April 2015 Question 6(ii) Underwriting cycle

[Miss_Vee]

Please explain why increasing the amount of capital in line with the premium income for that portfolio intensifies the underwriting cycle.

I would argue the reverse. My understanding is that increased rates, lead to increased premium income, which leads to increased capital requirements- hence will detract companies from joining. But the underwriting cycle states high rates attract new companies. So how is the point above encouraging the cycle?

 

[Ian Senator]

So many things drive the underwriting cycle and it's tricky to separate all the interacting effects.

Yes, increased rates lead to increased premiums, which leads to increased capital requirements, which detracts new joiners and existing insurers leave or reduce their volumes. This reduction in supply pushes premium rates up, and hence intensifies the cycle.

Now leave legislation alone. In the 'normal' situation, higher rates implies greater profitability (all else being equal). This would attract new companies, as you say.

The difference in outcome is because in the question, the extra capital requirement 'contradicts' the extra profitability of the rates.

 

[padasala]

Your understanding is a little bit off from a practical standpoint.

You are looking at if writing an extra dollar of business would be worth allocating the additional marginal capital towards it. The answer to this question is very complicated and the question itself does not provide any info about that (so you have to assume that it does i suppose).

A hardening underwriting cycle means that there are lesser competitors and higher premiums (which basically means higher profits). This induces companies to enter into the market because their RoCE makes sense

 

[Ian Senator]

Your understanding is a little bit off from a practical standpoint.

I think Miss_Vee had a valid question. The question says that the capital requirement is increasing with volumes.
Rather than 'hardening' (which you correctly describe), the question is asking about 'intensifying' - in other words, speeding up.

 

[E123]

Hi,
I was also caught out by this question and argued the opposite to the answer in the solutions. My thinking was that when the market is hard and premiums are high the capital requirement will be high and so be a deterrent to new entrants to the market which would act to slow down the cycle (as there would be less supply than there would otherwise be, if the capital requirement wasn't there).

The solutions say that in a hardening market the total premium income will be rising and so capital requirements will be rising which will discourage new entrants and exiting insurers may leave the market. I don't understand why an insurer who has lasted through a soft market would leave when it's starting to harden? I know they won't know the exact position of the cycle but surely after maybe writing loss-making business for a period they won't leave the market when they can start charging more?

Definitely seems like you could argue this either way so I thought there might be an allowance for that in the solutions but it doesn't seem like it. It would also depend on how much business they write at higher or lower premiums because the capital requirement depends on total premium income so if the increase in premium rates is offset by a decrease in volume there might be no change in capital requirement, or vice versa.