Underwriting Cycles and Insurance Solvency

Insurance failures are associated with swings in the underwriting cycle: insolvencies are particularly high following the troughs of the cycle. Common interpretations of the cycle, which ascribe profit fluctuations to rate making techniques, underwriting optimism or pessimism, and interest rate volatility, view failures simply as by-products of poor earnings. This paper examines the competitive forces that drive the cycle. 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. Insolvencies are not just a by-product of dismal earnings: they are a driving force behind the cycle. The paper considers several public policy alternatives to mitigate underwriting cycles and curtail insurance insolvencies. However, the social harm caused by these proposals, as well as the implementation difficulties, often outweigh the gains. Underwriting cycles may provide a bumpy ride, but they reflect the beneficial competition of a free market.