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Stationarity and stability of

underwriting profits in
property-liability insurance
Part II

Property-liability
insurance:
Part II
49

Chao-Chun Leng
Towers Perrin, Philadelphia, Pennsylvania, USA
Abstract
Purpose To examine the existence of underwriting cycles for the property-liability insurance
industry as a whole, and by line of business. Specifically to consider whether the combined ratio is
stationary and stable.
Design/methodology/approach The augmented Dickey-Fuller (ADF) test is employed for unit
roots, while dummy variable methods, the Chow test, and switching regression are used for stability.
Findings Underwriting profits of most lines of business and all lines combined are not stationary
and have structural changes. For the whole property-liability industry, a structural change occurred in
1981. Before the change, underwriting cycles existed since combined ratios followed an AR(2) process.
After the change, combined ratios are non-stationary.
Practical implications Without clear underwriting cycles, there is more difficulty for the
insurance industry in pricing and reserving, for regulators in monitoring the financial strength of
insurers, and for customers in terms of the affordability and availability of insurance.
Originality/value The paper recognizes the non-stationarity of combined-ratio series, years of
structural changes in the insurance industry and specific lines of business, and the possibility that
underwriting profit is cointegrated with investment income.
Keywords Underwriting, Property insurance, Insurance liability
Paper type Research paper

Introduction
In Part I of this work, we pointed out the severity of analyzing the underwriting cycle
with non-stationary or not stable series. More detailed analysis is needed to confirm the
preliminary results from Part I.
It is important to check the stability of a series before taking differences because
some properties of a series exist only on the original scale, but not after taking
differences. It is also important to be aware that a unit root test may indicate that a time
series is not stationary, when in fact the series is stationary but has undergone a
structural change during the sample period. In this case, neither taking differences nor
using a deterministic time trend will work well.
If the combined ratio is stable but not stationary, then the methods that make this
series stationary should work properly. If the combined ratio is not stable, apparent
non-stationarity may arise from the structural changes even though the sub-series
before and after the structural changes are stationary. Then, it is appropriate to inquire
what and when the change or changes might have been, and what might have caused
them. This research not only updates prior studies, but also extends them by

The Journal of Risk Finance

Vol. 7 No. 1, 2006
pp. 49-63
q Emerald Group Publishing Limited
1526-5943
DOI 10.1108/15265940610637807

JRF
7,1

50

conducting stationarity and stability analyses to bring different perspectives of

underwriting cycles.
Methodology
Stationarity tests: augmented Dickey-Fuller (ADF) test for unit roots
The augmented Dickey-Fuller (ADF) test is used to test for a unit root. This test is
based on the assumption that the time series is stable (Balke, 1991).
Haley (1993, 1995), Grace and Hotchkiss (1995), and Fung et al.(1998) did not include
either drift or time trend in their ADF tests. However, Venezian (1985) and Cummins
and Outreville (1987) implied that there was a time trend in their variables. Harrington
and Yu (2000) conclude that a drift and a time trend should be included in the analysis.
Since the expected value of CR is not zero, a drift in the test is expected. If CR has a
positive (negative) time trend, then CR will increase (decrease) as time goes by.
However, CR cannot go up or down without a limit. Even if CR has a trend, it would be
just a temporary phenomenon[1]. Therefore, the ADF test for CR should have a drift
but without a time trend:
1 2 L CRt c a CRt 2 1

p
X

gi 1 2 L CRt 2 i 1t ;

i1

where L is the lag operator and p is the total number of lags. The number of lags
included in the test is obtained by minimizing the Akaike Information Criterion (AIC)
and the Schwarz Criterion (SC). The null hypothesis is a 0; that is, CR has a unit root
or is non-stationary. MacKinnon critical values are used instead of the traditional t-test
to adjust for downward bias from ADF tests.
Stability tests
The dummy variable method. The dummy variable method[2] for CR as an AR(2)
process is as follows:
CRt c aCRt 2 1 bCRt 2 2 dD eDCRt 2 1 fDCRt 2 2 u; 2
where D 0 before the structural change and D 1 after the structural change.
The Chow test. Let t0 be the year of structural change. We fit an AR(2) process for
the entire period and for two sub-periods as follows:
CRt1 c1 a1 CRt1 2 1 b1 CRt1 2 2 1t1 ;
and
CRt2 c2 a2 CRt2 2 1 b2 CRt2 2 2 1t2 ;
where t 1 2T 1 , t 2 2T 2 with T1 and T2 being sets of years in the sub-periods before and
after the structural change, respectively. The sum T T 1 T 2 denotes the whole
data period. An F-statistic is used in the Chow test to see whether c1 c2 , a1 a2 , and
b1 b2 , simultaneously.

