Insurance Price and Profit Dynamics: Underwriting Cycles Can Occur in Competitive Markets

Thu Apr 01 16:24:38 EDT 2010
By Dr. Anne Gron

In this article, published in the Insurance and Financial Services Committee Newsletter of the ABA Section of Antitrust Law, NERA Vice President Dr. Anne Gron discusses the economics of underwriting cycles and the implications for evaluations of insurance industry pricing based upon traditional competitive insurance pricing models. Underwriting cycles are the alternating periods of high profitability hard markets and low profitability soft markets that characterize many insurance markets. The high profitability periods are often accompanied by reductions in availability where some policyholders experience problems with renewals and, in extreme cases, some policyholders may be unable to find coverage. As Dr. Gron's article explains, capacity constraint models are able to generate the features associated with underwriting cycles in competitive insurance markets with shocks to insurer capital and costs of capital adjustment, whereas these features do not arise out of traditional competitive insurance pricing models.

The analysis is relevant for understanding the dynamics of insurance markets. A typical method for assessing insurance markets involves comparing actual insurance prices to those that would prevail in a perfectly competitive marketplace. In such assessments, perfectly competitive insurance prices are usually measured as the present value of expected claims plus expenses. Such prices, however, assume that the financial capital held by insurers can adjust quickly and costlessly. The two models of insurance market pricing provide different interpretations of high insurance prices in hard markets. The traditional competitive insurance pricing model interprets high prices as a departure from competition and possible evidence of cooperative behavior among insurers. Under the capacity constraint model of insurance pricing, failure of insurance prices to follow the present value of costs does not, by itself, indicate noncompetitive behavior.