Commentary: Newton’s Third Law

By | September 25, 2006

Sir Isaac Newton’s third law of motion — “For every action, there is an equal and opposite reaction” — wouldn’t appear to have much to do with the insurance industry. If the Street thinks about it at all, it’s probably in terms of automobile accidents.

But perhaps the Street should pay a bit more attention to it, because on closer inspection it could explain the forces driving the current market rather well. It might even offer an explanation for the ever-present cycle that has been part of the industry’s economics seemingly forever.

A recent interview with National Association of Professional Surplus Lines Offices’ past-President Richard Polizzi, who is also president of Western Security Surplus Insurance in Pasadena, Calif., triggered the association. “The business cycle [faster or slower economic growth] and the insurance cycle never end,” Polizzi said, “but they [insurers] do react to outside pressures, such as regulatory changes, terrorism and catastrophe losses.”

Market reacts after 9/11
The Sept. 11 attacks triggered a deep-seated reaction that is still being felt. The hurricanes of 2004-05 provoked huge rate increases, a massive withdrawal of coverage from Florida and the Gulf States, affected energy related risks and, in a backlash effect, lowered rates in other regions of the country, where the companies fleeing the Gulf are seeking new business.

Although any generalization has exceptions, the market before 9/11 was mostly soft or softening. However, markets react to events — the bigger the event the bigger the reaction. The stock market hates uncertainty, so it usually declines following a major catastrophe or bad economic news. The insurance market, on the other hand, is more complicated, and takes longer — due to the nature of the business — to react. On the whole premium rates tend to rise in sectors affected by natural catastrophes, adverse jury verdicts or more stringent regulations, such as Sarbanes-Oxley. The increase can be geographically oriented, sector oriented or a combination of both, as in Florida property premiums.

The 9/11 attacks caused the biggest single-event loss in U.S. history and triggered a rash of lawsuits to settle who owed what to whom. It resulted in a diminution of capital for both insurers and reinsurers. This caused them to go to the capital markets with debt and equity issues to replace the losses. It also left a capacity gap, which was exploited within months by a number of new companies, mostly based in Bermuda, where you can actually start an insurance company in three months.

The start-ups weren’t exactly “new.” For the most part they were funded by some of the biggest players in international finance — Goldman Sachs, Morgan Stanley, Blackstone, etc. — and insurance — MarshMac, Aon, Zurich, AIG, etc. They reacted to the capacity gap, and the appearance of a newly hardening market to create new companies with “clean” balance sheets to meet increased demand.

The Terrorism Risk Insurance Act’s eventual passage and subsequent renewal was also a direct reaction to the terrorist attacks. It took the form it did mainly because the industry demanded it. Shortly after 9/11, Chubb’s Vice Chairman, John Degnan, called terrorist cover “an un-underwriteable risk.”

When Congress proposed backing loans to the insurance industry to get it to provide coverage, AIG’s then CEO Hank Greenberg tersely told the legislators: “We don’t need a loan. I don’t want any loans. I want reinsurance.”

Reaction after the hurricanes
The market reaction to the hurricanes has been somewhat similar, but it has also given a big boost to the Cat Bond market and has produced “the sidecar effect.” Companies set up their own privately held reinsurance entities, in which they may, or may not, have an ownership interest. Equity investors put up the majority of the capital, and the new entity, or sidecar, takes on a portion of the company’s quota share treaty risks.

So, if reactions to events push up rates, how does one explain the present generally acknowledged decline in most premiums?

According to Newton’s law they should remain stable, but insurance rates are not after all inert bodies. They are rather like the stone the Greek Hero Sisyphus was condemned to push up a hill in the underworld, only to see it roll back down to the bottom when he reached the top. Rates actually are like many such stones, depending on the geographical area, the type of coverage, the applicable regulations [admitted, non-admitted, etc.] and the consequent level of risk.

As long as they are reacting to adverse outside events they generally tend to rise — to be pushed up the hill, so to speak. But when nothing is pushing them up, they tend to react by rolling back down the hill for a number of reasons. Higher rates may have enticed more capital into the market. Greater risks in some areas may have lured companies to change their business plans to take in new areas or offer new types of coverage that are seen as less risky and/or that offer higher returns. The formation of new risk retention groups and captives may decrease demand. As this happens it tends to increase competition, and lower rates, i.e., a soft market.

Competition pushes down rates again
Headline making catastrophes aren’t the only source of reactions. A smaller series of events can push the market one way or another. In a recent interview Denise Morris, senior vice president, Excess Casualty, for Liberty International Underwriters in Chicago, described a market in flux with rates generally going down as new players enter the market. New market players, limits on class actions and to some extent tort reform have combined to put pressure on rates. But, pushing against this, are higher jury verdicts and emerging areas of litigation such as mold, silica and pollution. “A [wrongful death] auto claim used to be around $1 million,” Morris said, “but that’s no longer the case, now they’re worth more.” Eventually her market may move in the other direction.

Scientific formulas shouldn’t prove too difficult for the Street to master. The insurance industry is after all founded on the law of large numbers, and it has become increasingly dependent on probability theory to calculate the extent of the risks it covers. If you could create a formula using Newton’s third law to predict the future direction(s) premiums might move in, you might be able to take advantage of the knowledge to mitigate the consequences.

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