Switching regression. The log-likelihood ratio (LLR) is given by

1
l T 1 log s21 T 2 log s22 2 T log s 2 ;
2
where 2 2l approaches a chi-square distribution with k degrees of freedom, where k is
the number of parameters. The null hypothesis is that there is no structural change at
t0. To estimate t0, we maximize the LLR. The behavior of the LLR shows not only the
stability of the regression, but also whether structural changes have occurred
gradually or abruptly.
We use both the Chow test and switching regression[3] to find the years of
structural changes because both methods have their own individual limitations[4] (see
Poirier, 1976). Combining both methods may reduce these limitations and confirm the
results.
Having learned the exact years of the structural changes, we use the dummy
variable method to obtain separate results for each sub-period for which no structural
changes have occurred. If the difference in cycle lengths before and after the structural
change is significant, then structural change plays an important role in changing the
nature of the underwriting cycle.
Results
We proceed through a sequence of hypotheses to determine whether a change in CRs
properties has taken place. First, the ADF test is used to check stationarity. By
minimizing AIC and SC, we find that the number of lags ( p) in the summation term of
equation (1) is one. The results of the ADF test for CR (in Table I) show that inland
marine and private passenger auto physical damage are found to be significantly
stationary at the 5 percent level.
As mentioned in the discussion of Hypothesis 2, we check for structural changes in
the chosen years[5]. Since the private passenger auto physical damage and inland
marine series are stationary, they are excluded from the structural change analysis.
The results for a structural change in 1984 are reported in Table II[6]. Most coefficients
are not significant, which suggests that even though the liability insurance crisis seems
to have a substantial impact on the insurance industry, this impact did not extend to
most lines. Thus, the underwriting results of individual lines seem to behave
independently and we expect they may have structural changes in different years.
Since the chosen years do not show significant changes for most lines, we accept that
the years of structural change are unknown and thus we need to find the year of
structural change for each line.
The Chow test and switching regressions are used to find out whether or not a
structural change occurred, and if it did, to determine when it occurred. Table III shows
the results from the Chow test and switching regression method for the industry CR.
Even though both methods are used, we expect the results should be consistent. In
Table III, the values of the F-statistics and log-likelihood ratios (LLRs) are highly
correlated, but LLRs usually indicate greater significance than F-statistics. Also, two
different time periods for the industry data are used to check the reliability of the
shorter time periods results. Even though the longer series is more significant, both
series are quite consistent. However, the most significant F-statistic and LLR for CR is

Property-liability
insurance:
Part II
51

JRF
7,1

52

Table I.
Augmented
Dickey-Fuller test for
combined ratios

Constant
Line
Fire
FO
AEQ
HO
CMP
OM
IM
WC
MM
OL
AIR
PAL
CAL
PAPHD
CAPHD
FD
ST
BT
BM
RE
CR
CR1

Coefficient
49.752
67.521
89.992
51.430
35.175
55.057
45.218
26.497
27.137
45.215
41.573
16.752
35.440
61.169
38.772
28.438
22.422
13.648
54.513
83.429
23.927
39.198

CRt 2 1
t-value
2.460
2.519
2.756
2.008
2.274
2.684
3.103
2.170
1.486
2.411
1.907
1.416
2.857
3.097
2.930
2.101
1.367
2.074
2.275
2.407
2.787
2.108

Coefficient
20.506
20.627
20.873
20.476
20.330
20.515
20.478 * *
20.256
20.230
20.386
20.388
20.156
20.315
20.636 * *
20.412
20.311
20.257
20.194
20.569
20.735
20.234
20.373

t-value
2 2.462
2 2.524
2 2.831
2 2.007
2 2.279
2 2.694
2 3.116
2 2.189
2 1.526
2 2.466
2 1.954
2 1.433
2 2.860
2 3.106
2 2.936
2 2.140
2 1.502
2 2.218
2 2.308
2 2.416
2 2.772
2 2.120

Notes: *10 percent significance; * *5 percent significance; * * *1 percent significance

in 1981, but the most significant year for CR1 is 1993. This shows that both methods
have limited power at the beginning of the period. Therefore, the time period chosen for
this analysis is very important. If we allow more than one breakpoint, i.e. the
breakpoints in 1981, 1986, and 1993, both periods have the same results. But with our
data period, it is more likely to have only one breakpoint. In this case, we accept that
the year of structural change for the industry is 1981. Figure 1 presents LLR by year
for CR from 1952 to 1997, and shows that the structural change in the insurance
industry occurred gradually and reached its peak at 1981.
Tables IV-VI present the results of the Chow test and switching regression by line.
When the LLRs and F-statistics are significant in only one year for a given line of
business, it indicates that the structural change happened abruptly and the shock of
the change did not carry on for more than one year. Some lines, such as farmowners
multiple peril, allied lines and earthquake, ocean marine, workers compensation,
commercial auto liability, and reinsurance, have abrupt structural changes. Since some
lines do not have any year with significant F-statistics and LLRs at the 10 percent level,
we conclude that these lines did not undergo a structural change in the time period.
These lines are fire, aircraft, commercial physical damage, and boiler and machinery.
Most lines have more than one year with LLRs and F-statistics significant at the 10
percent level. This means that the structural changes occurred gradually and the shock
carried on for several years. The year with the most significant F-statistics and LLR is

