"I KNOW OF NO OTHER INDUSTRY or market in the world where people will knowingly or continuously sell products at a loss and take solace in the fact that they lost less than someone else." Thus spoke H. Edward Hanway, president of CIGNA Worldwide, in September 1992, the lowest point of the all too recent soft market; on what he referred to as, "that well known charity, the insurance industry."

Recently the climate has been more favorable and the last three years have given welcome relief to a lot of balance sheets. However, insurance rates have now leveled off and even started to fall within some sectors and one senses an air of helplessness among those who presumably feel unable to control their destinies.

Not everyone feels so powerless, however. A year or two before Mr. Hanway made his statement, at least one U.S. reinsurer executive in apparent anticipation of coming events took his team aside and told them he was giving them all an extra week of vacation that year-"not through benevolence," he stressed, but on the basis that "if you're writing bad business, I want you all to know it's in the company's interest for you to go and play golf."

The week of extra vacation was probably due to be awarded anyway. However, this executive was not one to pass over a unique opportunity to make a decidedly unambiguous point about underwriting bad business. It also looks to be the statement of a man confident of his strategy, rather than the type of panic reaction that presages some truly awful results three or four years later.

What is there about insurance that leads seemingly intelligent people to patently irrational behavior-and what have others picked up that has enabled them to anticipate the situation and avoid paddling their canoes over the waterfall?

Mr. Hanway deserves great credit for an excellent attempt to bring reality to the market and with that purpose his statement could not have been better phrased. However, strictly speaking he is wrong!

A soft market is purely and simply a price war. All industries have price wars and most end up selling products at a loss from time to time. So in this respect, as insurers, we do have the scant consolation of being in good company.

On the second count, however, we are on our own, and here our actions are less excusable. To knowingly sell products at a loss, one needs to master management accounting at least up to the high school level. A refresher:

Costs can be split into variable and fixed costs. Fixed costs are those that don't change with output, for example the rent on the building and the managing director's salary. Variable costs increase directly with output, such as raw material costs for a manufacturer. A firm has to sell each unit at a price that is high enough to cover the variable costs and make a contribution to fixed costs; it also has to sell enough units for the fixed costs to be covered by all of the individual contributions. Whatever is left after that is the profit.

If in a price war, a firm reduces sales prices to maintain market share, the first effect is that the profit per unit drops. If it drops the price further, it makes losses. At first, it is still better off continuing to produce, at least in the short term, because every unit sold is making a contribution toward fixed costs, if not enough to cover them. But there comes a point at which if the price drops further, every unit sold would actually make us poorer, because the price is so low that it doesn't even cover the variable costs.

Some lines of insurance, such as motor or personal lines, are typified by large volumes of similar policies where statistics allow profitability to be determined by more or less standard methods. However, in many lines-and particularly in reinsurance-variable costs are mostly comprised of claims that are erratic and cannot be neatly calculated in terms of man hours or yards of nylon cloth.

Catastrophe coverage, for example, can be written for next to nothing as long as there is no catastrophe, and catastrophes are unpredictable. Because of the inconsistency of the losses, statistics are not as helpful as we would like them to be. In manufacturing (or motor insurance) the profitability of a unit sold is a valuable piece of information. In catastrophe reinsurance-or, to take another example, industrial insurance-losses can be so much greater than the premium that the fact that a policy is sold at a profit (though it may make us feel warm inside) gives little clue to whether it was correctly priced or not.

We cannot use this as an excuse to ignore the facts. We still have variable costs and if we cannot calculate them, our profitability will be dependent on how well we estimate them.

Fixed costs on the other hand are as straightforward in insurance as in any other industry.

Their three most significant elements are generally office space, salaries and systems, in varying proportions. It is vital to survival to know them, live them and breathe them. It is also vital to survival to know, live and breathe the fixed costs of competitors, a practice commonly known as benchmarking. As in other industries, finding them out is not always straightforward and may involve some imaginative thinking, but then good business practice never has been easy.

