Global reinsurance: fighting the last war
Investors are often described as fighting the last war—they place too much importance on recent events when making decisions and assume the most recent trends will repeat themselves indefinitely. Owing to a series of costly disasters in 2017 and 2018, the global reinsurance market seems to have entered a period of seismic change and nerve-wracking uncertainty, after several years of benign loss activity.
Our natural human tendency is to resist change, as it is disruptive. The stock markets similarly hate uncertainty, as do most businesses—including re/insurance—because it makes long-term planning far more challenging. We insulate ourselves by thinking that the same market scenario will happen again, and that we will be better prepared by repositioning the portfolio. The more likely result is getting caught off-guard again.
Unfortunately, no two market cycles are ever quite the same, so the past cannot be a future prologue in precise terms. This causes investors to shift their tolerance for risk depending on market conditions. The underwriting cycle is no different: currently, it appears that the days of large catastrophic events triggering a widespread market hardening are gone, replaced by pockets of micro-cycles based on geographic and loss experience.
Third-party capital (TPC) has been around for well over a decade, but over the last five years it has proliferated more rapidly as investor interest has increased and reinsurance structures have become more varied in form. What is clearly transpiring through this aspect of the market’s evolution is that TPC is becoming more closely aligned with traditional reinsurance capital.
Nat cats challenge reinsurers two years in a row
The spate of natural catastrophes in 2017 and 2018 clearly illustrated the increased participation of TPC in these losses, mostly through the use of collateralised retrocession placed by traditional reinsurers. While this form of alternative capacity served to insulate the traditional market from excessive losses, it also delayed an adequate response to obtain higher risk pricing following the 2017 catastrophe losses.
The catastrophe events of 2018 may have further exacerbated this fact, but the loss creep, particularly from 2017’s Hurricane Irma, showed how the overall market failed to recognise and price for the fundamental changes that had occurred both operationally and structurally in the Florida property market.
The 2018 wildfires in California and Typhoon Jebi in Japan also caught many underwriters and capacity providers by surprise due to a failure to appropriately manage and adequately price for the actual underlying risk. The industry continued to rely on existing, inadequate models and underwriting tools that failed to keep pace with the changing dynamics of the true exposure.
In all these circumstances, one can point to a complacency that had built up during previous years of benign loss activity. It proves that models are no substitute for individual risk underwriting and relying solely on modelling can be a recipe for disaster.
TPC investors rightly felt disturbed by events that unfolded following the initial impact of the 2017 losses. Perhaps some of the subsequent surprise can be attributed to timing, but clearly more emphasis must be placed on improved risk selection, mitigation, and pricing by the underwriter or—in many cases today, the fund manager.
The 2017 and 2018 catastrophes point back to the warning that Warren Buffett made in his 2001 letter to shareholders, which followed the devastating events of 9/11: “When a daisy chain of retrocessionaires exists, a single weak link can pose trouble for all. In assessing the soundness of their reinsurance protection, insurers must therefore apply a stress test to all participants in the chain, and must contemplate a catastrophe loss occurring during a very unfavorable economic environment. After all, you only find out who is swimming naked when the tide goes out.”
While Buffett’s warning was at the time aimed at the re/insured, given the fact that much of the retrocessional capacity today is from collateralised vehicles, perhaps the warning should now also be aimed at the investor. If investors hope to achieve a reasonable return for risk, they must not only be well-informed as to the nature of said risk, but also be able to fully assess the underwriting and administration capabilities of the fund manager and underwriter.
Complacency over pricing
A long benign period for losses seems inevitably to lead to some level of complacency with regard to accumulation control and pricing, at least for as long as all are enjoying attractive profits. But it’s when that accumulated profit is wiped out from a single loss that the underwriting flaws are ultimately revealed.
An underwriting track record of excellence should be the prerequisite for any investor. Putting money in the hands of capable risk-takers keeps the market rational.
Given all that has transpired, finally it appears that TPC providers and traditional reinsurers both held capacity back at the midyear renewal for US and Japanese programmes. But this newfound discipline is once again being driven by the same old supply/demand equation as much as by pricing models.
It was apparent at the last January renewal that pricing for property catastrophe and longer-tailed classes of business remained weak despite the series of losses that had previously transpired. At the time, the rationale for the status quo on pricing was ample capacity despite losses, rather than acceptable return for the risk. The next question that arises is: how sustainable is this newfound underwriting discipline and how will market participants react if overcapacity begins to push pricing back to irrational levels?
Over the longer term, the failure of some reinsurers to adapt to changing market dynamics has resulted in AM Best’s Global Reinsurance composite producing a five-year average combined ratio of 97.6 (Figure 1) and a five-year average return on equity of 6 percent (Figure 2), hardly a reasonable economic return on capital considering the risk. Pockets of profitable business have dwindled in recent years and the subsidy they provided through favourable reserve releases to less profitable classes is running out.
What do the winners do differently?
The composite contains a few winners, companies that consistently outperform their peers—in some cases, by a considerable margin. The question is: what do they do differently?
Each company has deployed its own unique strategy, but there are some broad similarities. Each is globally diversified, capable of leading programmes across a broad spectrum of risks. It is also evident that, over time, their business models have continually evolved, adapting to the shifting dynamics of the reinsurance market.
Mergers and acquisitions (M&A) activity has not been central to the success of the better-performing companies, although it has been necessary for some second- and third-tier reinsurers simply to maintain relevance in an increasingly competitive landscape. But what appears to be the most transformative element recently is the embrace and use of TPC.
As such capital has grown in prominence and almost literally taken over the retro reinsurance space, it has provided ballast for traditional reinsurers to continue to offer property catastrophe capacity to clients, despite the rate pressures they face. Beyond retrocession, many traditional reinsurers have been at the forefront of managing this capacity on behalf of investors by using sidecar vehicles, which for the investor and the underwriter allow for a strong alignment of risk in terms of sharing profit and reputational exposure.
It should therefore be no surprise that more recently a growing number of M&A transactions have brought together traditional and TPC providers. This increasing alignment should serve to bring about a more rational and stable pricing environment, at least in the property catastrophe segment of the market.
With the mid-year renewals behind us, it remains to be seen what lessons have been learned from the loss events of 2017 and 2018 and whether those lessons will result in any meaningful and sustainable change in the market. No-one can predict the longer-term outcome; only time will tell.
We do know that the future landscape will be different from today’s, and market disrupters will continue to emerge. We also know that those who learned from the last war are not the ones still fighting the last war; rather, they are tactically preparing for whatever challenges lie on the horizon.
This article is an excerpt from AM Best’s Market Segment Report “Global Reinsurance: Fighting the Last War”.
Robert DeRose is a senior director at AM Best. He can be contacted at: robert.derose@ambest.com
Scott Mangan is an associate director at AM Best. He can be contacted at: scott.mangan@ambest.com