1.031
0.623 *
0.740
0.735
1.415 * * *
0.584
1.290 *
1.320 * *
1.486 * * *
0.059
0.891 * * *
1.918 * * *
0.974 * * *
0.870 *
0.522
1.331 * * *
0.967
1.720
1.205 * * *
1.282 * * *

1.277
1.971
0.422
0.856
3.299
1.334
2.058
2.592
3.374
0.112
3.078
5.126
2.886
1.948
1.500
8.016
1.544
0.827
3.134
6.138

2 0.238
2 0.294
2 0.268
2 0.574
2 0.519
2 0.045
2 0.893
2 0.572
2 0.954 *
0.446
2 0.564 *
2 1.200 * *
2 0.754 *
2 0.755
2 0.159
2 1.007 * * *
2 0.463
0.588
2 0.778 *
2 0.674 * * *
20.311
20.819
20.168
20.705
20.900
20.115
21.327
20.827
21.824
0.790
21.753
22.118
21.954
21.548
20.464
25.350
20.662
0.154
21.821
23.030

46.218
5.893
56.031
25.680
53.173
12.425
228.790
27.999
17.519
211.183
266.026 *
16.027
240.482
251.949
245.575
229.085 * *
20.513
248.641
8.707
27.911

0.579
0.101
0.303
2 0.055
1.121
0.236
2 0.632
2 0.151
0.338
2 0.145
2 1.750
0.434
2 1.035
2 0.899
2 0.951
2 2.093
0.291
0.857
0.161
0.892
20.479
20.433
20.762
20.576
20.587
0.402
20.083
20.596
20.710
0.617
0.555
20.856 *
0.194
20.129
0.346
20.862 * *
20.695
21.546
20.651
20.728 * *

0.180
0.006
20.226
0.111
0.587
0.337
0.714
0.590
0.519
0.229
0.785
0.775
0.636
0.647
0.455
0.925
0.003
20.102
0.444
0.732

D84*CRt 2 2
Adjusted
Coefficient t-value
R2

20.567
0.022
0.028
20.954
0.403
0.812
20.431
0.312
0.193
20.645
0.732
0.859
21.192
0.113
0.180
0.776 2 0.521
2 1.015
20.125
0.392
0.555
21.029
0.609
0.820
21.408
0.612
1.060
1.040 2 0.490
2 0.786
1.275
0.074
0.147
22.014
0.726
1.210
0.471
0.207
0.458
20.252
0.527
0.982
0.754
0.107
0.229
22.535
1.130 * * *
3.894
21.029
0.508
0.681
20.736 2 0.754
2 0.197
21.358
0.600
1.157
22.404
0.497
1.566

D84
D84*CRt 2 1
Coefficient t-value Coefficient t-value

Notes: *10 percent significance; * *5 percent significance; * * *1 percent significance

Fire
20.286
0.271
FO
70.564 *
1.797
AEQ
49.983
0.277
HO
83.118
0.856
CM
10.961
0.269
OM
49.978
1.088
WC
59.866
1.415
MM
33.059
0.679
OL
51.611
1.190
AIR
51.147
0.700
PAL
70.289 * *
2.183
CAL
30.588
0.912
CAPHD
75.451 *
2.094
FD
91.713
1.638
SR
61.078
1.399
BT
54.666 * * *
4.820
BM
46.096
0.733
RE
2 134.741
2 0.471
CR1
58.106
1.417
CR
38.902 * *
2.514

Constant
CRt 2 1
CRt 2 2
Coefficient
t-value Coefficient t-value Coefficient t-value

Property-liability
insurance:
Part II
53

Table II.
Dummy variable method
with 1984 as the year of
structural change

JRF
7,1

54

Table III.
Industry structural
changes by Chow test
and switching regression
method

CR
Year

F-statistic

1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
SC

0.350
0.143
0.494
0.580
0.540
0.611
0.651
0.454
0.438
0.471
0.972
0.703
0.682
0.647
0.993
1.776
2.203
2.160
1.660
1.634
2.511 *
4.150 * *
4.632 * * *
4.664 * * *
5.058 * * *
4.673 * * *
3.668 * *
3.211 * *
3.338 * *
4.550 * * *
4.157 * *
4.286 * *
3.892 * *
3.499 * *
4.063 * *
4.089 * *
4.409 * * *
1.147
0.604

p-value

LLR

0.789
1.201
0.933
0.494
0.688
1.685
0.632
1.968
0.658
1.837
0.612
2.074
0.587
2.206
0.716
1.549
0.727
1.494
0.704
1.606
0.416
3.253
0.556
2.378
0.568
2.308
0.590
2.193
0.407
3.320
0.168
5.773
0.104
7.054 *
0.109
6.929 *
0.192
5.419
0.198
5.338
0.073
7.957 * *
0.012
12.468 * * *
0.007
13.713 * * *
0.007
13.795 * * *
0.005
14.784 * * *
0.007
13.817 * * *
0.020
11.190 * *
0.034
9.942 * *
0.029
10.292 * *
0.008
13.503 * * *
0.012
12.487 * * *
0.011
12.825 * * *
0.016
11.789 * * *
0.025
10.734 * *
0.013
12.241 * * *
0.013
12.311 * * *
0.009
13.141 * * *
0.343
3.813
0.616
2.051
1981, 1981 1986 and 1993

p-value
0.753
0.920
0.640
0.579
0.607
0.557
0.531
0.671
0.684
0.658
0.354
0.498
0.511
0.533
0.345
0.123
0.070
0.074
0.144
0.149
0.047
0.006
0.003
0.003
0.002
0.003
0.011
0.019
0.016
0.004
0.006
0.005
0.008
0.013
0.007
0.006
0.004
0.282
0.562

