Fear is the Key: A Behavioral Guide to Underwriting Cycles

Abstract:     
Although the traditional economic explanations of insurance underwriting cycles add to our understanding of the phenomenon, as explanations for the cyclical nature of insurance markets they go only so far. While identifiable phenomena such as the "pricing problem" (i.e., the inability of insurers to calculate their cost of goods sold at the time a policy is underwritten) and the "interest rate problem" (i.e., the dependence of insurers on investment income to generate earnings) can be viewed as immediate causes of the unusual volatility of liability insurance markets, other forces are at work at a more basic, behavioral level - forces that are given particular reign by the lack of certainty inherent in pricing a product designed to indemnify unpredictable future losses. First and foremost is competition for revenue and market share, which as a practical matter drives the day-to-day behavior of underwriters to a far greater degree than concerns with ultimate profitability. Underwriters - like everyone else in business - are motivated by (i) the desire for financial reward and (ii) fear of losing employment or opportunities for advancement. And, during all but the absolute peaks of the underwriting cycle, underwriters are evaluated according to the amount of premium they can generate. The second factor is what can best be described as the ebb and flow of bureaucratic influence within an insurer that accompanies shifts in perceived profitability. The third factor is the influence of insurance agents and brokers on the pricing behavior of insurers, and the consequences of that influence.

Keywords: insurance, underwriting, insurance pricing, torts, medical malpractice, directors and officers, errors and omissions, underwriting cycle, insurance pricing

JEL Classifications: G22, K13

Accepted Paper Series