The largest failure in Australian corporate history accelerated a regulatory tightening that introduced security-linked capital charges for reinsurance recoverables. In consequence, the catastrophe excess-of-loss Australian reinsurance market swung from being largely subscription-based, to one dominated by differentiated pricing with higher rated reinsurers receiving higher prices for their capacity.
Using Australia as a case study upon which to assess the pros and cons of differentiated pricing, it is possible to consider whether non-subscription placements are a superior model for other global markets. Non-subscription placements are not new, but they do offer an increasingly workable solution to filling gaps in reinsurance capacity requirement, and to reflecting other operational attributes such as risk management strategy, quality of service and relationships.
The impact of HIH
In March 2001, HIH, the second largest Australian insurer, was put into provisional liquidation. Policyholders were critical of the regulator, the Australian Prudential Regulation Authority (APRA), for what appeared to be a failure to protect the interests of the insured from insurers, and to anticipate the collapse, which would leave a $4bn shortfall, mostly in the form of unpaid claims. The HIH failure did not in itself initiate market reform, but it certainly accelerated the process of implementation and paved the way for a new set of more stringent regulations.
The Reform Act came into effect in July 2002, setting a comprehensive set of compliance rules and prudent guidelines, including requirements in respect of reinsurance management and capital adequacy. Significantly, under the new Act, the creditworthiness of a cedant's reinsurer could have a massive impact on its capital requirements (see table 1).
A sea change
The largest single change that the Reform Act produced in reinsurance buying was a swing in the Australian market away from subscription placement towards differentiated pricing. This was led by one of the principal brokers in the market. It argued that in a subscription market, the clearing prices tend to be determined by the key capacity providers. With a non-subscription placement, whilst the key capacity providers generally receive a higher price than under a subscription placement, reflective of how this reduces the associated capital charge, a lower overall programme price is in fact also achieved because the remaining, previously following markets, generally receive less favourable terms. In fact, according to some reinsurance buyers in the Australian market, underestimation of the value of their product from some of the large capacity providers can also reduce overall price.
Differentiated pricing, with associated differentiated wordings, became a rapidly successful model for Australian catastrophe excess-of-loss reinsurance programmes, and also a number of property and liability programmes. The methodology used by brokers also quickly became more refined, establishing private prices with a core panel of higher-rated reinsurers and a "take it or leave it" price for the remaining capacity providers. Over time, however, the pendulum has swung back a little.
In the current context of the Australian market, direct financial penalties and substantial "soft" pressures have led insurers to look to maximise the capacity that they purchase from higher-rated reinsurers. In turn this has led to differentiated pricing, with higher rated reinsurers receiving better prices for their capacity. However, whilst three of the top four insurance players purchase on an almost entirely differentiated pricing basis, one has returned as far as possible to subscription placement. In addition, many smaller buyers are now, even despite the regulatory driver in that market, once again fully subscription-based.
Swings and roundabouts
One factor restricting differentiated pricing from dominating global markets, also at play in Australia, is that subscription markets generally arrive at a consensus price where there is little weighting given to credit quality. In these circumstances, the price set by a highly rated reinsurer may be equally weighted in the consensus setting as that of an average rated reinsurer. This can be effective from a pricing standpoint for buyers purchasing limited capacity, but the dynamics may shift when programmes need to tap more capacity.
The exact tipping point will vary, but smaller and medium-sized programmes are relatively easy to place with a couple of key reinsurers and following markets. Here, an equally weighted consensus price is arrived at and there is no need to look for private capacity. Throughout Asia, Latin America (with the exception of Mexico currently) and much of Southern Europe and the Middle East, reinsurance purchases fall mostly within this category. Even in Australia, the effects of capital charge generally cannot outweigh the efficiency of subscription placement for smaller programmes.
Large cat excess-of-loss programmes are a different story because significant global capacity may be needed to complete the whole programme, which explains why some of the larger European insurers tend to purchase their substantial catastrophe risk capacity on a differentiated pricing basis, which is generally done via both direct and broker channels.
Other factors also impact on placement decisions, including: whether or not brokers offer this as a service, the contribution of underwriting cycles (a softer market tending to favour subscription) and the overall value proposition of a reinsurer. For example, the jump in catastrophe bond placements and hedge fund activity following Hurricanes Katrina, Rita and Wilma, effectively increased the proportion of capacity purchased on a non-subscription basis, admittedly by changing the placement basis entirely. In this case too however, there will probably be at least a partial swing back, as new traditional capacity fills the gap between current supply and demand.
The way forward
Considering the benefits that non-subscription placement delivers, it seems reasonable to expect that a proportion of the most sophisticated buyers will switch at least part of their purchasing to non-subscription: the buyer gets value, the broker can provide value, and the most potent sellers will obtain a price they believe is commensurate with their security.
We expect to see a continuing trend towards non-subscription placements, with the trend more pronounced at specific points in the market cycle and following different patterns in different segments. As risk-based capital models become more prevalent in the international regulatory environment, it is reasonable to expect that reinsurance credit quality will increasingly be considered an asset. With the advent of Solvency II and other regulatory developments around the world, this issue is likely to be a common discussion point between clients, brokers and reinsurers.
- Rick Thomas is head of the catastrophe underwriting team for PartnerRe's global (non-US) operation. Vincent Gerondeau is a senior P&C underwriter for PartnerRe.
Table 1 - The Reform Act 2002
Reinsurance management: Following the HIH collapse reinsurance deals with no or little risk transfer came under scrutiny. Insurers are now required to outline and submit to APRA for approval a comprehensive filing of reinsurance strategy and arrangements, with clear disclosure requirements on "financial" or "limited risk transfer" reinsurance. Insurers are required to pay particular regard to counterpart diversification and to the creditworthiness of their reinsurers.
Capital adequacy: The solvency requirements of the Act are based on a risk-based capital adequacy standard, departing from the common solvency margin formula. The regulator provides a "prescribed" method, which defines the minimum capital requirement (MCR) as the sum of the capital charges for insurance risk, investment risk and concentration risk. Insurers are encouraged to develop their own tailored, model-based method, which must be approved by APRA.
Significantly, the minimum capital charge for the reinsurance component of investment risk is expressed as a percentage of the reinsurance recoverable, and this depends on the rating of the counterpart. For example, the capital charge for a reinsurance recoverable from an AM Best "A+" rated reinsurer would be one third of the same recoverable from a "BBB" rated reinsurer. The difference that rating makes to the MCR can therefore be substantial.
Table 2 - Pros and cons of differentiated pricing
- Maximise the capacity purchased from higher-rated reinsurers (reducing overall capital charge) while maintaining a reasonable, and possibly even reduced, reinsurance spend;
- Some higher-rated reinsurers provide their capacity relatively cheaply (with non subscription, reinsurers do not see the prices that their competitors have quoted or received); and
- Cedants can reward consistent quoting with consistent pricing and higher shares of their programme.
- Reinsurers with a better rating receive a better price. This is, however, a double-edged sword;
- By quoting for all programmes, reinsurers can increase their advantage over following markets because only quoting markets have access to better pricing; and
- Higher premiums help the reinsurer to finance the extra capital cost of a higher rating.
- The biggest challenge for a broker is administration. Since each reinsurer has a different price and, in the case of some catastrophe excess-of-loss covers, a different contract wording, the potential confusion and administrative burden in the event of a claim is obvious. Insurers face uncertainty over reinsurance recoverables as a result of differences in wordings. This has been noted, and insurers are now pushing to achieve as much standardisation as possible for wordings.