F-statistic

CR1
p-value

LLR

p-value

1.484
0.254
5.350
0.148
1.871
0.173
6.562 *
0.087
1.954
0.159
6.814 *
0.078
2.171
0.129
7.460 *
0.059
2.075
0.142
7.176 *
0.067
1.487
0.254
5.360
0.147
1.171
0.350
4.319
0.229
1.466
0.259
5.291
0.152
2.112
0.137
7.286 *
0.063
1.859
0.175
6.526 *
0.089
2.000
0.152
6.952 *
0.073
1.904
0.167
6.662 *
0.084
1.858
0.175
6.523 *
0.089
2.220
0.123
7.605 *
0.055
2.248
0.120
7.685 *
0.053
2.751 *
0.075
9.103 * *
0.028
0.741
0.542
2.827
0.419
0.548
0.656
2.125
0.547
1993, 1981 1993, 1981 1986 1993

Notes:: F-statistics are from the Chow test; log likelihood ratios (LLR) from switching regression
follow a x 2 distribution; SC is the year of structural change; *10 percent significance; * *5 percent
significance; * * *1 percent significance

conventionally taken as the breakpoint. The year of structural change for each line is
listed on the bottom line in Tables III-VI.
The next step is to apply the dummy variable method to every line with structural
change. The results are shown in Table VII. The significant coefficients and the

Property-liability
insurance:
Part II
55
Figure 1.
The behavior of
log-likelihood ratios
(LLRs) for the combined
ratio

improvement of the adjusted R 2 imply that the explanatory power of the AR(2) process
for CR increases significantly by identifying the years in which structural changes
occurred.
There is another issue worthy of attention. For the AR(2) process as in equation (2),
a is expected to be positive and b to be negative. When structural changes are involved,
e and f are expected to have signs consistent with a and b. However, the results in
Table VII show that e and f have opposite signs to a and b and that the coefficients
cancel each other out. In other words, most lines followed AR(2) processes before the
structural changes, but AR(1) after the changes[7].
For lines that are non-stationary and have no structural change fire, aircraft,
commercial auto physical damage, and boiler and machinery we use the first
difference of CR to run AR(2) processes. Unfortunately, the coefficients are not
significant and the explanatory power of the AR(2) process is not satisfactory.
Our final step is to compare the cycle lengths before and after the structural
changes. Table VIII presents the cycle lengths of all lines from an AR(2) process
without time trend, with a time trend, of those lines without structural changes, and of
those lines with structural changes. AR(2) processes with time trend is the same model
as Venezian (1985) and Cummins and Outreville (1987), but the cycle lengths are very
different from these two studies. Many lines are not cyclical, which makes it difficult to
compare cycle lengths before and after the structural changes. The change of cycle
lengths, increasing number of non-cyclical CRs, and switching from AR(2) process to
AR(1) show that the nature of the time series properties of CR has changed.
Conclusions
Traditionally, the AR(2) process plays an important role in modeling underwriting
margin, explaining underwriting cycles, obtaining the cycle lengths, and predicting
when a soft or hard market is coming. In recent years, the AR(2) process seems to have
reduced explanatory power for the underwriting margin. Structural changes may
explain the observed changes in the underwriting cycle, such as long cycle lengths and
the low explanatory power of the AR(2) process.
Figure 2 shows that CR underwent a structural change in 1981. According to the
definition from Balke (1991), CR is consistent with a shifting trend rather than a

0.814
1.395
2.939 *
1.352
1.366
0.514
0.497
0.303
0.312
0.322
0.441
1.181
1.030
1.048
0.947
1.216
0.748
1.538

3.087
5.062
9.610 * *
4.921
4.969
1.995
1.934
1.199
1.234
1.271
1.722
4.355
3.840
3.904
3.553
4.472
2.851
5.522
1980

Farmowners
F-value
LLR
0.243
0.967
0.289
1.145
0.286
1.132
0.260
1.031
0.297
1.174
0.285
1.127
0.253
1.006
0.259
1.029
0.271
1.076
0.437
1.708
0.792
3.008
1.333
4.859
0.937
3.518
1.089
4.044
1.637
5.837
1.594
5.702
2.842 * *
9.350 * *
0.818
3.102
1994

AEQ
F-value
LLR
0.545
0.807
0.848
0.836
0.932
0.868
0.940
0.904
0.775
0.948
1.802
2.784 *
2.550 *
2.908 *
2.543 *
3.006 *
0.489
0.501

