Understanding the Cycles of Insurance: Underwriting and Reserving

1. Introduction: The Rhythms of the Insurance World

The insurance industry, like many natural systems, operates in rhythms or cycles. These patterns of expansion and contraction are not random; they are driven by predictable market forces that influence everything from the price you pay for a policy to the way an insurer handles its claims. Understanding these two interconnected cycles—the underwriting cycle and the reserving cycle—is crucial for grasping how insurance companies manage risk and maintain profitability.

Think of it like a farmer's market. When a certain crop has a great season (a profitable "hard market"), more farmers start growing it, increasing supply. This increased competition drives prices down for everyone. Eventually, prices get so low that it's no longer profitable, and some farmers stop growing the crop (an unprofitable "soft market"). With less supply, prices begin to rise again, starting the cycle over. The insurance world experiences a very similar ebb and flow.

The most visible of these rhythms is the underwriting cycle, which governs the very price of insurance.

2. The Underwriting Cycle: The Ebb and Flow of Premiums

2.1. What is the Underwriting Cycle?

The underwriting cycle is the process where premium rates for a specific class of insurance business oscillate between high and low levels over a period of several years. This fluctuation creates distinct market conditions where the business being written is either highly profitable or unprofitable.

2.2. The Two Faces of the Market: Hard vs. Soft

The cycle is defined by two primary phases: a 'hard market' and a 'soft market'. Each has distinct characteristics that shape insurer behaviour.

Characteristic	Hard Market	Soft Market
Premium Level	High	Low
Typical Profitability	Profitable	Unprofitable
Market Behaviour	More companies enter the market to seek profitable business.	Companies withdraw from the market or reduce capacity.

2.3. How the Cycle Works

The transition from a hard to a soft market and back again follows a logical, repeating pattern driven by competition and profitability.

1. The Hard Market: The cycle begins with a 'hard market', where high premium rates make the business very profitable. This profitability attracts new insurance companies to enter the market or encourages existing insurers to expand their capacity.

2. Competition Increases: As more insurers compete for the same profitable business, they begin cutting their rates to gain a larger market share. This increased supply and competition puts downward pressure on premiums across the board.

3. The Soft Market: This competitive process continues until premium rates fall to an unsustainable level. At this point, the business being written is no longer profitable, and the industry has entered a 'soft market'.

4. The Market Corrects (and a Dangerous Delay): Faced with losses, insurers should logically take corrective action—either by withdrawing from the market or increasing rates to restore profitability. However, this correction is often delayed. In practice, reserve releases from the profitable hard market period can mask the poor results of the current soft market, delaying the recognition of losses and the implementation of necessary rate increases.

External events, such as large catastrophe claims, can significantly reduce insurer profitability and accelerate the hardening of rates. The length of a full cycle varies by the type of insurance; for example, for some UK personal lines classes, it is around seven years.

This constant shift between profitability and unprofitability doesn't just affect premiums; it creates a shadow effect that influences how claims themselves are reserved.

3. The Reserving Cycle: The Underwriting Cycle's Shadow

3.1. Defining the Reserving Cycle

The reserving cycle is a phenomenon that is highly correlated with the underwriting cycle. It describes the observation that the pattern of claims development—how quickly the final cost of claims becomes known—changes depending on whether the market is hard or soft.

3.2. The Core Effect on Claims

The central characteristic of the reserving cycle is how it affects the speed at which claims develop.

• In a Soft Market: Incurred claims development patterns tend to be slower (or 'longer-tailed'), meaning it takes more time for the final, true cost of claims to become known.

• In a Hard Market: Incurred claims development patterns tend to be faster than in a soft market.

3.3. Why Does This Happen?

The source suggests several reasons for this slowdown, all of which stem from the business practices and pressures inherent in a soft market:

• Weakened Terms and Conditions: During soft markets, insurers may have offered looser policy terms to attract business, which can lead to more complex or litigated claims that take longer to settle.

• Increasing Tendency to Dispute Claims: As profitability falls, insurers may become more inclined to dispute claims, extending the settlement timeline.

• Less Conservative Case Reserving: There may be a less conservative approach to setting initial estimates for claims costs (case reserves) when financial results are already poor.

Understanding these two cycles individually is one thing; appreciating their combined impact on an insurer's financial stability is what truly matters.

4. Why These Cycles Matter

4.1. The Impact on Profitability

Failing to account for these cycles can lead to significant misjudgments about an insurer's financial health. If an actuary uses a standard projection model without adjusting for the current phase of the cycle, they risk:

• Underestimating the final cost of claims during a soft market (because claims are developing slower than the model expects).

• Overestimating the final cost of claims during a hard market (because claims are developing faster than the model expects).

This underestimation during a soft market creates a dangerous blind spot. As we saw, the release of older, healthier reserves can mask current unprofitability. This creates a vicious feedback loop: the false sense of profitability reduces management's urgency to raise rates, which in turn prolongs the unprofitable soft market and deepens the eventual losses.

4.2. The Impact on Reserving Practices

Because of these risks, an insurance company has a strong incentive to "flatten the reserving cycle" by adjusting its analysis to account for these effects. The primary benefits of doing so are:

• Improved Accuracy: It reduces the likelihood of setting insufficient reserves for past years, which would have a negative impact on the ongoing business.

• Better Decision-Making: It allows management to more readily understand the true, underlying profitability of their business. With a clearer picture, they can make better strategic decisions about whether to continue, contract, or expand a particular line of business.

5. Conclusion: A Connected System

The underwriting and reserving cycles are not separate, isolated events. They are deeply interconnected forces that constantly shape an insurer's financial results and strategic decisions. The underwriting cycle of rising and falling premiums directly influences the reserving cycle's patterns of claims development. Ultimately, recognizing that the underwriting cycle drives insurer behaviour, which in turn shapes the reserving cycle, is the key to moving from simply observing the market to truly understanding it.