Underwriting and Credit Cycle Circles

An article from Buttonwood in March reviewed a book by Thomas Aubrey – “Profiting from monetary policy – investing through the business cycle”. Aubrey argues that credit cycles are better predictors of equity and asset prices rather than economic growth. Differentials between the cost of capital and the return on capital drive capital supply.

In previous presentations on the insurance sector and the factors affecting underwriting cycles, I have used the credit cycle as an explanation for demand and supply imbalances. Given the current influx of yield seeking capital into the wholesale insurance market, by way of new risk transfer mechanisms in the ILS sector, and the irrational cost of capital driven by loose monetary policy around the world, Aubrey’s arguments make sense.

Using the calendar year combined ratios of the Lloyds of London insurance market as a proxy for the wholesale market, discounting such ratios at the risk free rate for each year with an assumed payout duration, and comparing these to an index of S&P defaults by origination year illustrates the relationship.

The more recent impact of natural catastrophes from 2005 and 2011 illustrates the higher concentration of shorter tail business lines in the past decade as interest rate reductions make longer tail lines less attractive.

Of course, no one factor drives the insurance cycle and there may be a degree of circularity in this picture. Many of the losses at Lloyds in the 1980s and 1990s came from asbestos and pollution claims, issues which drove many companies into insolvency. There is also a circularity between the insurance losses from the events of 9/11 and the economic impact following the bursting of the internet bubble. In addition, there are limitations in comparing calendar year ratios which includes reserve deterioration (particularly from asbestos years) against defaults by origination. Notwithstanding these items, it’s an interesting graph!