In the latest in our series of interviews with figures from the risk transfer and insurance-linked securities markets, Artemis spoke with Joseph L. Petrelli, President, Demotech, Inc. Although Demotech reviews and follows 420 carriers operating in the U.S., it is known for its key role in the Florida insurance market.
As such, Demotech has a unique position to provide insight and opinion on how the commoditization of primary insurance risks has helped to accelerate the convergence of reinsurance and capital markets through ILS.
To start, could you please explain to the Artemis readers what you mean by the convergence of capital markets and insurance, and also a brief description of commoditization in insurance and reinsurance?
Ratings agencies, regulators, reinsurers and even investors speak of the convergence of capital markets and insurance. This term is utilized to describe the development of alternative sources of securitization and capital outside of the insurance industry.
Commoditization is the process by which goods or products that have economic value and possess unique attributes become viewed as interchangeable and nearly indistinguishable in the eyes of market consumers. Insurance policies are examples of this, as despite inherent differences, they are often viewed as uniform.
So Joseph, as the convergence market continues its impressive growth path, is there anything in particular that Demotech feels is driving this trend?
Although most attribute this phenomenon to financial innovation, Demotech believes that one of the forces accelerating the flow of alternative capital, perhaps even enabling alternative capital to compete with traditional reinsurance, was the commoditization of the domestic U.S. personal lines insurance markets; i.e., homeowners and personal auto insurance.
In part, alternative capital is the result of a natural process that began with the commoditization of the primary coverages that then engulfed the reinsurance of those same products.
Can you provide any insight into the commoditization of the U.S. property and casualty lines you mentioned, so homeowners and personal auto insurance?
Consider the following: In 2014, homeowners insurance accounted for 15.3% of domestic US Property and Casualty premium volume. Personal automobile insurance, from no-fault, bodily injury, property damage, medical payments, uninsured and underinsured motorists and physical damage, was another 35%. Combined, homeowners and personal automobile insurance amount to $283.6 billion of a $564.3 billion U.S. market, or modestly more than 50%. The primary motivation for most consumers is cheaper is better. If this is the perspective of the consumer, brands and coverage enhancements are less important than price. Therefore, the personal lines of insurance are undergoing or have undergone commoditization.
In your opinion then, is there any particular reason why commoditization has occurred most prominently in these business areas, enabling the entry of alternative reinsurance capital?
Homeowners insurance has long been viewed by consumers through the lens of cheaper is better. Similarly, the coverage enhancements provided by carriers are often included in the package at less than full actuarial value in order to sustain the carrier’s competitive position.
Personal automobile insurance is touted as a coverage where one can save 15% for being willing to spend a few minutes investigating alternatives. Consumers are also encouraged to retrofit or adjust their coverage to fit their budget.
Although these messages are meaningful advantages if one is a low cost carrier, an unintended yet underlying message to consumers is that despite differences in premium, coverage is uniform and indistinguishable.
And you feel this serves as a catalyst for the persistent inflow of third-party reinsurance capital in the space?
Yes, therein lies one of the proximate causes of the influx of alternative capital as a competitor to reinsurance – if a fundamental insurance product is viewed as uniform and generic, the reinsurance for that same insurance product can similarly be uniform and generic. Unique attributes and advantages of traditional reinsurance became obscured and then, slowly and inexorably, rarely referenced. A billion dollars of cash sitting in a trust becomes no different than a billion dollar reinsurance treaty from an established reinsurer that has an extensive infrastructure of expertise and experience as well as an established brand and operating history. Although convergence is a popular term, Demotech respectfully submits that the commoditization of personal lines coverage is leading to the commoditization of the reinsurance facet of those same coverages. This was a contributing factor to the influx of alternative capital.
What of the remaining approximately 50% of domestic U.S. property and casualty market participants that aren’t focused on personal lines?
Demotech is hopeful that the nearly half of the U.S. Property and Casualty marketplace that is not personal lines take note. Incessant price competition coupled with a failure to consistently and effectively differentiate policy provisions as well as reinsurer capabilities may be detrimental to long term pricing stability. This is an unintended consequence of the commoditization that took place. No one is immune from unintended consequences. Not even a P&C industry with more than $564 billion of annual direct written premiums supported by more than $1.7 trillion of admitted assets and nearly $700 billion of surplus.
So do you believe that this commoditization of primary insurance and then reinsurance has benefits for the consumer?
The benefit to the consumer is lower cost including the savings associated with alternative capital versus its traditional counterpart, if any, and yet a competitive marketplace likely to be focused on exemplary claims service. In an operating environment where price is the focus and not coverage enhancements, the claims administration process becomes the differentiation that consumers will focus on. Similarly those focused on the personal lines of insurance, whether agents, carriers or reinsurers, find themselves focused on reducing expense levels so as to offer competitive cost structures without sacrificing claims paying ability.
Finally, can you explain a little about how Demotech views the use of collateralized reinsurance, catastrophe bonds and other ILS solutions by the primary companies it rates?
Demotech views collateralized reinsurance, catastrophe bonds and other insurance linked securities solutions through the same lens that we view reinsurance. We use the terms “quantity” and “quality”.
Quantity is our term for whether or not the protection available is sufficient to provide the financial stability that we believe the carrier requires from its reinsurance program. Similarly, within the term quantity, we consider whether or not the construction of the program is consistent with the business model utilized by the carrier.
Quality is our term for the anticipated collectability of the protection and the consistency of the reinsurance coverage triggers by and between the treaties, collateralized reinsurance, catastrophe bonds or other ILS solutions. We perform our own internal analysis on reinsurers and alternative capital even if the source of the protection has been rated by others.
Demotech recognizes the value of traditional reinsurance while concurrently embracing the availability of realizable claims paying ability that alternative markets bring to the industry. Our focus is on the applicability and realization of the protection; whether the protection emanates from a traditional treaty or an alternative source of capital.
Our thanks go to Joseph L. Petrelli for this insight into how he and Demotech views the convergence of reinsurance and capital markets through ILS and how this affects the Florida property insurance market as well as other domestic U.S. insurance markets.