The commercial insurance premium market cycle is near bottom andgeneral commercial insurance prices will start to rise by thefourth quarter of 2009 or the first quarter of 2010, Advisen Ltd.,predicted earlier this week.

Advisen estimated the property-casualty insurance industry wasroughly $100 billion overcapitalized as of the end of 2007. It saidpolicyholders' surplus–statutory accounting terminology for thecapital supporting underwriting operation–needed to be reduced byabout $100 billion through losses, dividends, share buy-backs orother means to bring insurance supply in line with demand.

Advisen said that U.S. policyholders' surplus declined $36.8billion, or 7 percent, for the 12 months ended Sept. 30, 2008,according to A.M. Best. Consultancy Towers Perrin forecasted asmuch as an $80 billion decrease in surplus by the end of 2008.Advisen added that while $80 billion represents a significant sumof the $100 billion in excess capacity–moving the market muchcloser to the bottom of the soft market cycle–the demand side ofthe equation also has changed since the end of 2007.

According to the International Monetary Fund, Advisen said, theglobal economy is now in a recession, with growth projected at 2.2percent for 2009, down from 3.7 percent projected for 2008. The IMFprojected that advanced economies as a group will contract 0.3percent, with the U.S. contracting 0.7 percent.

“In years past, insurance companies recouped underwriting losseswith investment income, but in 2008 the combination of underwritinglosses and material investment losses means a five-year soft marketis coming to an end,” David K. Bradford, Advisen executive vicepresident and chief knowledge officer said in a statement. “Theglobal recession may delay the return of hard market conditions bykeeping demand for insurance down, but once the hard market setsin, it is likely to last longer than was the case in recentcycles.”

The report explained that the commercial insurance pricing cycleis a function of the law of supply-and-demand. When the supply ofinsurance–as measured by the capital held by insurers to supportunderwriting–grows faster than the growth in demand for insurance,rates fall. Between the fourth quarter of 2003 and the secondquarter of 2008, capital to support underwriting grew rapidly,driven by underwriting profits and strong investment returns. Therapid accumulation of risk capital fueled competition, driving downrate levels.

Advisen said that in mature economies, such as the U.S., Canadaand Western Europe, the demand for insurance grows about the samepace as the overall economy. Until the collapse of the U.S.subprime mortgage market threw the global economy into a recession,economic growth was robust–although the increase in insurancesupply far outstripped the growth in insurance demand.

The economic crisis impacts both the supply of and the demandfor commercial p-c insurance, Advisen said. On the supply side,plummeting stock markets, frozen credit markets and in some cases,investments in “toxic” mortgage-backed assets caused many insurersto post investment losses in the third quarter.

These investment losses are on top of underwriting losses drivenby five years of price cutting, higher than average catastrophelosses ($24.9 billion, higher than the full year totals for both2006 and 2007), and reserves for directors and officers liabilityand errors and omissions liability claims resulting from thesubprime mortgage meltdown and the subsequent credit crisis ($9.6billion in ultimate losses over accident years 2007, 2008 and 2009,according to Advisen forecasts).

Through nine months of 2008, the U.S. p-c industry's net incomeafter taxes fell 85 percent to $7.3 billion according to A.M. Best.After-tax return on equity (return on surplus), was only 1.4percent for the nine month period; down from 9.5 percent for thesame period of 2007. Best projects the first full-year underwritingloss since 2005, Advisen said.

According to Advisen, as companies downsize, the demand forinsurance not only decreases, it decreases at a pace faster thanthe contraction of the overall economy.

While going without insurance is not an option for mostcompanies, many will look for ways to slash their insurance bills.An obvious option is to raise retentions–which will increase theuse of captives and other alternative risk financingmechanisms.

Advisen said that more companies will also gravitate to low-costproviders, even if it is necessary to loosen financial securitycriteria. Although these are typical responses to hard marketconditions, it is likely that companies will resort to them evenbefore the market turns as they are squeezed by a deterioratingeconomy. All these factors will help prolong the current softmarket, Advisen said.

One thing that could keep market conditions competitive in somesectors is a weakened AIG battling for renewals, Advisen said.Because AIG is perceived by its competitors as vulnerable,competition for its clients will remain intense. This heightenedlevel of competition could keep price levels in some segments ofthe commercial lines market depressed after economic factorsindicate the market should be hardening.

Advisen added that one or more very large catastrophe lossescould trigger a sudden and sharp increase in insurance prices. Ifcatastrophe losses are mild-to-moderate in 2009, average commercialinsurance prices will begin to creep higher in the fourth quarterof 2009 or the first quarter of 2010.

Not every line of business will increase at the same pace,Advisen said. Premiums already have increased for financialinstitution D&O and E&O, where claims are up sharplybecause of the meltdown of the subprime mortgage market and theensuing credit crisis.

The reinsurance market will firm up sooner than the overallprimary insurance market, placing upward pressure on heavilyreinsured lines such as excess liability, Advisen observed.