Capital Flows and Underwriting Cycles in Liability Insurance

Abstract

Reported underwriting profits in property-liability insurance are characterized by significant cyclical fluctuations. The pricing pattern usually identified as the underwriting cycle is portrayed in figure 5-1, which shows the all-lines combined ratio for the period 1951 to 1987. Venezian (1985) identified the cycle as a second-order autoregressive process. The cycle in figure 5-1 is statistically significant and approximately six years in length. The presence of significant autoregression in prices and profits would not seem to be characteristic of a rational market (see, e.g., Abel and Mishkin, 1983). In property-liability insurance, however, cycles are not necessarily inconsistent with rationality. Cummins and Outreville (1987) have shown that cycles can occur in property-liability insurance markets even if prices reflect rational expectations. They demonstrate that intervention factors, such as policy renewal lags, information lags and regulatory delays, can create autoregressive patterns very similar to those observed in actual insurance markets.