Understanding market cycles
|Chart provided by Insurance Information Institute, iii.org|
Commercial insurance buyers who have been in business for a while have experienced firsthand the cyclical nature of the insurance market.
Even if a business is static, the rates it pays for insurance will fluctuate up or down. Why is that?
Competition is a big factor. There are nearly 2,700 property and casualty insurance companies in the U.S. and American Rental Association (ARA) members are served by no less than 24 different companies. Competition is fierce. As insurance companies strive for more share of a given market, such as the rental industry, they lower rates to attract more customers. They also may soften underwriting guidelines, so more customers fit their model. Other insurance companies, which typically don’t write a particular class of business, will enter the market to get a piece of the action, which further increases competition. The result is even lower rates and softer underwriting, and is aptly called a “soft market.”
However, losses eventually catch up to the rates, especially for companies unfamiliar with their markets. They realize they are not charging enough for the risks they’re taking. They raise rates and tighten underwriting guidelines, and may even get out of certain markets altogether. In a “hard market,” all buyers pay more for insurance and higher risk businesses — such as equipment rental companies as compared to office buildings — get hit the hardest with higher premiums.
Another factor in insurance market cycles is changes in interest rates. Insurance companies are required by law to retain surplus capital, typically about 50 percent of their total premium, and they earn interest on that capital. As interest rates rise, there’s enough surplus to write more business, so they lower rates and loosen underwriting guidelines to attract the business, and the soft market returns. The opposite happens when interest rates drop — insurance companies must rely solely on underwriting profit, so rates increase, guidelines tighten and the market hardens.
Other factors also affect insurance market cycles. The market softens in a declining economy, for example, because premiums are based on customers’ revenues and assets. As customers bring in less revenue and cut insured assets, insurance companies lose premium and make up for it by lowering rates to draw new customers. On the contrary, rising medical costs, unfavorable changes in laws and significant catastrophic losses harden the market because insurance companies are forced to raise rates to make up for expensive losses.
The length and severity of the peaks and valleys vary by the factors that affect them. Typically, the longer and deeper the soft market, the steeper the rate increases during the hard market and the longer the increases last. While ARA Insurance must follow the ebb and flow of the market to some degree, the company strives for stability. ARA Insurance can weather the cycles because the company understands the rental risk and is dedicated to it. Losses will not surprise ARA Insurance and the company will not leave the equipment rental industry market or enter others. Instead, ARA Insurance uses risk management to temper rate increases. — Phil Kelling
The need for captive insurance
The American Rental Association (ARA) established a captive insurance company, ARA Insurance Ltd., in 2001 to complete its insurance program. A captive insurance company is defined as an insurance company, closely held, supplied by and controlled by its owners; most captives only insure the business of the parent.
In ARA’s case, the captive bears risk for the ARA members who buy their insurance from ARA Insurance, ARA’s agency. Owning its own insurance company makes the ARA-endorsed program unique in the industry — no other program for rental dealers participates in the
risk-bearing aspect of insurance.
When the insurance marketplace is very competitive, as it has been for the last several years with some companies selling below cost, it can be somewhat difficult to understand the benefits of owning your own insurance company.
However, those benefits are very real. On a short-term basis, ARA Insurance Ltd. has earned some profit during recent years and this profit belongs to ARA rather than the external insurance company that issues the policies. Even more important are the long-term benefits. By taking a share of the risk via the captive, ARA Insurance Ltd. is able to offer the best coverage and can do the underwriting of the risks through ARA Insurance, closely monitor claims handling and be the driver of risk management activities and innovations.
ARA Insurance Ltd. can do these things because, as ARA’s insurance company partner, they listen to the association since it shares the risk with them. When the marketplace changes and premiums start going up, ARA members will benefit as the ARA program will be able to better stabilize pricing. Also, the ARA program will provide access to insurance when some insurance companies abandon the rental class of business.
Without the risk participation provided by ARA Insurance Ltd., ARA would not have the influence to steer and maintain a stable program that leads the marketplace and ensures a long-term program that meets the insurance needs of ARA members. The two keys are availability and reasonable stability — this is what ARA brings to the table for the insurance needs of its members. — Linda Crookshanks