2.112
3.062
3.209
3.167
3.502
3.279
3.529
3.404
2.948
3.559
6.350 *
9.193 * *
8.547 * *
9.527 * *
8.525 * *
9.789 * *
1.904
1.950
1993

Homeowner
F-value
LLR
1.185
1.759
1.672
2.098
1.552
0.974
1.011
2.527 *
0.813
1.890
2.192
3.047 *
2.877 *
3.053 *
3.758 * *
2.034
1.328
0.584

F-value

LLR
4.369
6.217
5.947
7.245 *
5.568
3.649
3.774
8.480 * *
3.085
6.620 *
7.520 *
9.897 * *
9.442 * *
9.911 * *
11.700 * * *
7.055 *
4.842
2.254
1992

CM

Notes: SC is the year of structural change; *10 percent significance; * *5 percent significance; * * * 1 percent significance

1.840
3.196
2.950
2.954
2.945
2.744
1.442
3.352
1.282
1.987
4.438
6.045
4.517
4.835
3.763
1.784
1.433
1.789

0.472
0.845
0.775
0.777
0.774
0.718
0.367
0.889
0.325
0.511
1.206
1.703
1.230
1.326
1.007
0.457
0.364
0.458
None

1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
SC

Table IV.
By-line structural
changes by Chow test
and switching regression

Fire
F-value
LLR

1.228
1.333
1.289
0.339
0.378
0.386
0.368
0.449
0.373
0.245
0.248
0.200
0.063
0.106
0.149
1.060
0.733
3.463 * *

4.511
4.858
4.715
1.335
1.487
1.516
1.447
1.754
1.464
0.973
0.987
0.798
0.254
0.425
0.596
3.944
2.799
10.969 * *
1995

Ocean marine
F-value
LLR

56

Year

JRF
7,1

0.142
0.218
0.292
0.460
0.498
0.758
0.444
0.945
1.079
0.029
0.090
0.165
0.213
0.346
1.707
2.958 *
0.441
0.387

0.569
0.867
1.154
1.796
1.937
2.886
1.735
3.547
4.009
0.118
0.362
0.660
0.850
1.364
6.057
9.661 * *
1.724
1.521
1993

WC
F-value
LLR

MM
LLR

0.510
2.039
0.384
1.553
0.403
1.628
0.630
2.494
0.801
3.119
1.756
6.322 *
4.929 * *
14.407 * * *
3.136 *
10.225 * *
3.456 * *
11.035 * *
5.392 * * * 15.363 * * *
1.880
6.702 *
1.115
4.227
0.902
3.484
1.112
4.217
0.203
0.837
0.024
0.099
1989

F-value
0.706
0.894
1.324
1.275
1.292
0.929
0.972
1.924
2.317
2.362
0.916
1.060
1.298
1.877
3.770 * *
1.919
3.723 * *
3.746 * *

2.702
3.369
4.830
4.669
4.722
3.491
3.641
6.725 *
7.884 * *
8.012 * *
3.446
3.945
4.743
6.579 *
11.729 * * *
6.708 *
11.615 * * *
11.671 * * *
1992

Other liability
F-value
LLR
0.696
2.666
0.502
1.951
0.689
2.640
0.820
3.107
0.539
2.091
0.508
1.976
0.501
1.948
0.508
1.973
0.561
2.173
0.897
3.380
1.263
4.628
0.937
3.518
0.935
3.513
0.098
0.395
0.060
0.242
0.661
2.538
1.158
4.278
0.936
3.515
None

Aircraft
F-value
LLR

PAL
LLR

5.772 * * * 16.155 * * *
4.365 * *
13.137 * * *
3.276 * *
10.492 * *
3.044 *
9.890 * *
3.127 *
10.108 * *
2.667 *
8.870 * *
1.337
4.873
0.754
2.875
0.731
2.790
0.707
2.702
0.713
2.725
0.767
2.918
0.946
3.551
1.430
5.175
0.913
3.435
0.770
2.931
0.816
3.096
0.543
2.103
1978

F-value

Notes: SC is the year of structural change; *10 percent significance; * *5 percent significance; * * * 1 percent significance

1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
SC

Year

CAL
LLR

1.071
3.981
1.145
4.233
1.137
4.206
1.269
4.648
0.775
2.950
0.900
3.391
1.569
5.621
19.357 * * * 34.160 * * *
0.855
3.231
0.510
1.982
0.227
0.905
0.208
0.828
0.181
0.724
0.171
0.683
0.098
0.396
0.074
0.299
0.075
0.304
0.102
0.410
1985

F-value

Property-liability
insurance:
Part II
57

Table V.
By-line structural
changes by Chow test
and switching regression

0.499
0.505
0.187
0.479
0.446
1.179
2.206
4.153 * *
4.357 * *
4.314 * *
3.901 * *
3.015 *
2.903 *
2.398
0.020
0.371
0.272
0.548

1.942
1.963
0.746
1.867
1.743
4.348
7.561 *
12.645 * * *
13.117 * * *
13.020 * * *
12.047 * * *
9.812 * *
9.514 * *
8.118 * *
0.083
1.459
1.079
2.124
1986

