In order to satisfy the demands of increasingly sophisticated buyers, reinsurers must be able to provide a full line of alternative risk products and services in addition to their traditional offerings. Bill MacLachlan tells it as it is.
While many people continue to debate the extent to which the reinsurance industry and capital markets have converged, there is little question that sophisticated reinsurance and investment professionals, along with their respective clients, have very similar views regarding risk and risk management. Volatility - whether caused by natural disasters, disruptions to market capacity, or mergers and acquisitions - is a threat to the bottom line. Reinsurance mitigates this threat for its buyers.
Just as prudent investors build solid portfolios with a carefully balanced selection of stocks and bonds, sophisticated reinsurance buyers manage the inherent risk in their insurance portfolios with a blend of traditional and non-traditional reinsurance coverages. While standard problems can be solved using traditional products and services, unique problems require tailored solutions. Buyers who have taken the alternative risk route have discovered that a partnership relationship with their reinsurers allows collaboration on solutions that are as unique as the situations they face. Because non-traditional reinsurance transactions essentially involve only one or two reinsurers and the ceding company, the relationship is by nature an intimate one.
To effectively compete in this environment, today's reinsurance sellers must offer a full range of flexible products and services that can adequately respond to the risk management needs of the marketplace. In order to satisfy the demands of their buyers, reinsurers must be able to provide a full line of alternative risk products and services in addition to their traditional offerings. This requires not only a broad range of products, but also sufficient capital, timely response time, market presence, a dedicated team, customized service and a global reinsurance perspective.
As a global business, reinsurance is exposed to dramatic shifts and pricing cycles. The industry currently is in a soft market. Reinsurance written premiums dropped to $19.4 billion in 1998 from $19.9 billion a year earlier, according to the Reinsurance Association of America (RAA). Moreover, reinsurance comprised only 7.4% of all property/casualty industry premiums in 1998 compared to almost one-tenth of the industry's premium the prior year. A lethal combination of fluid capital, declining premium, new forms of competition, more complex issues, and customers who are keeping or managing more of their own risk, has created new challenges for reinsurers. Consolidation and recent market disruptions head the list.
The increasing pace of consolidation is having a tremendous impact on the industry. The number of companies reporting results to the RAA declined by half from 1982, when 149 companies reported results, to 1989 when 74 reported, and was halved again by 1998 when only 38 companies reported results. Like other financial service industries, reinsurers require capital, a balanced book of business, products and services, geographic reach, underwriting discipline and experienced employees to grow profitably. Many believe these objectives can be achieved through merger and acquisition and have acted accordingly. Logically, the merging of two large entities should create operating efficiencies. If a merger has the effect of doubling surplus, though, it doesn't necessarily double capacity. When companies merge, the risk appetites of the combined entity are frequently less than the total appetite of the separate entities due to the intrinsic need to balance assumed risk over a broader financial base. In such cases, total industry capacity is diminished. If reduced capacity is an offshoot of the trend toward consolidation, the soft pricing and overheated competitive environment facing the reinsurance market should stabilize.
While consolidation of reinsurers may have affected capacity, consolidation of primary insurers has led to an increased demand for retroactive products. Many times the consolidated entity begins to rethink its overall business mix. Thereafter, if the company decides to exit a line of business, it may look to purchase retroactive cover in the form of a loss portfolio transfer, a reinsurance transaction which covers losses that have already been incurred but not paid. This need arises when one company acquires another, yet is not comfortable with all lines of business that the acquired writes. Consequently, a reinsurer is brought in to assume a capped dollar amount of losses. With the recent growth in merger and acquisition activity, it is helpful to the company when the reinsurer is able not only to provide risk financing in the form of a loss portfolio transfer, but also to aid in the claims-handling process.
In the last quarter, the workers' compensation market has seen a dramatic downward shift in capacity. This contraction has caused companies to purchase prospective reinsurance products to mitigate future losses and to quantify its total loss potential. In these cases, reinsurance protection is used as a risk management mechanism. One example of such a product is an aggregate stop-loss cover, which provides a dollar amount of coverage above a set retention (usually based on a targeted loss ratio). This effectively protects the company's underwriting loss ratio and its income statement by putting a corridor of reinsurance protection in place to reduce their possible losses and stabilize operating results.
Another example of market flux affecting reinsurance buying is the recent evaporation of capacity provided by the Australian property catastrophe market. Many reinsurance buyers discovered a shortfall as they tried to renew their reinsurance property programs. Other buyers guarded against such a contingency by using prospective reinsurance in the form of a multi-year loss-stabilization product. This allows for reinsurance recovery in the year of a loss, improves the insurance company's annual results, and provides ongoing capacity in subsequent years for the benefit of company and reinsurer. The risk and profit sharing features of such a transaction make it extremely appealing to companies who want their reinsurance programs to provide stabilization. The reinsurer pays the losses, and the company can spread the negative effects of a loss over numerous years.
Hurricane Andrew, whose devastating $15.5 billion in insured losses in 1992 resulted in shortages and high costs of traditional catastrophe reinsurance, exposed the need for greater capacity. This inspired the creation of new reinsurance companies, many of which were set up in Bermuda. The addition of this market added capacity and fostered greater competition.
Indirectly, Hurricane Andrew also was influential in bringing together reinsurance and the capital markets. The insurance industry's augmented demand for insulation against large losses and the investment world's escalating interest in the world of insurance facilitated the trend toward securitization. As financially savvy companies recognized their need for greater property catastrophe protection, they realized they could access the capital market by packaging risk to sell as bonds or notes to third party investors.
Known as cat bonds, these arrangements subject investors to loss of principal if losses from a hurricane or other catastrophe reach a trigger level specified in the bond offering. While cat bonds have gained in popularity, they still represent an evolving market. Investment bankers estimate there are currently fewer than 200 active investors in cat bonds. As this number continues to grow, cat bonds can be expected to provide even more significant capacity to reinsurance buyers.
Reinsurers and investment bankers alike are counting on the next big catastrophe and the continuing strength of booming financial markets to spur interest in these products. To meet the anticipated increase in demand, the market is testing products such as weather derivatives, credit enhancements, and guaranty of the residual value of assets, which they hope will be attractive to third party investors. Nonetheless, capital, experience and a global presence are essential in allowing a reinsurer to undertake such tasks.
The need to gain and retain business under these conditions is driving reinsurers to expand their role as capacity providers to include consultative products and services among their offerings. Their insurance company clients are demanding integrated risk management solutions to increasingly complex problems. To do this reinsurers need a clear understanding of financial, as well as reinsurance risk. And, like traditional insurers who are finding new partners in banks and financial services, there is an undeniable convergence between reinsurance and investment banking products. Reinsurance companies are no longer the only source of capacity for insurers. The increasing popularity and availability of catastrophe bonds is expanding the risk management solutions available in the market.
All of these developments make the dawn of a new millennium a very exciting time to be in the alternative risk reinsurance business. The risks and the demands are high, but so are the challenges and the rewards. Alternative risk products and services are designed to respond when our clients face challenging market issues. We look forward to the challenge- BRING IT ON.
Bill MacLachlan is president of the alternative risk division at HartRe Company.