurer profits $10,000,000!
Hard Insurance Market Basics
In a hard market, insurers have dwindling reserves (of money in the bank), cannot make money on the “investment” side and need to generate a profit based on generating more premium than what is paid out in claims. What’s next? You guessed it; insurers accept less overall risk and raise premiums to ensure more money is coming in from “underwriting.”
Again, the scope of this topic is too large for any one post, but keep in mind that each line of insurance (car, home, general liability, worker’s compensation) has its own independent cycle.
So one market “hardening” may not necessarily lead to the others doing so.
What Causes the Change?
There are a few factors that can cause any particular line of insurance (or the whole industry) to move through the cycle. Let’s take a look.
1. Continued underwriting losses – As discussed above, rates can only go down for so long before the insurers are not making enough money from underwriting.
2. Decrease in Reserves – The industry is highly regulated. One of these regulations requires insurance companies to PROVE they have enough money to pay for their claims. Once they get to a point where they don’t have enough in the “bank,” they have to raise premiums to fill the coffers back up.
3. Risk Adversity – In a soft market, insurers are more lenient about the level of risk they will accept. In a hard market, insurers reduce their risk tolerance…and only want to insure those of us who they think have a LOW chance of filing claims, which leads to an underwriting profit (hopefully).
4. Reinsurance – Reinsurers are the companies who insure the insurance companies. If their premiums increase (for all of the same reasons above), those costs are passed on to the end consumer.
Depending on where in the cycle insurers are in the above referenced points, the market may find itself “softening” or “hardening.” As a consumer, you would prefer the soft market.
For the record, the losses stemming from 9/11 caused the last hard insurance market. It has been soft ever since.