Australian primary insurance group IAG has entered into a five-year 12.5% quota share arrangement with reinsurance giants Munich Re, Swiss Re and Hannover Re, in a transaction that will see the insurer passing on more of the risks it underwrites, while the reinsurers benefit from gaining access to diversifying risks.
Effectively, for the global reinsurers backing this deal, the arrangements are a way of sourcing risk from a recognised underwriter in the region, so are a way of accessing risk at a lower cost than the firms could underwrite it themselves, or likely source it in the traditional reinsurance renewal cycle.
For IAG, the quota shares lock-in reinsurance pricing from some of the biggest sources for a minimum of five-years, providing it with the security and financial backing to grow in profitable areas of its business, while offloading a portion of the volatility in its risk portfolio to diversified global players better able to manage it.
IAG said that the arrangement will, “Improve IAG’s capital mix through placing greater emphasis on the application of more efficient reinsurance capital.”
The underlying quota shares are whole account arrangements, covering IAG’s book of underwriting in Australia, New Zealand and Thailand, running for at least five years.
The three major reinsurance firms will take on 12.5% of IAG’s consolidated gross earned premiums from across the covered business and pay 12.5% of its claims and expenses that arise.
IAG will also receive profit commission on the business underwritten, incentivising the insurer to keep the quality of the book and the ceded business under the quota shares high, as part of an exchange commission recognising the value of its franchise. The exchange commission will largely be a fixed fee as a % of premium plus the profit share.
This isn’t the first major risk-sharing deal that IAG has entered into, the insurer has an arrangement with Warren Buffett’s Berkshire Hathaway that sees it cede 20% whole-of-account quota share across a 10-year period to the reinsurer.
IAG said that it expects the arrangements with Munich Re, Swiss Re and Hannover Re to deliver similar financial benefits.
IAG CEO Peter Harmer explained, “While our strategic priorities of customer, simplification and agility go to the heart of maximising the value of our customer platform, it is important we continue to pursue initiatives that optimise the mix of the supporting capital platform. These transactions are a clear step forward on that front.
“In tandem with the Berkshire Hathaway quota share, we have removed downside earnings risk from 32.5% of our business while retaining significant exposure to earnings upside via the profit share arrangements. We believe this is a good outcome for IAG shareholders.”
IAG CFO Nick Hawkins also said, “We have previously indicated our intent to explore further quota share opportunities and are pleased we have been able to meet our return criteria via agreements with three of our key reinsurance counterparties.
“The agreements further reduce the volatility of our earnings, while delivering greater diversity of quota share counterparties and maturities. We see this form of reinsurance capital as an integral part of our capital mix and long-term sustainability.”
In terms of benefits, IAG says the 12.5% quota share will help to reduce its earnings volatility, which has been an issue in recent years as catastrophe losses have eaten into profits, reduce its requirement for catastrophe reinsurance at the next renewals, lower its required regulatory capital by $435 million over three years, and only have broadly neutral impacts on EPS and ROE.
However, the crux of the benefit, which works both ways, is that IAG says the deal will see, “12.5% of insurance risk effectively exchanged for a more stable fee income stream.”
So IAG can continue to do its business of underwriting insurance in Australia, New Zealand and Thailand, safe in the knowledge that 12.5% of the risk is going to flow to these three major reinsurers, while Berkshire takes its slice as well.
That means less risk on IAG’s books, while income still flows for its underwriting business, providing a more predictable flow of earnings across this piece of its book and making management of the rest of its book simpler as well.
For the reinsurance firms backing the quota shares this is effectively a way to get closer to the risk without needing their own primary underwriting arms, while also securing a significant chunk of diversifying business without needing to compete in the reinsurance renewals market for it.
It’s likely cheaper for reinsurers like Munich Re, Swiss Re and Hannover Re to source risk in this way, from a diversifying region. Trying to acquire the same portfolio in the renewals could be more expensive, while trying to set up the underwriting operations to secure it yourself would be even more costly.
If a recognised underwriting shop like IAG is willing to swap a portion of its risk for a steady stream of income over a minimum five-year term then it is much simpler and likely more efficient for the reinsurers to work in this way.
For IAG these arrangements will, “reduce IAG’s reliance on catastrophe reinsurance cover and its exposure to future volatility in reinsurance rates.”
In fact, the insurer said that thanks to the quota shares at its, “2018 catastrophe renewal IAG will reduce the placement of its gross cover, from 80% to 67.5%.” Additionally, the 2018 financial year natural peril allowance is to be reduced to $627 million (from $680 million) to reflect these reinsurance arrangements.
The impact to the bottom-line will not be insignificant either, with the reported insurance margin at IAG expected to increase by approximately 250 basis points per annum.
But overall this is a story of using efficient reinsurance capital support to manage volatility in earnings, gain stability and also put in place the financial backing that can also help the insurer grow.
The reinsurers do well from the deal, as long as IAG’s underwriting remains robust and they will manage any volatility through their own retrocession anyway.
Could the deal have been more efficient? It’s possible. Is it only a matter of time until we see an enterprising primary insurer setting up similar quota shares with ILS investors or even a direct pension investor? Yes, in fact there may already be a few transactions in the market that achieve similar goals, but on a smaller scale.
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