This time rates started to go positive in some lines at the end of 2017, and picked up into a broad-based turn from Q1 2019.
The cycle has increasingly decomposed into a collection of micro-cycles, and there are a number of areas like public D&O, transactional liability, cyber, and construction that look soft.
But despite some fraying at the edges, we are watching the most remarkably extended cycle.
And, as of Q4 2023, the Long Firming seems alive and well, with signs that parts of the casualty market are heading into a fresh micro-cycle of their own.
For a fragmented industry not typically perceived as having much pricing power, this is a remarkable performance on commercial lines pricing. And, of course, it also misses the other changes that have driven a transformation in portfolio quality.
Limits have been compressed dramatically. Retentions have risen. Terms and conditions have tightened.
The latter part of the “cycle overtime” has played out against a rapid interest rate tightening cycle, which created some initial stress due to mark-to-market losses, but which represents a massive net win for insurers.
Commercial lines insurers are effectively levered bond funds with broadly twice the investment leverage that they run on the underwriting side. A few hundred bps of increased yield can easily be 5-6 percentage points of ROE.
You just have to look at some of the Q3 net investment income figures to see how big a driver of earnings growth this can be, particularly if higher-for-longer expectations play out.
Commercial lines insurers aren’t without problems. They are working through the “upstreaming” of cat risk from reinsurers that necessitates the management of more volatility. On casualty, the fear index has also risen around reserve deficiencies on back years. Insurers are also concerned about squeezing enough rate out of insureds to make sure they don’t fall behind monster loss trends.
The strategic opportunity
While there are lots of positives for commercial lines insurers that might bear out in financial results over time, my central point here is that overtime on the firming phase of the market also gives them a strategic opportunity to get ready for the soft market.
The one that was due in 2021, then 2022, then 2023, and which – I suppose – is conceivably due in 2024.
In prior cycles, you can perhaps understand how companies highly focused on exploiting the hardening market would be caught cold by a rapid reversal of pricing conditions.
When the cycle was faster moving, it was more forgivable to break the emergency glass and find a few scribbled notes inside.This time insurers have extra time to create those plans to effectively manage the soft market, and to lay the groundwork where lead time is required.
"That is a huge strategic opportunity and should not be missed."
Even the long summer will eventually end.
So what does that look like?
The playbook will look very different depending on competitive positioning, maturity, business mix, strength of shareholder support etc.
But there are at least some common areas that warrant consideration, even if not all of them require work at every insurer.
1. Examine breadth of offering/distribution
Being able to flexibly allocate capital across as broad a range of products, platforms and distribution channels as possible provides the best opportunity to deliver better returns in a weak market. The extended cycle may provide the time needed to establish new units, add adjacent products, support new programs, or make bolt-on acquisitions to build a more diverse business. Given the rise of micro-cycles, the ability to dynamically (and intelligently) re-allocate capital is likely to be even more important than in past soft markets.
2. Build relationship equity with key partners
Insurers are more reliant on external stakeholders to succeed in a soft market. With securing a good showing of business increasingly important, early efforts to deepen senior relationships and relationships with central placement teams at brokers may pay dividends, even if they represent a cost and time drag. Greater use of data and analytics would point towards even more soft market “rationalization” this time from brokers. Insurers are also likely to want to lay off more of their books to reinsurers as profitability deteriorates – something which may militate against playing hardball over a couple of points of casualty cede at January 1.
3. Reserve conservatively
Strength of soft market earnings will depend heavily on insurers being able to resist the Stanford Marshmallow Test on reserving by holding loss picks high, and leaving the 2020-21 years alone. No one publicly admits earnings management goes on, but it absolutely does – and good companies should take advantage of higher-for-longer rates to build as much buffer as they possibly can to support calendar-year earnings in the thin years.
4. Prepare to clamp down on costs
Insurance companies have a baseline of inefficiency, and rarely prioritize cost control in the hardening phase of the cycle when they are trying to capitalize on strong conditions. This has likely been exacerbated this cycle by inflation’s impact on staff and non-staff costs. Operational efficiency programs will likely be on the table, and some firms are believed to have these kind of plans ready to go. Indeed, the brokers have been moving already.
5. Decide if you are a buyer or a seller
M&A has largely been in abeyance outside distressed situations for commercial lines insurers, something which is likely to change in the soft market. Insurers should address the question whether they are potential buyers or sellers (or switch-hitters). Buyers should be laying the groundwork via relationship-building with key targets – think of those CEO dinners often referenced in the S4 narratives on how deals come together. (Some of this is definitely happening already.)
In addition, they should build the M&A wherewithal to clinch a deal if they currently lack it, while building the operational capability to integrate effectively. There is probably less for sellers to do, and indeed they are likely to want to sell later in the soft market when valuations tend to move higher.
The list above is subjective and far from exhaustive, but it represents a place to start in thinking about how to take advantage of a window of opportunity. At some point the long summer will give way to winter, and soon enough we will see who has a full granary and who has an empty one.
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