Auto Insurance Cycles

The 2005 annual report of Progressive presents an impressive graph. It depicts the rarity of the recent trend of profitable underwriting. The profits of the last three years have been unmatched since the late seventies. Inquiring minds will want to know: what's the similarity? For my part, I believe that investment returns had been miserable then, as they have been recently. When profitable investments justify underwriting insurance at a loss (as was the case in the eighties and nineties), then companies compete to irrational pricing levels. If this reasoning is correct, there is no reason to expect that the cycle will change dramatically, as investment profits are still uncertain.

(By the way, thank my daughter Tessa for this first blog image. Without her help, I could not have gotten it done.)

The World of Risk according to MBIA

MBIA is the world's leading firm in credit enhancement - similar to the dangerous business of "co-signing" a loan - but getting paid for it. MBIA has insured $2 trillion of debt with a loss rate of only .04% or 4 basis points. That's alot better than the record of most "co-signers." As a recent test of this "no-loss" approach, MBIA's $33 billion balance sheet only had to pay out $2 million for the hurricane damages last year, and has already been fully reimbursed. Risk is MBIA's specialty.

MBIA's comments in the 2005 annual report confirm some of my observations on risk: "We believe the perception of risk is very much understated relative to the level of real risk in today's market." CEO Gary Dunton does not explain what he views as the cause of such a change, only stating, "we do not believe that the characteristics of today's market reflect a new and permanent economic paradigm."

The annual report does not state how extreme today's case is. A normal spread between a "credit enhanced" AAA and a AA 10-year municipal bond is 25 basis points. So, on $10 million, the "credit enhanced" AAA issuer gets to pay $25,000 less in interest for the higher rating. What is the spread in today's ebulliant period? Zero.

MBIA went through a similar situation in 1999, when a powerful economy and excitement over technology stocks combined to remove any sense of risk. Then and now, MBIA'a underwriting revenues dropped significantly. The business cycle may have been tempered, but the risk cycle is alive and well.