Fidelity
F-value
LLR
1.113
0.918
0.577
1.147
0.473
0.512
0.338
0.550
1.354
2.277
3.412 * *
3.425 * *
3.532 * *
3.564 * *
2.304
2.887 *
0.672
0.604

4.124
3.454
2.232
4.239
1.843
1.989
1.334
2.131
4.928
7.770 *
10.841 * *
10.873 * *
11.141 * *
11.223 * *
7.848 * *
9.469 * *
2.578
2.331
1991

Surety
F-value
LLR
0.548
0.604
2.076
5.097 * *
6.624 * * *
7.724 * * *
8.791 * * *
8.245 * * *
8.279 * * *
7.872 * * *
5.274 * * *
4.609 * *
4.635 * *
3.509 * *
4.012 * *
2.622 *
4.039 * *
0.540

2.123
2.328
7.179 *
14.756 * * *
17.807 * * *
19.780 * * *
21.543 * * *
20.657 * * *
20.713 * * *
20.033 * * *
15.130 * * *
13.690 * * *
13.748 * * *
11.085 * *
12.313 * * *
8.746 * *
12.378 * * *
2.094
1984

Burglary and theft

F-value
LLR
0.265
1.053
0.539
2.090
0.585
2.261
0.651
2.503
0.686
2.629
0.446
1.743
0.469
1.827
1.445
5.223
0.802
3.043
0.560
2.167
0.924
3.474
1.152
4.256
0.696
2.666
0.259
1.029
0.230
0.913
0.207
0.824
0.222
0.882
0.142
0.570
None

BM
F-value
LLR

Notes: SC is the year of structural change; *10 percent significance; * *5 percent significance; * * * 1 percent significance

1.552
5.567
1.059
3.941
0.779
2.962
0.717
2.741
0.737
2.813
0.642
2.469
0.563
2.178
1.101
4.083
0.808
3.066
1.251
4.588
1.342
4.889
0.644
2.475
0.569
2.199
0.779
2.964
0.293
1.158
0.273
1.084
0.462
1.804
0.507
1.970
None

1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
SC

Table VI.
By-line structural
changes by Chow test
and switching regression

CAPHD
F-value
LLR

0.476
1.978
0.535
2.212
0.636
2.602
5.698 * * *
15.948 * * *
1.317
5.041
1.527
5.734
1.561
5.846
1.216
4.698
0.956
3.789
0.930
3.696
0.870
3.477
1.047
4.110
0.256
1.089
0.893
3.558
1985

Reinsurance
F-value
LLR

58

Year

JRF
7,1

C
Coefficient

t-value

CR(2 1)
Coefficient t-value

D
Coefficient

Notes: *10 percent significance; * *5 percent significance; * * * 1 percent significance

2 0.816
51.179
2 0.351
148.610
2 0.196
128.970
2 3.020
179.162 *
2 0.893
105.446 * *
2 3.370
126.263
2 0.873
44.475 *
2 2.160
115.929 * *
2 2.680
147.878 * *
2 2.783 2 223.601 * * *
2 3.286
68.126 * * *
2 4.165 2 202.188 * * *
2 2.486 2 16.758
2 1.638
31.102
2 5.350 2 29.085 *
0.229
254.032
2 3.091
18.438
2 2.080 2 11.960

CR(2 2)
Coefficient t-value

2.317 2 0.354
FO
40.879
0.796
0.925 * *
AEQ
104.391
1.380
0.124
0.219 2 0.213
HO
2 35.567
2 0.767
1.467 * * *
3.188 2 0.097
CM
38.862 * *
2.665
1.203 * * *
6.077 2 0.582 * * *
OM
51.005 * *
2.342
0.719 * * *
3.067 2 0.188
IM
42.801 * * *
3.163
1.169 * * *
6.341 2 0.622 * * *
WC
12.930
0.962
1.108 * * *
4.594 2 0.225
MM
39.378 *
1.963
1.245 * * *
4.923 2 0.543 * *
OL
40.392 * *
2.283
1.256 * * *
5.576 2 0.608 * *
PAL
239.879 * * *
4.036 2 0.327
2 0.687 2 0.978 * *
CAL
1.567
0.126
1.889 * * *
9.410 2 0.893 * * *
CAPHD
243.234 * * *
5.769 2 0.302
2 0.893 2 1.048 * * *
FD
96.732 * * *
2.978
0.956 * *
2.770 2 0.892 * *
SR
63.780 * *
2.613
0.709 * * *
3.185 2 0.355
BT
54.666 * * *
4.820
1.331 * * *
8.016 2 1.007 * * *
RE
2 144.036
2 0.859
1.786
1.455
0.610
CR
53.980 * * *
3.219
1.110 * * *
5.080 2 0.659 * * *
CR1
32.237 *
1.846
1.168 * * *
4.907 2 0.471 *

