Stephen Searby considers the pricing trend divergence in 01/01 renewals

One of the most interesting outcomes of the January renewal season has been the apparent disconnect between the primary rates being offered on large commercial risks, where significant price competition has emerged, and reinsurance involving similar underlying risks, where there appears to be more price discipline. During previous cycles a closer relationship between the direction of primary and reinsurance pricing was observed with reinsurance often "leading" primary rates lower.

There are three possible explanations for this disconnect. First is the increased use of modelling in the pricing of property risks by reinsurers.

Pricing models are more relevant, and are consequently in more widespread use, when applied to a large diversified pools of risks such as those written in a reinsurers treaty book. Bespoke models can be developed for the sorts of individual risks which are more prevalent in the primary commercial lines markets, but a greater degree of subjectivity is required.

In a softening market it is the more consistently and transparently modelled risks where pricing remains resilient.

A second possible explanation (and indeed probably also symptomatic of the divergence in primary and reinsurance rates) is the growing "remoteness" of the reinsurers from the original risk. This has manifested itself in an ever increasing share of business being written on a non-proportional rather than a proportional basis. Allied to this has been the increasing attachment points - ie the level at which a reinsurer would come on risk for a certain loss - in non-proportional contracts. This has been driven by reinsurers' desire to obtain more control of their underwriting rather than simply "following the fortunes" of their cedents, as well as the cedents wanting to retain profitable premium income.

A final and perhaps most intriguing explanation is that the demand for reinsurance by sophisticated cedents is becoming more stable year on year, due to the fact that they are increasingly beginning to assess the benefits of reinsurance in terms of optimising returns on capital, rather than viewing it simply as a risk management expense that needs to be kept to a minimum or an opportunistic purchase. Reinsurance can validly be used to smooth results by, at a cost, removing the loss spikes resulting from high severity events. Generally accepted theory is that lower volatility means lower costs of capital and therefore all other things being equal, increased returns above cost of capital. The primary company's reinsurance purchasing decision should, therefore, be determined more by its prevailing cost of capital than the underlying conditions of the markets in which it operates.

None of the three hypotheses in themselves offer a conclusive answer to the pricing trend divergence. However, all three exist within the same analytical frame of reference - accurate measurement of the amount and cost of capital employed. Better understanding of this dynamic should be a driving force to remove the historic cyclicality of the industry.

"What is your cost of capital?" will be a question that will be increasingly asked by analysts over the next few years.

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