A Piece of The Puzzle

Loving the Sector & Sovereign Blog.

One of my most enduring frustrations with the insurance industry is that there is this bizarre cycle:

For those that don’t want to read about this graph: the industry loses money when the lines cross the horizontal blue line.

This insurance cycle is somewhat related to the business cycle, but the relationship isn’t terribly strong. What the hell is going on then? Some of it is pricing, where rates are cut. But S&S suggest that this masks a shadowy increase in exposure, by way of loosening terms and conditions (T&C) [emphasis in original]:

Rather, we think price declines are concurrent with deteriorating policy term & conditions, and that this is the main source of loss trend deterioration. In other words, we think the industry contributes more to its own loss trend experience than external inflation

We test this theory using loss trend data for work comp, available from the NCCI. We model frequency, medical severity, and indemnity severity separately as well as together. In every case, pricing from 3 years ago matters more than any possible macroeconomic factor.

Now that’s a cool idea. And probably a correct one.

A problem, of course, is that it’s not a terribly useful idea, from the perspective of making money. The market stays stupid for longer than you can stay liquid, after all.

And this isn’t directly observable or measurable, even for reinsurers. People will conceal this kind of T&C deterioration and, because of its lag, the villains have good reason to believe they will get away with it in advance. And for good reason: everyone else in history has.

I’m still ruminating on my critique of S&S’s compelling but (I believe) flawed theory of supply and demand in the insurance market.

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