JB Crozet and Tom Rivers take inspiration from budget airlines for managing capacity and the underwriting cycle post-Katrina

Katrina, Rita and Wilma have abruptly reversed the progressive softening of property catastrophe markets, paving the way for substantial rate increases, and triggering a scramble to the capital markets to seize hard market opportunities.

This influx of new capital, backing both existing reinsurers and a new generation of Bermuda start-ups, reflects the common approach to cycle management: raise capital and increase volumes when the market is hard, reduce capital and write less when rates soften.

Capital plays

As simple as they sound, capital-driven strategies such as these encounter several practical challenges.

Firstly, raising and returning capital are not straightforward tasks, especially on the scales required to achieve efficient cycle management.

Raising capital is an expensive, potentially cumbersome, and long-term strategic decision; returning it can be interpreted negatively by the markets and rating agencies. Adjusting the capital base to manage short-term cycle movements is therefore likely to be a difficult strategy.

Additionally, the theoretically ideal timing for a capital injection may not always be favourable in practice, as could be seen for some reinsurers after Katrina. These reinsurers went to the capital markets in a relatively defensive position, focused on protecting their ratings after their hurricane losses and had to compete for funds against other capital raising initiatives.

The capital raised has often not brought the capital base back to its pre-Katrina level, while capacity-driven cycle management approaches would recommend increasing capital (relative to pre-Katrina levels) to take advantage of the hard market.

Finally, the post-Katrina uncertainty also highlights some of the risks with capital-driven strategies. Predicting rate-levels for the 2006 underwriting year is a difficult enterprise, as conflicting forces come into play.

On the one hand, there is potential for abrupt rate increases due to the sheer size of capacity lost in the hurricanes, combined with the heightened risk aversion and the higher capital charges for property catastrophe from Standard & Poor's and AM Best. On the other hand, this trend may be attenuated by the influx of capacity into the property catastrophe market, whether from new capital or reallocation from other lines of business.

In particular, the emergence of many well capitalised start-ups, which have to deploy their capital and write large volumes very quickly to provide a return to their shareholders, may result in the market rapidly becoming more aggressively priced than initially anticipated.

For a reinsurance company, this raises the question: "Did we commit too much or not enough capital to this line of business? If so, what should we do about it?"

These challenges highlight the need for reinsurers to complement their capital-driven strategies with a more refined cycle management approach, to enable them to maximise their profits on the capital committed across the cycle.

"No frills" active pricing strategies

Solutions come from other industries as diverse as airlines, hospitality or car rental, who also face the constraint of a fixed, committed capacity in the short term (for instance, the number of seats on a plane). These industries have adopted active pricing strategies known generically as "revenue management", to optimise their prices according to the variations of supply and demand.

Anyone who has booked a flight with a low cost airline has encountered their active pricing strategy; and anyone who follows their financial results has witnessed the success of this approach. The ticket price for a flight is not fixed but is instead driven by the number of spare seats and the remaining time before the flight departs. The risk of an unsold seat is balanced against the risk of missing out on a potential premium customer. In the 1980s and 1990s, hotel chains and airlines realised that they could significantly increase revenues and profits by using active pricing strategies such as this.

One can easily draw parallels with the reinsurance industry, where the capital committed is fixed in the short-term and reinsurers are trying to maximise their profits according to the variations of supply and demand represented by the underwriting cycle.

Currently, many reinsurers allocate capital to individual contracts and load their technical price to achieve the target return promised to shareholders (typically 15%) regardless of the market conditions or their capacity utilisation to date. In the airlines lingo, this is equivalent to the old fixed fare system.

Unfortunately, targeting a fixed 15% return on allocated equity for individual contracts does not translate into a 15% return to shareholders, nor does it maximise profits. In a soft market, the reinsurer would not write enough business to use all its capacity, and does not get a return on its unused capital. In a hard market, it would lose out on achieving a potentially higher return.

Setting optimum prices is therefore a complex process, dependent on the state of the market and the capacity available to the reinsurer at any particular point in time. Figure 1 provides an example of the evolution of a profit-maximising pricing strategy over time. The scenario is one of sustained softening market rates, followed by a supply shock from a catastrophe event triggering an abrupt hardening of rates.

For multi-line reinsurers, another application of this approach is the optimal allocation of capacity between lines of business. This is determined by the price environment in each market, together with the diversification benefit from writing across several lines of business. Figure 2 provides an illustration for the optimal allocation across two lines of business.

Underwriters' intuition

In many ways, an active pricing strategy is only a formalisation of the underwriters' intuition: with their knowledge of market conditions, experienced underwriters set rates to strike the right balance between volume and profit. They decide to charge over or below technical prices, depending on supply and demand.

One should not, however, underestimate the benefits of formalisation and modelling to support and optimise decisions regarding price, volume and allocation of capacity. A useful parallel can be drawn with catastrophe aggregation monitoring, where sophisticated models have long surpassed intuition and mental calculations.

What goes up must come down

In the prelude to a hard market post-Katrina, it is certainly tempting to discard cycle management and make hay while the sun shines and lose sight of the potential for rates to soften in the medium term.

Rating agencies and investors, however, will expect companies to have a game plan over the entire underwriting cycle, and will not bless those without a focused cycle management strategy. In September, Standard & Poor's branded cycle management the "key to reinsurer financial strength" and institutionalising insurance cycle management was rated the number one priority for the London Market in PricewaterhouseCoopers' 2005 London Market Survey, "Driving performance forward".

As uncertainty increases and accurate prediction becomes more difficult, reinsurers will need flexible strategies which will allow them to adapt to a "whatever comes next" response capability. If an active pricing strategy cannot turn lead into gold, it can certainly complement capital-driven activities and provide reinsurers with additional flexibility to help them manage the ups and downs of the cycle effectively.

- JB Crozet is a principal consultant and Tom Rivers is a consultant in the actuarial & insurance management solutions practice at PricewaterhouseCoopers.