There are ten lines in that graph..
The straight blue line is the 1-1 line, which is the measurement of a year’s performance 1 year out. This is a pure fudge figure because the insurer doesn’t have enough information to measure the cost yet.
The fact that this line is at 1.00 is important. 1.00 means that the insurer expects to pay out 100% of its premium in claims. Nominal Revenue = Nominal Cost. 10 years of interest makes this possible.
As you look back at the year over time (1-2, 1-3, etc), the amplitude of the ‘wave’ increases. This happens because, over time, insurers gain information about how well that year is going and absorb the volatility in the relationship between revenue and costs.
Workers’ Compensation business is the most ‘long tail’ of insurance businesses. This means that the claims cost of comp policies take the longest to resolve.
In fact, insurers have very little idea for the ultimate cost when they write a comp policy. Workers’ comp is notorious for this and many, many insurance companies avoid it entirely because of this uncertainty.
The cycle is present in all insurance businesses, though. Once people figure out they’re losing money, they pull capacity and rates go up. The difference with comp is that there is more risk of finding out too late.
Think of that realization like a tsunami. When they’re out to sea, small waves look like big waves because very few have enough power to displace the entire vertical distance of water from the ocean floor all the way to the surface. Good years and bad years and company-killing years look pretty similar.
But once the sea floor shortens up and you hit the shore, you find out how much energy was in the sucker.
And with comp, those suckers can be big.