Underwriting Cycles - Part II

The Nature of Underwriting Cycles


The insurance industry generally holds the perception that underwriting cycles typically run six years from peak to peak or from trough to trough. The industry also seems to hold to the belief that the vacillations of the cycles are generally modest and the trend line is steady.

Using the Elliott Wave Principle, this report applies technical analysis to underwriting cycles. An analysis of the data suggests that the industry’s perceptions of underwriting cycles are not accurate.

Analysis suggests that the industry is currently experiencing a "supercycle" where the industry's combined ratio is trending downward. The combined ratio will likely continue downward for at least another 14 years. While there will be vacillations within the supercycle the next move will be sharply downward.

Elliott Wave Theory

The Elliott Wave Theory is a form of technical analysis that is widely used to predict trends in the financial markets. Since underwriting cycles often function as a reaction to the financial markets (as is shown in Part I of this two-part report), Elliott Wave Theory is ideal for analyzing and forecasting underwriting cycles. Analysis using the Elliott Wave Theory identifies repeating patterns in terms of highs and lows. Each form of a cycle (a wave) consists of “sub-cyles” that operate in the same manner. Each set of sub-cycles can be broken down further and further down to Miniscule cycles.

The longest wave within the Elliott Wave Theory is a "grand supercycle," which spans the course of multiple centuries. No one can say with any certainty where we are within the current grand supercycle because there is not enough historical data to make an evaluation. Labeling the grand supercycle in the following chart is necessarily arbitrary. However, since we can see the movement of the sub-cycles, we do have the ability to forecast the continued movement of the next “sub-cycle,” and future movement within the grand supercycle.

Analysis of Combined Ratios

The following is a chart of the industry’s combined ratios from 1920 to 2008. The information was gathered from various editions of A.M. Best Company’s Best’s Aggregates & Averages.

The sub-cycle of a grand supercycle is a "supercycle." In the following graph, we can clearly see the directions of the channels that are cut by the Supercycles. The duration of a supercycles are usually least 40 years, however a supercycle can continue for more than one century. The last completed combined ratio supercycle trended upward from where it began in 1942 and was completed in 1985. (It is noted that these dates coincide somewhat with the supercycle in the financial markets that began in the Great Depression and continued until the bursting of the Dot Com Bubble in 2000. It is remarkable that the industry trend preceded the trend in the financial markets. In an earlier post it was demonstrated that for short term trends, the industry tends to react to markets.)

In 1985, a reversal occurred and the industry entered into a supercycle that is trending downward. As noted above, this trend will likely continue at least 2025.

 
An underwriting cycle is actually two consecutive sub-cycles of a supercycle - one upward and the other downward. Elliott Wave Theory coincidentally calls these sub-cycles "cycles." The following chart breaks down the supercycles into cycles.

We are currently at the end of an (a) corrective upward wave in within a downward supercycle that I have labeled as an (a) wave of the Supercycle. The next movement will be a (b) move down.

Note that it was recently announced that the year-end combined ratio for 2008 was 105.1. Yet on September 16th, the Property Casualty Insurers Association of America (PCI) issued a press release stating that the combined ratio "deteriorated" to 101.7 percent for six-months 2010 from 100.8 percent for six-months 2009. The movement is hardly a deterioration compared to 2008. Note that small increases within the downward trend are not only expected, but they are required, for the waves to take their course. The data released by PCI serves to reinforce the fact that we have now entered the (b) move down.

Methodology

Future posts with explain in more detail how the workings of the Elliott Wave Theory in more detail.

There are notable limitations in charting Elliott Waves for the industry's combined ratios. The only data available to us are end of the year data compilations. We therefore have only “snapshots.” In contrast, when analysts chart financial markets, they have the advantage of the available daily and hourly data. Waves can be broken down into smaller waves. The financial market information “flows” and the peaks and valleys of the waves are more fully revealed. This perhaps explains why there are some waves in the above chart that seem to have progressed either too high or too low.

One wave that bears mention is (I) in 1946. It should not be higher than (III) in the same supercycle. However, the extremes may be due to the fact that in 1942, Congress passed the Emergency Price Control Act. In an attempt to ward off war-time inflation during World War II, the Act created the Office of Price Administration. The Office prohibited businesses from charging more for commodities than they charged on September 15, 1942. This created an unnatural force from outside the insurance marketplace that limited the natural wave movement. The steep decline in the wave following (I), wave (II), may suggest that once the wartime controls were relaxed, insurers tightened up underwriting standards and/or increased premiums.

Conclusions

The following are the conclusions of the two reports on underwriting cycles:

• The industry is incorrect in its belief that the trend lines of underwriting cycles oscillate steadily along a horizontal axis;
• During the last thirty years the industry has done a good job in reacting to economic downturns;
• The industry has been reactive, but not proactive;
• Combined ratios are in the midst of a downward supercycle that will likely continue for at least another 14 years; and
• The next movement has already begun and it will be downward.