Reinsurance Industry Faces Uncertain Future as Time Moves On

By | July 2, 2015

It’s around two months until the annual Reinsurance Rendezvous in Monte Carlo, where the reinsurers, brokers, carriers, lawyers, accountants and cat modelers discuss the state of their industry. That industry, until recently a rock solid bastion of the “we do it that way because we’ve always done it that way” school of management, is in a state of flux, roiled by events both from within and without. It is searching for ways to continue to provide the risk coverage that underpins economic life in a world that has been changed drastically in a very short period of time.

Mike Van Slooten’s task, as head of Aon Benfield’s International Market Analysis team, is to make some sense of what’s going on in order to advise the firm’s clients what to expect and to guard against. But even he admits “it’s not an easy job.”

The exponential growth and sophistication of technology, and rising global temperatures; i.e. climate change, have affected everyone, not just the reinsurance industry. The technology now being used has altered the way analytics are done, as vast amounts of data are available to construct models. It has also changed completely the way people communicate, instantaneously, and, unless a solar storm or similar catastrophe sends us back to the 19th century it’s here to stay.

There may still be arguments about the causes of climate change, but anyone who has looked at the data realizes that the ocean temperatures are rising, it’s getting hotter in the summer, and there are more blizzards in the winter, and the natural catastrophes, which form the bulk of the reinsurers’ activities, are being affected, even though as yet it’s unclear just how.

“You need to invest globally.” Mike Van Slooten, Head of Aon Benfield's International Market Analysis Team

Van Slooten and the rest of the reinsurance community can only affect certain variables. He pointed out the ripple effects of some of the more recent developments, starting with the prolonged period of low interest rates, which shows no signs of abating.

As neither reinsurers (nor anyone else) now expects to make a significant return on debt investments (bonds, notes, savings accounts, etc.), sound underwriting has become a paramount factor in avoiding losses and making a profit. “Choosing an underwriter depends on the circumstances,” Van Slooten said. He explained that while the increasingly sophisticated cat models are one factor, they’re not the only one, as an underwriter’s expertise in understanding a certain risk is also important.

Increased regulatory supervision, notably Solvency II in the European Union, and the heightened surveillance by the rating agencies has accompanied the lower interest rates, and has thereby put pressure on capital. It must be deployed carefully and wisely.

The reinsurance market used to be governed by cycles alternating between a hard and a soft market. Big catastrophe losses usually hardened the market, as premiums were expected to rise, and this attracted more capital into the market. The “cycle,” however, has become a thing of the past.

As an example: According to Aon Benfield’s Catastrophe report for the year 2011, there were 253 separate events, which generated a record total economic loss of $435 billion, and total insured losses of $107 billion. Only 2005 topped it with insured losses of $120 billion – $90 billion of which resulted from the major hurricanes Katrina, Rita and Wilma. But no significant hard market developed. Rates rose only in those areas that had actually experienced extensive damage and losses. If that didn’t move the market nothing will.

The reinsurance market had the capacity to absorb those losses and move on. The industry was better prepared through the use of risk management and accurate enterprise risk management, made possible by more sophisticated and accurate software programs.

Most importantly the growth of alternative risk transfers (ARTs), now referred to as insurance linked securities (ILS), helped to replenish the capital the industry needed – at a price. According to a recent study, summarized in two earlier articles, they are a factor in moving the reinsurance market towards “the commoditization of risks.”

The other factor is the aforementioned sophistication of catastrophe models in the developed markets – U.S. hurricanes and tornadoes, European windstorms, Japanese earthquakes/tsunamis, Australian bush fires and cyclonic storms, etc. In those countries where they are used extensively the market is moving from coverage of “acts of God” to one that covers commoditized risks. If you substitute the “law of large numbers,” which has been the basic premise on the insurance industry since it began, for “acts of God,” you can see that this is potentially an existential concern.

According to Van Slooten, however, that from a reinsurance industry point of view it isn’t really becoming a commodity, except perhaps in some personal lines coverage, notably household and auto insurance. Slightly more complex risks are still required to be analyzed on a case by case basis. “What this has done, he said, “is to narrow the [pricing] band for reinsurance.”

If the price is too high, there are alternatives in other reinsurers, retaining the risk, or the ILS market. If the carrier is asking for a price that’s too low, it won’t be available outside the band, unless other factors are brought into play. As an example Van Slooten explained that a reinsurer might accept a lower price on some business, seen as having more risk, if the carrier also offers to reinsure another line of business, which has less risk.

The consequences of the changes detailed above have coincided with what has been described as the increasing irrelevancy of the reinsurance industry. Several factors are involved: Growth in the developed markets is at a standstill; prices are stagnant; major carriers are retaining more risk, and buying less reinsurance; a number of large multi-national companies have more capital than the entire reinsurance industry, so they’re quite capable of insuring themselves through captives or otherwise, and don’t need reinsurance.

The ILS market has enough capital, and its managers are knowledgeable enough, to structure alternative reinsurance vehicles – mainly cat bonds and collateralized reinsurance. According to a report from Guy Carpenter, as of June first there was “$21.83 billion of P&C 144A catastrophe bond risk capital outstanding.”

Capital remains the most important factor, however, in being able to compete, or even to survive, in the market. “Right now there’s a lot of pressure on earnings and on capital efficiency,” Van Slooten said. “The bigger a company’s balance sheet, the more efficiency [in the use of capital] they have.”

The situation affects every reinsurer. The bigger companies – Munich Re, Swiss Re, Hannover Re, etc. – have the capital to expand on their own both geographically and through acquisitions. Munich Re’s ERGO subsidiary is one of the top 10 largest primary insurers in Europe.

The other alternative is market consolidation through merger and acquisition (M&A). A partial listing of consolidations concluded or pending since the first of the year would include the two blockbusters – ACE and Chubb and Willis with Towers Watson. There’s also XL and Catlin, PartnerRe and either AXIS of EXOR, RenRe and Platinum, Tokio Marine and HCC, Montpelier Re and Endurance, as well as speculation about AXIS and Arch Capital and Cigna – Anthem.

Van Slooten also explained that companies are reducing the number of individual entities they do business through in favor of one large group entity that controls the business, and is frequently located in a less heavily taxed country such as Ireland or Switzerland. “A broader, more diversified balance sheet gives a company more opportunities to achieve growth,” he said.

As growth won’t be much, if any, in the developed economies, reinsurers must look elsewhere to achieve it, and that is mainly in emerging markets. They are by definition more difficult. Van Slooten described expansion into them as “sort of a Catch-22.” In order to adequately price the risk you might want to accept, you first need to have a decent model of that risk, but you can’t construct that model unless you have the data to do so, which, in many developing countries is either erroneous or unavailable.

The advantage gained by being a large company is that it has the resources and the time to gather that data and, along with having people in place locally, begin to understand local conditions, which will eventually permit writing local business and thereby achieving overall growth.

Big companies can be in many places at once, and can plan for long term development in emerging markets. “You need to invest globally,” Van Slooten said. “You’re looking for diversified risk. That way a loss in any one area can be covered by offsetting profits elsewhere.”

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