Elliot Richardson considers the critical role which facultative reinsurance has played in the January renewals
With one of the most challenging 1 January renewal seasons for the last decade now behind us, it is interesting to reflect on the critical role played by the new generation of facultative reinsurance offerings in helping risk carriers to manage catastrophe exposure issues. While dramatic rate increases were not as widespread as some originally anticipated, the hurricanes had a severe impact on pricing in the US, causing significant increases in non-marine retrocession and marine reinsurance rates as well as for property catastrophe business in the loss-affected areas.
On the property side, Benfield Industry Analysis and Research's recent "Reinsurance Market and Renewals Review" found that whereas rates generally fell by up to 20% in January 2005, at this renewal, loss-affected property catastrophe treaties in the US saw increases of more than 100% in some cases and even loss-free property business in the US was up by 10-20%.
Elsewhere, 1 January increases were not so significant but in most non-US territories there was a marked swing from the downward trend seen through the first half of 2005, with renewal rates at best flat and in many cases showing a significant reversal of the previous downward trend.
Just as important, however, is the continuing development of 2005 losses, recalibration of catastrophe models and the shrinking appetite for peak exposures. All are factors which are continuing to exert upward pressure on pricing and to prompt reinsurance buyers to consider ways in which facultative reinsurance can assist with particular challenges. In part this reflects the fact that with the evolution of global treaties, the bespoke nature of facultative business has once again come into its own as it provides insurers and reinsurers with a mechanism to tailor global programmes to reflect local market dynamics and territorial differences in exposures.
Equally critical, especially at times like these, facultative cover also helps risk carriers to overcome one of the potential disadvantages of global treaties - that of not being able to change direction quickly to exploit opportunities. Accordingly, facultative reinsurance is now being used as a tool to deal with various underwriting issues which have emerged in the wake of the hurricane losses, such as the mismatch between catastrophe treaty pricing and primary market rates, greater desire to mitigate peak exposures on property books and the need to respond to strategic decisions to scale back catastrophe exposures.
Several of the specific challenges of the recent 1 January renewals look set to continue to be a feature of the market as we move into 2006. These include tackling legacy issues where excess of loss cover has been written on a losses occurring basis, and helping risk carriers to scale back books of business in line with strategic repositioning regarding maximum foreseeable losses.
A CUSTOMISED APPROACH
In both cases, the customised nature of facultative cover enables risk carriers to reinsure onwards potential "hot spots" which have emerged as a result of strategic decisions to rebalance their portfolios, so giving underwriters the flexibility to continue to write business as terms become more attractive.
One of the attractions of using facultative cover is that not only are such contracts usually placed on concurrent terms and conditions to those in the underlying policies - so giving cedants seamless cover to protect against the exposures - but also, as facultative placements have not traditionally been focused around key renewal dates, there is the flexibility to continue to use this approach as the underwriting year unfolds.
One factor has been key to the gradual return from the sidelines of facultative reinsurance, which had been left languishing by the development of treaty business. This has been the analytical tools which are now available to brokers to analyse and assess risk. These are essential in delivering the complex solutions which facultative reinsurance is now providing.
The considerable strides made by the facultative broking community in using these specialist skills have been essential to the facultative renaissance.
For instance, facultative brokers have been able to respond to recent catastrophe issues by developing new approaches to risk assessment and the mitigation of peak windstorm or quake exposures.
In Benfield's case these include the use of a dynamic portfolio optimisation methodology in combination with specially developed software to identify the policies, and the locations within those policies, which are disproportionately driving probable maximum loss (PML) curves for a given annualised event probability.
The impact of such solutions can be significant. In one working example based on a portfolio's 1:250 PML loss, Benfield found that some 5% of the portfolio's multi-location commercial property policies accounted for 25% of the probable loss. By removing risks in force that could cause exposure spikes on accounts that would otherwise not be regarded as being catastrophe exposed, such facultative applications, can significantly enhance the attractions of a portfolio at treaty renewals.
Another advantage is that such analysis can also be used by risk carriers to test more effectively their assumptions on the overall benefit of particular elements of their business when looked at in relation to the wider capital considerations of their businesses.
Such applications mean that facultative reinsurance is becoming a more mainstream part of risk carriers' outwards programmes, which is giving impetus to another key change within the market.
The increasingly grey area between facultative and treaty reinsurance means that if customers are to derive maximum benefit from the fusion of facultative and treaty solutions, there is a greater need for facultative brokers to work more closely with their treaty counterparts. To date, this has only been achieved in pockets within the various brokers in sector and as yet there is probably no broker that can claim to have cracked this issue across its business as a whole.
At the same time, the facultative reinsurance broker of today needs to have a much wider range of skills than was the case even just five years ago. Such brokers need to be versed in alternative risk as well as the more traditional sources of capacity and where a customer's needs cannot be met by the insurance and reinsurance market, the broker needs to be able to source additional contingent capital elsewhere.
WIDENING THE SCOPE
In addition, as the scope of facultative business widens, today's facultative brokers must be equipped to deal with all areas of the market including managing general agents, captive associations, regional carriers, retailers, national account carriers and wholesalers - and where necessary the broker also needs to be able to sell such facilities as the electronic platforms to support customer initiatives.
Facultative cover has come a long way from its perceived position as a cumbersome paper-intensive form of reinsurance with which to plug any gaps in treaty coverage. Not only has its much wider relevance been increasingly proven in recent years, but also much hard work has taken place behind the scenes to limit the cumbersome aspects of facultative reinsurance transactions - for instance, by making it possible to do full electronic submissions to markets. As a result, facultative cover is fast coming of age as a product that can offer the kind of complex solutions that are becoming an every day part of the overall management of risk.
Reflecting this, where traditionally the buying of facultative reinsurance has been a line management decision, the buying process is now coming increasingly under the control of senior management. Indeed, in the future, the 1 January 2006 renewals - and the particular challenges they generated - may well be seen as the point at which facultative cover once again became regarded as a core element of outwards programmes.
- Elliot Richardson is global team leader of Benfield Facultative Solutions.