Let us take an example of a line on Florida catastrophe cover. An underwriter may ask for $50,000, and be comfortable that over four years that will be profitable. Underwriters on the whole are quite good at knowing what prices should be, but not so good at knowing how they are made up.

So in our example, in a price war there may still be some benefit in writing the risk for perhaps $40,000. But if this equals the expected long term value of claims (variable cost), this is the limit and below that there will be no profit and no contribution to fixed costs except through short-term luck. If we then write it for $35,000, we are giving away $5,000 of shareholders' capital just as though we had written out the check. The risk may run loss free for one, two or 10 years. But in the long run, it is an inescapable fact that we would give better service to our shareholders if we left the $5,000 in the bank, and much the same service if we put it on the roulette wheel.

The depth of market cycles shows clearly that on the whole, underwriters have not overcome the difficulties of applying these principles to specialist areas of insurance. Added to the difficulties in costing, there are aspects of insurance economics which other industries don't have to put up with. Losses are random to a point, but the actions of underwriters can and do influence them.

Let us take another theoretical example. Consider a responsible client with five loss-free years on record and an appropriately low premium. In the sixth year he has a few claims amounting to, say, 20% of premium. Normally this would warrant a modest increase in premium or increase in deductible because the immaculate record has been slightly tarnished. However, it happens to be a soft market and all our accounts are vulnerable to price competition. We take what seems a very reasonable decision to hold responsible clients. To do this we are obliged to maintain the existing rate or even give a reduction.

On face value this may still be one of the better risks on our portfolio. But what are we telling our client by this action? We are telling our client that losses don't matter. And we can be sure that as he has pressing problems of his own, he will pay less attention to loss prevention. We have not just reduced the premium, we have increased the risk.

Similarly, in tough conditions it is all too conveniently forgotten that the purpose of deductibles is not to reduce the amount we have to pay on a loss, but to impose responsibility on the policyholder. When we reduce them, or for that matter broaden the terms of cover, we are reducing the responsibility that we impose on the client as his side of the bargain. The consequences of these actions, though inevitable, may take a year or two to filter through. Of course when the market hardens all this gets redressed-often in a somewhat brutal manner that causes resentment and accentuates the cycle still further. Until then we should expect loss ratios to increase, not only because of lower rates but also because of higher losses.

These phenomena are unique to insurance and have resulted in our soft markets being softer than others. But there is yet another difference between insurance and other industries which works against us and ironically ought to be a blessing: we have an easy ride with cash flow.

Manufacturers selling below cost will rapidly run out of cash, so their price wars have a necessarily limited duration. But in insurance, we can be deluded by cash pouring in for years on end, and it generally takes a major disaster or more to bring us back to reality. Many in business would give an eye to have our cash flow profiles, but in soft markets many insurers have somehow managed to turn an advantage into a liability and the result is that our soft markets are longer than they would otherwise be.

Adding these factors up, it is an economic fact that soft markets in insurance are not only softer but also longer than those of other industries. So what can we do to survive them?

If we can understand where we have gone wrong in price wars by looking at other industries, we can also look to them to understand the strategies of those who have remained profitable-a key strategy being to compete on issues other than price. In consumer business, non-price tactics are very apparent-advertising, free air miles, and many others. But it is now becoming accepted in centers of business expertise that the long and the short of it is that the ones that can stand the pain the longest are invariably the ones with the lowest overall costs. Other strategies can win battles but on the whole they don't win wars because they can mostly be copied. Deep pockets can help, but how long can they last if you are giving away money with every unit sold, while your competitors are breaking even?

A maxim often used in respect of consumer products is "never compete on price (profitability generally comes from having reasons other than price to distinguish your product) but always compete on cost." When applied to insurance, the emphasis has to be on cost because product differentiation is difficult.

Variable costs/claims can be controlled to some extent by good underwriting, but as even the best risks have claims, there comes a point beyond which it is low fixed costs that count.

