Reflexivity in Competition‐Originated Underwriting Cycles

• Author: Vsevolod K. Malinovskii
• Published date: 01 December 2014
• Date: 01 December 2014
• DOI: http://doi.org/10.1111/j.1539-6975.2013.01527.x

©

DOI: 10.1111/j.1539-6975.2013.01527.x

883

Reflexivity in Competition-Originated

Underwriting Cycles

Vsevolod K. Malinovskii

Abstract

This article addresses the fundamental observation that aggressive newcom-

ers seeking greater market share trigger the industry response of reducing

rates that may gradually fall below marginal cost. In this study,the concept

of reflexivity as connection between the participants’ thinking and the situa-

tion in which they participate is applied. This article suggests applying as an

insurance regulation technique, while the competition-originated cycle is in

its early stage, the triplets of year-end market share,profit, and solvency indi-

cators. It emphasizes the need for applying all these characteristics together,

rather than the first two.

Introduction and Rationale

In insurance, two major types of cyclic behavior are known: irregular short-range

fluctuations and regular up- and downswings, occurring over many years, referred to

as underwriting cycles. The former are due to unpredictable fluctuations in economic

surroundings; the latter are due to price competition and its consequences.

Doing research of the relationship between underwriting cycles and insurance in-

solvencies, Feldblum (2007) yields the epitome of the competition-originated under-

writing cycles: “The apparent ease of entry into the insurance market, the low price

elasticity of demand, and the lack of product differentiation among rival insurers

encourage aggressive firms to seek greater market shares. The industry response of

reducing rates below marginal cost forces insolvencies among weaker carriers and

thereby shifts strategic goals from market share gains to profitable operations. Insol-

vencies are not just a by-product of dismal earnings; they are a driving force behind

the cycle.”

However, unless the industry is monopolistic, no individual firm, no matter how

aggressive or influential it may be, can unilaterally call forth the industry response of

reducing rates or,put it another way, year after year decline of the market prices. And

Vsevolod K. Malinovskii is at the Central Economics and Mathematics Institute (CEMI) of the

Russian Academy of Science, 117418, Nakhimovskiy prosp., 47, Moscow, Russia. The author

can be contacted via e-mail: malinov@orc.ru. The author is grateful to Jim Gordonwho carefully

readand helped to improve the text. This work was supported by RFBR (grant no. 11-06-00057-a)

and by the Cariplo Foundation/Landau Network fellowship 2011/2012.

1

The Journal of Risk and Insurance, 2013, Vol. 81, No. 4, 883–905

884 THE JOURNAL OF RISK AND INSURANCE

what in fact is the “market price”? In particular,is it an average price over the industry,

or the price of the most optimistic insurer,or an agreement of the participants, or what?

The concept of market price is of paramount importance. For instance, it is widely

assumed that in the year when the market price is above the marginal cost of producing

the product, called year of hardmarket, insurance operations are profitable. In the year

when the market price is below marginal cost, called year of soft market, insurance

operations are unprofitable. This difference between hard and soft markets entails

numerous consequences. For instance, in years of hard market a large portfolio is an

advantage because it yields more profit, while in years of soft market a large portfolio

may be a burden producing more loss.

On the one hand, while the market is hard,1all newcomers must discount prices.

Indeed, it is difficult to attract new customers in an established and profitable insu-

rance market, and new insurers believe that they have little to lose by charging lower

rates. They have no income now,so any price above marginal cost is additional profit.

On the other hand, any firm, not only those aggressive newcomers, may decide to cut

prices slightly to garner a greater market share and increase its profits.2How much

may prices be cut in such a way? It depends on the propensity to migrate among the

insureds3and on the behavior of other insurers in the market: having cut prices, one

may find that a competing company has cut its prices even more.

Behavior of competing companies in this respect becomes paramount. It faces great

uncertainty. No one knows exactly the next-year market price, meaning by that

the aggregate of the total internal price politics of individual firms on the market.

Nevertheless, the general trend is typically known. If an aggressive intruder slashing

1It is unlikely that a profit-seeking firm would be happy to enter a soft insurance market.

2Some behavioral explanations of self-inflicting, if it goes too far, conduct are presented by

Fitzpatrick (2004). According to him, “a disconnect between the incentives provided to un-

derwriters and the long-term interest of the insurer (and its capital providers) in generating

profitable premium growth is a key element in creating market cycles. Many companies seek

to mitigate this tension by designing long-term incentive compensation plans for underwriters

that are tied to profitability, but such speculative potential compensation does little to motivate

the vast majority of underwriters. First, underwriters—like most people—are more sensitive

to short-term incentives (Will I get a year-end bonus? Willa poor annual review cost me that

promotion?) than they are to more speculative, deferred benefits. Moreover, the structure of

the employment market in property-casualty insurance provides regular opportunities for

‘good producers’ to move from company to company in search of greener financial pastures.

In fact, the absence of significant barriers to entry in the insurance market makes for a robust

employment environment and all but guarantees that an underwriter can parlay a talent for

short-term premium production into a series of ever higher paying jobs at differentcompanies.

Thus, short-term incentives to produce top-line growth and a ‘sellers’ “job market combine

to ensure that few underwriters in long-tail lines stay in one job long enough to suffer for, or

even learn from, their past mistakes.”

3By migration we mean transition from one insurer to another. If, to consider an extremecase,

migration is forbidden, lower prices do not affect portfolio size.