Despite capital on sideline, reinsurers expect payback. Should they?

by Artemis on September 19, 2014

Traditional reinsurance players still believe that they will be able to claw back losses suffered during a given treaty year by raising prices in subsequent years, despite the widely expected readiness of more new and alternative capital sitting on the markets sidelines.

The concept of payback seems like an old-fashioned one to many who believe that it is reinsurers jobs to accurately price risks up front with enough margin to allow for a level of losses in the future. Certainly prices should fluctuate after major loss events, with some upwards movement to recalculate rates to allow for new modelling of events to be factored in, but are the doubling and trebling of rates seen previously still going to be a factor in the future?

Here are a few, slightly naive and not particularly well-formed, thoughts on this matter. We don’t have any answers at this time but feel the following questions and scenarios are worth pondering as they pertain to the future of a reinsurance market which is going to have to adapt to new capital, new technologies and new risks.

Deutsche Bank equity analysts held a post-Monte Carlo roundtable the other day, where the discussion with a number of traditional reinsurance players that had just returned from the annual Rendez-vous turned to whether reinsurers would be able to hike prices after losses as they have in the past.

With alternative capital having moved into the catastrophe reinsurance space in recent years and much more capital said to be waiting on the sidelines for any rate increases, it seems like the market cycle may be dislocated and the peaks and troughs of pricing seen historically may not be seen any longer.

The traditional reinsurer participants at the Deutsche Bank led discussion disagreed. A larger event will be needed to turn pricing hard across the market than in the past, the reinsurers agreed, but we will still see localised dislocations in pricing where areas are particularly loss affected.

Any market areas where pricing or underwriting contract terms have been irrational, due to aggressive competition, which see even a modest loss could trigger a pricing correction, the reinsurers said.

Most interestingly, the reinsurer participants said that the payback principle still applies in the traditional reinsurance market. In other words, they still expect to be able to claw back losses after a major event by hiking rates over subsequent years. So price increases post-event will still be seen, particularly as the traditional reinsurance market remains based on longer-term reinsurance purchasing relationships.

So, is payback an old-fashioned concept that will (or should) disappear in a more efficient, structurally changed and capital agnostic reinsurance market of the future?

The concept of payback seems as if traditional reinsurance firms have in the past been able to come out with pricing that is below adequate technical levels for a current treaty year, knowing that if they suffer a huge loss they can hike pricing so much that it will be worth offering the most competitive pricing they can.

Some newer players in the reinsurance space, particularly some of the more forward-thinking insurance-linked securities (ILS) players, feel that reinsurance capital needs to become more efficient. Capital needs to understand the pricing as accurately as possible right now at the time of contracting, so that it does not have to double or treble the same contract rate even if huge loss events occur.

The concept of payback does not exist in other industries. Imagine a car manufacturer who has an expensive recall on a certain model, causing a major financial impact. They do not expect to be able to claw back any losses they faced as a result of the recall. In fact they use insurance and hedging to mitigate these costs up front, as well as likely factoring some risks into pricing all the time, thus ensuring that they can remain in the market with an accurately priced and competitive product.

A bank which suffers a loss due to a regulatory matter, a loss of data, a lawsuit, or a loss on its investments side, similarly does not claw back these losses from customers. The use of insurance, enterprise risk management, hedging and keeping pricing consistent is common in the financial industry.

So why don’t reinsurers operate in this way and with a price upfront and hedge the risk of losses mindset? Well they do, but it seems the concept of payback may be so deeply ingrained in the industry that it will take a long-time for it to disappear.

The problem is uncertainty. It is impossible to model unexpected events accurately and even more impossible for an underwriter, no matter how experienced, to really price accurately for every possible event scenario.

But, if uncertainty and model error is the real reason, that reinsurers cannot accurately price upfront and use hedging more comprehensively to allow for losses in the future, then is the market broken structurally? Has the market then been underpricing risks with the knowledge that it can claw back losses in subsequent years? It’s possible, perhaps a change of mindset, to a degree, in the way reinsurers approach the pricing of all risks is required.

It is possible that the introduction of more efficient capital and innovative business models, including insurance-linked securities (ILS) and other models with a lower cost-of-capital, may force reinsurers to think again about how they apply this payback principle.

Imagine a huge loss occurs in a peak catastrophe zone such as Florida, eroding say 25% of reinsurer capital, how would traditional reinsurers react? Would they attempt to increase all rates by 25%, to claw back over a longer-term, or perhaps they would attempt to add 75% or even more to claw back much more rapidly.

Now, at the same time consider that an ILS manager, who has also seen a similarly impactful loss, looks to increase his average rate-on-line by around 2% to 4% as that is all they need to achieve an increased return that will allow them to atract significant sums of new capital. If they undercut the traditional reinsurers price hikes, with fresh capital perhaps even reducing their cost-of-capital even further, what then for the traditional markets share?

At the same time, imagine all the new capital interest saw it as preferable to be invested in a nimble ILS vehicle, where they can access the returns of the risk with lower credit risk, less exposure to expense ratios and a lower volatility return. At the same time traditional reinsurers struggle to attract new shareholder capital to replenish their eroded capital base. Would that mean the price hikes made on the traditional side had to be even higher, or that they had to find another way to accept new funds?

After a very large event, where reinsurers find they are going to be undercut on price, that the new capital wants to flow into more efficient vehicles and find themselves forced to also create new structures to attract capital (like sidecars and funds), would reinsurers find themselves even more marginalised?

These questions are not going to be answered without the kind of market dislocation that is caused by a major reinsurance loss event, catastrophe or otherwise. It’s hard to imagine the traditional insurance market accepting massive price hikes if cheaper and more efficient forms of capital become increasingly prevalent after an event occurs.

Our simplistic view is that price rises post-event will always exist, but in the future these should be aligned with changing views of risk and not solely linked to a desire to claw back losses, which perhaps should and could have been mitigated by accurate pricing of risk and the use of hedging and retrocession.

An efficient reinsurance market of the future should have a much flatter price cycle, with some peaks and troughs due to events, demand and capital inflow, but significantly flatter than has ever been seen before. Changes in capital sources will be a major factor in this, but so should be technology and the introduction of new business models.

In an efficient market any attempt to impose unwarranted price increases, while others offering a similar product do not, could be met by a demonstration that perhaps the relationships that once mattered so much are now less important and that reliability, price transparency and price consistency may become the key client relationship building blocks.

Should reinsurers be able to claw back their losses and should this principle of payback still exist in the future? Will ILS managers want to claw back losses in the same way and at the same rate? Or will new capital demonstrate efficiencies by disrupting this legacy of the reinsurance market in the same way that it has pricing today?

If you have thoughts to share on the future of the reinsurance market with us and our readers you can always use the comments box below.

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