In manufacturing (and in many service industries) the importance of costs is very apparent and so the concepts are well understood in those realms. When I moved from industry to insurance it was natural to question some of the salaries and expenses that were approved without an evaluation of benefit. The answer: "Insurance is about security, so credibility is important and consequently you need a respectable office; when you're dealing with large sums of money, you must have good accountants; an underwriter can take half a million dollars of premium in a day, you have to have the best."

This line of thinking is difficult to argue against until the realization dawns that it is often about establishing comfort zones. I don't think the danger of this can be overestimated, but the real damage is worse: it provides a smoke screen to the true competitive aspects of the industry.

Salaries commonly make up 50% or more of fixed costs of insurers. How should they relate to premium volume? A million dollars of premium might equate to a billion dollars of liability. Is that a million dollar book or a billion dollar book? When considering pay increases, we should keep in mind that in terms of profit it is likely to be less than $100,000. A small rise for the team of people required to service the book can easily take this up and of course makes it more difficult to compete on price.

What about the need for prestigious offices? A company that stands out perhaps above all others as being able to name its terms when selling insurance is Berkshire Hathaway Inc. I am told, though, that their offices are "nothing special to look at." What Warren Buffet does in setting their strategy is look after his capital and keep his prices above the variable cost of his product. His success suggests this matters to both clients and stockholders more than marble in the entrance hall. That is not to deny that there may often be good business sense in prestigious offices, but it can just as often be a weak tactic to make up for not having the fundamentals right. Anyone looking at benchmarking would do well to match Berkshire Hathaway.

However, is it not worth paying whatever it takes to get a good underwriter? Underwriting is about avoiding losers rather than picking winners. Underwriters do not have the potential which, for example, fund managers have of identifying star performers that will make a portfolio shine even when the market as a whole is uncompetitively priced. Underwriters offering insurance below the variable cost will always be reduced to Mr. Hanway's problem of "taking consolation in losing less than anyone else."

It is a manager's duty to employ competent staff; but maintaining comfort zones at the expense of obtaining value for money is surely breaching the trust bestowed by the shareholders.

With the benefit of hindsight, that reinsurer executive's method of saving money by sending his underwriters out of the office is patently obvious. Though he didn't actually drive them out of the building, he did make it unequivocally clear that he was prepared to sacrifice premium volume and was not prepared to take on underpriced business.

Interestingly, when David Rowland assumed the chairmanship of Lloyd's of London, he wasted no time in attacking costs, particularly salaries-not only those of underwriters but throughout the system. With combined losses of the past five years threatening to break the 8 billion ($12 billion) mark, many argued that this inherently unpopular move was irrelevant.

I don't think it is coincidental that David Rowland was formerly a broker.

Brokers, like manufacturers, work on tight margins and understand their costs. So as we all nervously watch the movement of rates, some people-including many in Lloyd's and I assume at that U.S. reinsurer-are anticipating a reduced work load, if not some time outdoors.

For the rest of us, the time to engineer a competitive position is now.

Would you like advice from an experienced colleague on a risk management, benefits management or actuarial problem? Four quarterly features in the Perspective section of Business Insurance can give you some answers.

Ask A Risk Manager, Ask A Benefits Manager, Ask A Benefit Actuary and Ask A Casualty Actuary answer written questions from readers on risk and benefits management issues and actuarial problems.

This month's column on risk management issues is written by Susan M. Werner, director of risk management at Hardee's Food Systems Inc. in Rocky Mount, N.C. Dennis J. Nirtaut, managing director of compensation and benefits for Arthur Andersen & Co. S.C. in Chicago, answers questions on employee benefit plans. William J. Miner, an actuary with Watson Wyatt Worldwide in Chicago, answers actuarial questions on benefits issues. And, Richard E. Sherman, president of Richard E. Sherman & Associates Inc. in Ashland, Ore., answers actuarial questions in the casualty field.

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