Line
0.879
1.486
1.680
1.831
2.231
1.361
1.940
2.263
2.564
2 3.714
4.430
2 4.334
2 0.406
0.511
2 2.093
1.483
0.638
2 0.163

t-value
2 0.797 *
2 0.559
2 1.488 * *
2 1.855 * * *
2 0.443
2 1.767 * *
2 0.386
2 1.447 * * *
2 1.345 * * *
1.701 * * *
2 1.179 * * *
0.972 * *
2 0.759
2 1.055 *
2 0.862 * *
2 1.727
2 0.552 *
2 0.898 *
2 1.741
2 0.894
2 2.688
2 2.973
2 0.787
2 2.509
2 0.919
2 3.368
2 3.115
3.335
2 5.040
2.440
2 1.554
2 1.877
2 2.535
2 1.387
2 1.829
2 1.809

D*CR(2 1)
Coefficient t-value
0.392
2 0.187
0.276
0.368
2 0.670
0.452
2 0.097
0.227
0.217
0.455
0.556 *
0.949 * * *
0.686
0.449
1.130 * * *
2 0.645
0.427
0.982 *

0.799
2 0.279
0.476
0.694
2 1.163
0.732
2 0.248
0.574
0.573
1.135
1.902
2.975
1.659
0.924
3.894
2 0.241
1.477
1.892

D*CR(2 2)
Coefficient t-value
0.288
0.147
0.323
0.707
0.562
0.635
0.798
0.771
0.662
0.869
0.935
0.644
0.723
0.646
0.925
0.454
0.755
0.549

2.783
1.757
3.098
11.636
6.644
8.657
18.345
14.480
9.606
30.083
64.287
8.968
12.479
9.018
55.540
3.993
27.443
6.346

Adjusted
R2
F

Property-liability
insurance:
Part II
59

Table VII.
Dummy variable method
for all lines

JRF
7,1
Without T

60

Table VIII.
Cycle length with/without
time trend, and
before/after breaks

Fire
FO
AEQ
HO
CM
OM
IM
WC
MM
ML
AIR
PAL
CAL
PAPHD
CAPHD
FD
SR
BT
BM
RE
CR
CR1

10.976
NC
NC
NC
11.808
7.985
8.237
12.604
NC
9.431
NC
33.280
10.597
6.810
9.018
13.864
NC
15.557
NC
8.382
NC
14.339

With T

Without structural change, first difference

6.097
3.723
9.791
3.551
NC
8.113
7.933
8.022
12.320
NC
8.288
NC
NC
NC
10.467
5.172
8.938
5.321
7.718
NC
9.300
NC
NC
NC
8.265
10.300
p
Note: If b . 0 or a=2 2b . 1, then CR is not cyclical, denoted by NC

With structural
change
Before SC After SC
9.235
4.376
NC
9.487
10.551

NC
3.269
NC
2.669
4.420

NC
11.149
9.902

7.134
3.587
3.826

3.618
183.851

19.872
6.882

6.040
6.738
7.430

4.644
NC
NC

NC
7.443
11.355

4.451
7.289
NC

Figure 2.
Combined ratio with
structural change

segmented trend. Thus, we cannot simply use one deterministic trend to represent the
whole relevant time period without considering the possibility of breaks.
Figure 3 reveals the behavior of the nominal interest rate for three-month Treasury
bills. It shows a similar pattern as the combined ratio. Malliaropulos (2000) found that
the real interest rate, nominal interest rate and inflation went through structural

Property-liability
insurance:
Part II
61

Figure 3.
Interest rate with
structural change

changes around 1981[8]. It will be interesting to find the possible reasons to explain the
cause of the structural change for the insurance industry and why it happened in 1981.
Since the interest rate and the combined ratio have a similar pattern, we may be able to
explain this phenomenon by examining the relationship between the interest rate and
CR before and after the structural change (Leng et al., 2002).
Notes
1. Consider the combined ratio series from 1952 to 1997 with a break in 1981. From 1952 to
1981, CR has a positive time trend significant at 1 percent, but from 1982 to 1997 it has a
negative time trend significant at 5 percent. The time trend for the whole period should be
the weighted average of time trends from both sub-periods. However, it is greater and more
significant than the trend for the first sub-period. This shows that the existence of a time
trend for CR is temporary and it depends on which data period is chosen. Diebold and
Nerlove (1990) stated that the deterministic trend often appears significant, due to
downward bias in the estimated standard error of the estimated trend coefficient. This
explains why the combined ratio from 1952 to 1981 is stationary (later shows) but has a
positive time trend. The existence of upper and lower bounds of CR makes it different from
other macroeconomic variables, such as GNP and consumption, which contain a positive
time trend in the long term.
2. The dummy variable method is a special case of spline functions (see Poirier, 1976).
3. Judge et al. (1985) describe the method of switching regression, which seeks to identify the
switching point or year of structural change. Brown et al. (1975) call this method Quandts
log-likelihood ratio technique, developed by Quandt (1958).
4. Switching regression assumes that the number of breakpoints is known. Poirier (1976)
quotes from Farley et al. (1975) using a sample size of 60 observations to compare the power
of three tests: the Farley-Hinich (FH) test, the Chow test, and switching regressions. The FH
test is very similar to our dummy variable method. The only difference is that the FH test
does not include the dummy variable, but does include the interaction variable. It is more
powerful than the switching regression in the middle of the period, especially at the 15th to
45th observations. Assuming that the break occurred in the midpoint of the record, the Chow
test dominated the FH test only at the 27th to 35th observations.
5. The results of structural changes in 1989 and 1994 are not significant for most lines, similar
to those in 1984. Therefore, we only report the result for 1984.

