Masking the true exposures
The way reinsurers use industry loss warranties (ILWs) can be a relatively opaque world, somewhat removed from the norms of either traditional forms of risk transfer or the ultra-transparent world of insurance-linked securities (ILS).
Yet for those with access to the pricing and trends in this world, some interesting insights into the way a market and individual reinsurers are behaving can be revealed.
This was the case for Stephen Postlewhite, chief executive of Aspen Re, speaking in the aftermath of the June/July renewals, commentating on the way pricing in this sector moved.
Some reinsurers are taking on more catastrophe risk than their investors realise by using ILWs to offset the risk, which ultimately masks the true extent of their cat exposure, Postlewhite claims.
He says that demand for ILWs in the June and July renewals actually caused rates for this product to harden—an unusual dynamic in an otherwise very soft market. But he also warned that players operating in this way were opening themselves up to greater volatility as a result.
“There was an increase in demand for reinsurance and retro coverage in the recent renewals driven by people taking on more cat risk in the US. In turn, that led to more demand for ILWs and the level of demand pushed pricing up,” Postlewhite says.
“The use of ILWs was driven by certain companies not wanting to draw attention to the fact that they are taking on more cat risk at a time when rates are so soft. By using ILWs, the impact on the probable maximum loss (PML)—the main indicator of exposure to catastrophe risk that investors look at—is mitigated. They are trying to manage the message to investors.
“A PML is only a measure of extreme cat risk in the tail of the curve (at one-in-100-year or one-in-250-year return periods) and not an indication of the true cat exposure at lower return periods. For reinsurers using ILWs in this way, it is an efficient means of protecting their capital position, but does not protect against volatility from more frequent and more likely cat events.
“We tend to look at the entire curve of cat risk rather than just the PML. Where we have increased our exposure to cat we have done it while managing the entire curve and also through the use of alternative structures and sidecars.”
Aside from this unusual dynamic around ILWs, Postlewhite believes the main dynamic of the negotiations around renewals this year will revolve around the extent to which rate decreases may be slowing or even flattening out. He believes there is now a clear sense in some parts of the market that further significant declines are now becoming unrealistic.
“There was some indication in the July renewals that declines in cat rates were starting to decelerate,” he says.
"Where we have increased our exposure to cat we have done it while managing the entire curve and also through the use of alternative structures and sidecars.”
“The appetite for that is certainly starting to diminish. There will be some interesting conversations about the appetite third party capital investors have and the returns they expect.
“My feeling is that there is not much more room for movement in cat rates and, certainly on the peak perils, we might be approaching something resembling a floor.”
Postlewhite adds that if any sort of floor has been reached, it will be interesting to see if there is a knock-on effect to other lines of business. He notes that there have been many new entrants into specialty business in the past year and fears rate reductions could start to creep into these areas.
He says that in his experience, cedants will push for the best deal they can get—in terms of both rate reductions and changes in terms and conditions. He warns that of these two points of negotiation, the latter is the potentially more damaging to reinsurers.
“Cedants will just do what is best for their own business. But while pricing is not great in terms of return on equity (ROE) at the moment, it is far from franchise-damaging to reinsurers. The real problems come when terms and conditions are renegotiated,” he says.
“Maybe that will be the next port of call for some cedants who realise the floor on pricing has been reached. But loosening terms and conditions is what has caused big problems in the market in the past. We will be very rigorous here, because we know that you can end up with exposures you do not understand and they have the potential to damage your business.”
The momentum in negotiations may start to shift in the favour of reinsurers in some areas.
First, Postlewhite believes the trend of buyers reducing their panels of reinsurers has started to reverse this year. One reason for this is that consolidation in the industry has sometimes meant that, where two players both on an already small panel merge, cedants suddenly have a concentration of credit risk they must mitigate by finding new business partners.
He also sees more demand for reinsurance emerging in some areas. This is partly opportunistic, with some cedants simply leveraging the cheap coverage available in the market, but also partly by increased regulatory oversight, which in some areas is driving a requirement for a greater protection of the balance sheet or higher capital and, thus, more reinsurance.
Finally, he noted that many governments, squeezed in their own budgets, are also increasingly open to shifting risk into the private sector, noting the UK Flood Re scheme and US mortgage insurance as good examples of this.
“There has been something of a trend emerging recently of cedants buying more, especially on the higher layers,” he says. “This could start to counter some of the many pressures the industry is facing. There has been a trend of the bigger players taking risk more on their own balance sheets but, driven partly by regulatory changes, maybe that is starting to reverse as well.”