Fears that falling rates may herald another bloodbath underestimate the technical knowledge that reinsurers have acquired, argues Raj Ahuja.
Disciplined underwriting in a softening market has been the Holy Grail for the reinsurance industry for as long as anyone can remember. Fine words about writing for profit have counted for nothing in the heat of competition. As reinsurance rates head in the wrong direction again, are we about to see history repeat itself? I believe not. I think that we have finally learnt our lessons as an industry.
Up to now, the optimists have invariably been proved wrong as underwriters and their managers repeated the same old mistakes of earlier cycles. Yet the industry is now better placed than it has ever been to control the soft market. Results will still deteriorate, and some will look truly dreadful, especially at those companies whose technical skills do not match their competitors. Overall, though, it will be a milder, shorter-lived dip than we are used to seeing in these situations. Why should this be?
The explanation can be both technical and historical. From a technical point of view, it is a truism that underwriters show restraint when they understand the real cost of the risks they see and operate within a robust strategic framework. They may make compromises to maintain market share, but they do so within strictly defined limits. Those underwriters who do not understand, on the other hand, are frequently tempted to chase rates down, sometimes to suicidal levels. It is equally true that managers who are able to monitor the progress of their portfolios in a detailed and timely fashion can respond swiftly and decisively when certain lines of business underperform.
For the historical answer, we need to go back to 2001 when the terrorist attacks on September 11 crowned what would have been a terrible year for reinsurers anyway. It was part of a sequence of loss-making years that made commentators speculate whether reinsurance could ever be consistently profitable again.
Everyone knew that data was part of the problem. The general understanding was that reinsurers had to accept lower-quality data than the primary market. It was a fact of life, a bit like saying that people in Britain had to cope with dreary weather. Because reinsurers deal with small numbers of large claims, they do not have sufficient data for accurate pricing – or so the argument went. It followed that meaningful modelling, and therefore accurate pricing, was bound to be more difficult.
Instead, reinsurance underwriters would rely more on “instinct”, which helped to give them their mystique and status; at quite some price to their shareholders. This type of attitude was unnecessarily defeatist. It underestimated the value of the existing data, including what was already in the public domain.
After 9/11, senior management, under pressure from the same shareholders, demanded to know more about the risks that they were selling. And they wanted to be told in detail. A more technical approach to underwriting and capital allocation, with greater use of modelling and better application of data, became imperative.
This improvement was made easier by two factors. Firstly, developments in pricing, reserving and modelling techniques facilitated the better storage, retrieval and analysis of data. The rapid emergence of dynamic financial analysis as a mainstream corporate tool made it possible for reinsurers to develop risk frameworks that accurately reflected the realities of their businesses.
Secondly, a slowdown in the previously frenzied level of merger and acquisition activity among reinsurers left top management with more time to think about other matters, including the urgent need to improve underwriting methodology.
Six years later, and the reinsurance industry is a world away in terms of its technical capabilities from where it was at the start of the decade. Many of the top reinsurers have embedded a technical approach to underwriting within their organisations, while many others are only a short way behind.
The changed culture has spread within the organisation and throughout the value chain. Insurers find their reinsurers demanding better quality data and they, in turn, are making similar demands on risk managers and other corporate customers. Internally, even staff away from the underwriting arena are involved, such as claims adjusters, reinsurance managers, accountants and actuaries.
“In 2001 everyone knew that data was part of the problem. It was a fact of life, a bit like saying that people in Britain had to cope with dreary weather
What does this mean in practice? From a top-down perspective, enterprise risk management (ERM) is embedded within the company. This brings a range of competitive advantages, including improved underwriting. They include the ability to base all major corporate decisions on a full understanding of your risk profile.
Returning to underwriting, a reinsurer with a robust ERM culture driven from the top and running throughout the enterprise will operate within a sound framework based on the board’s business priorities and risk appetite. Senior management can monitor exposures and underwriting performance in a segmented fashion, by line of business and by layer. When part of the portfolio starts to misbehave, they can make prompt corrections, instead of learning the hard way 15 months later, as often used to be the case.
Underwriters, meanwhile, have a much better understanding of the risks they see. Where cedants present incomplete or badly-reconciled data, their reinsurers will likely impose more demanding terms and conditions, so encouraging greater discipline down the chain. Reinsurers will still compete on price, and they may even undercut the technical rate, but they will be constrained by the overall policy laid down by senior management.
Moving up the value chain, companies will have a much better idea of their own exposures. Just as insurers have tended to buy reinsurance inefficiently, the same could also be said of retrocession. Scenario testing by using the new generation of financial models makes it possible to identify retrocession needs and possible solutions with far greater accuracy. It supports better decisions about retentions, aggregations and cessions, for example. And it enables a more adventurous approach, with greater use of capital market instruments such as insurance-linked securities and index loss warranties.
The other side
All this may seem like an idealised picture – and it is. In case this gives the impression that we have achieved the reinsurance CEO’s idea of Nirvana, it has to be said that the real world is a different place.
There is considerable variation between companies. In any event, reinsurance underwriting is not an exact science, and it will never be entirely numbers-driven. There are still areas where judgement calls have to be made, from underwriting priorities to the assessment of individual cedants. And people still make mistakes.
Nonetheless, the market leaders who set the pace have moved a long way towards embracing ERM, and many do it very well. Having both the knowledge and the desire to protect their balance sheets, they are establishing a standard for the following market. They are also putting their less-advanced competitors in a difficult position.
Because true ERM leads to better use of capital and better management decisions, the more technical reinsurers are at an advantage. For example, this means that Company A, which leads the risk, can afford to reduce its rate by 10% in a soft market and remain profitable. Company B, meanwhile, can only manage to do so with an 8% cut. Company A stands to make a profit, whilst its rival must either decline the business or write at a technically unsatisfactory level.
A simplified picture, of course, but the principle is there. That is one reason why the soft market will make it obvious which are the best run reinsurers, as soft markets always do. There are likely to be corporate casualties.
So, where does this leave the reinsurance industry? 2008 will probably provide the moment of truth. That is when the greater technical understanding evident in the market will really be put to the test. If there is a further sizeable market softening, it may suggest that the lessons have not been learnt after all.
I remain confident, however, that reinsurers are in a stronger position than ever to handle and control the downward cycle. In that sense, we are on the cusp of a genuine breakthrough.
Raj Ahuja is a partner at non-life actuarial consultancy EMB.