JRF
7,1

62

6. When the breakpoint is 1984, only the private passenger auto liability and burglary and theft
have significant changes in the intercept. Commercial auto liability and burglary and theft
have a significant coefficients of the first interaction variable, and only burglary and theft
has significant coefficient of the second interaction variable. This means that burglary and
theft does have a structural change in 1984, private passenger auto liability and commercial
auto liability might have such changes in 1984, but the rest of the lines do not.
7. This result is confirmed by ADF tests. For the first sub-period of industry CR, the ADF test
rejects the unit root hypothesis at the 1 percent level, but for the second sub-period it cannot
reject the hypothesis at the 10 percent level. Also, the CRs of most lines before the break are
more significant AR(2) processes than the CRs of the whole period are.
8. Malliaropulos (2000) used quarterly data and concluded that there was a structural change in
the interest rate at the third quarter of 1980, which is very close to the year of structural
change we found for the insurance industry.
References
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Brown, R.L., Durbin, J. and Evans, J.M. (1975), Techniques for testing the constancy of
regression relationships over time, Journal of the Royal Statistical Society, Series B, Vol. 37,
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of Econometrics, 2nd ed., Wiley, New York, NY.
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Further reading
Banerjee, A., Lumsdaine, R.L. and Stock, J.H. (1992), Recursive and sequential tests of the
unit-root and trend-break hypotheses: theory and international evidence, Journal of
Business and Economic Statistics, Vol. 10, pp. 271-88.
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San Francisco, CA.
Cummins, J.D. (1988), Risk-based premiums for insurance guaranty funds, Journal of Finance,
Vol. 43, pp. 823-39.
Cummins, J.D. and Weiss, M. (1992), Structure, conduct, and performance in property-liability
insurance, financial condition and regulation of insurance companies, Federal Reserve
Bank of Boston, Boston, MA.
Doherty, N. and Kang, H. (1988), Interest rates and insurance price cycles, Journal of Banking
and Finance, Vol. 12, pp. 199-214.
Downs, D.H. and Sommer, D.W. (1999), Monitoring, ownership, and risk taking: the impact of
guaranty funds, Journal of Risk and Insurance, Vol. 66, pp. 477-97.
Dunleavy, J.H., Edelman, R., Ryan, D.J. and Lawless, C.B. (1996), Catastrophes force shift in
focus of P/C insurers, Bests Review Property/Casualty Edition, A.M. Best Company,
Oldwick, NJ.
Fields, J. and Venezian, E.C. (1989), Profit cycles in property-liability insurance: a desegregated
approach, Journal of Risk and Insurance, Vol. 56, pp. 312-9.
Greene, W. (1993), Econometric Analysis, 2nd ed., Macmillan, New York, NY.
Gujarati, D. (1995), Basic Econometrics, 3rd ed., McGraw-Hill, New York, NY.
Hamilton, J.D. (1994), Time Series Analysis, Princeton University Press, Princeton, NJ.
Joskow, P.L. and McLaughlin, L. (1991), McCarran Ferguson Act reform: more competition or
more regulation?, Journal of Risk and Uncertainty, Vol. 5, pp. 273-99.
King, R., Plosser, C., Stock, J. and Watson, M. (1991), Stochastic trend and economic
fluctuations, American Economic Review, Vol. 81, pp. 819-41.
Lai, G.C. and Witt, R. (1992), Changed insurer expectations: an insurance economics view of the
commercial liability insurance crisis, Journal of Insurance Regulation, Vol. 10, pp. 342-83.
Leng, C. (2000), Underwriting cycles: stationarity and stability, paper presented at the Annual
ARIA Conference, Baltimore, MD.
Nelson, C. and Plosser, C. (1982), Trends and random walks in macroeconomic time series,
Journal of Monetary Economics, Vol. 10, pp. 139-62.
Perron, P. (1989), The great crash, the oil shock and the unit root hypothesis, Econometrica,
Vol. 57, pp. 1361-401.
Schmidt, P. (1990), Dickey Fuller tests with drift, in Fomby, T. and Rhodes, G. (Eds), Advances
in Econometrics, Vol. 8, JAI Press, Greenwich, CT, pp. 161-200.
Winter, R. (1988), The liability crisis and the dynamics of competitive insurance market, Yale
Journal on Regulation, Vol. 5, pp. 455-99.
Zivot, E. and Andrews, D.W.K. (1992), Further evidence on the great crash, the oil price shock,
and the unit root hypothesis, Journal of Business and Economic Statistics, Vol. 10,
pp. 251-70.
Corresponding author
Chao-Chun Leng is the corresponding author.

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Property-liability
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