Terry Masters examines the evolving nature of buying strategies and finds decisions are increasingly reliant on modelled data and group risk management strategies, a process that takes the onus off relationships.

Historically, client companies have purchased reinsurance following minimal strategic planning. There would be some discussion between the reinsurance buyer and the broker as to what the broker should try to achieve but these discussions focused on results of the contracts to date, the burning cost and the amount of premium spend on a year-on-year basis. It was often thought that buying the same amount of cover as was purchased in the previous year for a lower premium was more advantageous for the client than changing the reinsurance programme to provide more effective cover, possibly ending up paying more premium than was paid in the previous year. The perception of "a good deal" may have been obtained by paying the same amount of premium for more cover or greater exposure.

Effectively this strategy was one that related to the profit and loss account and was related to the amount of premium spend and the potential reinsurance recoveries. There was no consideration of the capital usage, the cost of that capital or the reinsurance return on capital. On renewal, the broker would discuss the expiring current programme and some variations with reinsurers. Discussions would continue until the broker had achieved what he believed his client wanted.

If the programme was in deficit, or if there were losses in the prior year, the discussions would centre on the pricing and the effective amount of payback within the subsequent year's premium. All parties would understand that the reinsurer would try to recoup some of its losses, but the relationship between the parties would affect the amount of payback and lead to the inclusion of other classes and treaties.

Close partnerships

Going back ten years or so, the market was dominated by talk of relationships. It is possible to argue that the desire to buy reinsurance was driven by the need to reduce the effect of the unknown. If you could not put a good numerical framework around the lower frequency/higher severity events in your portfolio then there was plenty of reinsurance and retrocession to solve the problem. Reinsurers and retrocessionaires talked a lot about relationships since they too had little by which to price the business.

For many parts of the reinsurance world this has changed. "Relationship" is still a key word in certain markets, such as Japan or Germany. It can still be found in some areas of the market where modelling is either difficult or has failed to penetrate, and also where a precise definition of "loss" is difficult to obtain. The marine reinsurance market offers a good example, as does the heavier end of the casualty market, but overall a world of modelled risk provides shallow soil for relationship-based reinsurance.

Today's world has brought capital to the forefront of reinsurance buying decisions. Sophisticated models are used to consider the potential range of outcomes in all scenarios and the probability of those outcomes in terms of 1-in-100 and 1-in-250 year events. This has turned the reinsurance buying decision into one where, throughout the year, a significant amount of time is spent looking at the benefit of reinsurance in terms of the cost of capital. This, in turn, leads to an insurer asking reinsurance-related questions as part of its risk management strategy. Now, all major clients are effectively considering reinsurance buying in terms of the cost of running the exposures against their own capital compared with the use of reinsurance, the amount of volatility transferred to the reinsurer and the cost of the reinsurance.

At the same time, the modelled numbers are driving other greater behavioural changes within the insurance companies themselves. Nowhere is this clearer than the transformation in the buying habits of the larger companies. It is an economic imperative that larger companies, with a spread of class and territorial exposure, assess their overall risk portfolio centrally and maximise their own diversification credit rather than allow it to pass to reinsurers. There is one proviso, however, and that is that the numbers provide a good model for reality. The result is far more risk retention and, as a result, the risk that is passed onto reinsurers is more volatile.

Sovereignty retention

The central assessment and pooling of risk threatens past buying patterns. For the larger federal-type companies with strong local subsidiaries, the loss of sovereignty over the purchase of reinsurance is a major culture shock. For reinsurers this can also be an issue where global treaties, often the local flagship accounts, are absorbed into global programmes written at the head office. This change is not unique to the larger companies. In smaller specialist companies the retention is set by a central assessment of risk and not for the comfort of, or by the instincts of, the line underwriter. In short, the balance of power has shifted from the underwriters towards the chief financial officer.

As a consequence, the role of the main brokers has also changed. They now employ teams of actuaries, cat modellers, accountants and other specialists who, together with clients, work throughout the year on what options are available in terms of risk retention and reinsurance buying. As major insurance groups consider their risk retention strategies and develop approaches to benefit from the diversification of risks within the group when buying reinsurance, there has been an increase in the current trend towards global treaties, and mixed and diversified risks within individual treaties. Brokers with the global perspective have been at the forefront of assisting clients in looking at reinsurance strategies which involve the use of globally diversified treaties.

This has been especially true in catastrophe classes but is now becoming increasingly important for other lines as well. In some ways this has led to differential pricing relative to exposure. This was seen in the last renewal season where reinsurers were prepared to write territorial business at premiums below the technical rate in order to acquire a portfolio of global risks outside of the US earthquake and wind exposure lines. In this process it has been vital that while working on pre-renewal reinsurance strategies, brokers have been able to advise on likely pricing by reinsurers.

As a result, the actual buying process, whereby a broker negotiates with reinsurers, has occurred later in the year and has been a relatively short process because so much preparatory strategic work has been done before renewal. The fact that modelled data is passed between client, broker and reinsurer has, in some ways, sped up this process but has also led to a reduction in the effect of the relationship between the reinsurer and the client. Since the modelling of data has such an important part to play in negotiations, it has reduced the overall onus on relationships between the parties and the influence of the past result. But despite the importance of modelling, the historical relationship focus should not be underestimated.

Wind exposures

As a result of the model-induced changes in the reinsurance buying habits of insurers, brokers find themselves in a position of needing to analyse and reconcile different objectives within the client company. For example, the objectives of the group are frequently different from those at the underwriting level and the broker needs to move from the "academic" best solution to a practical solution which meets the client's objectives and is achievable within the market. The large number of issues, including conflicting client objectives, which the broker needs to address, means that the broker is under pressure from all sides prior to placement of a reinsurance programme. The current lack of capacity for Gulf wind exposures is a major talking point but still only affects those clients with those specific exposures. However the effect on these clients and their buying strategies is enormous and much work has been done throughout the year with regard to strategy.

As we are presently in the wind season, and fortunately so far there have been no major hurricane losses, clients are adopting various strategies and working with brokers throughout the world to find capacity. In this instance, client buying and broker advice is somewhat old-fashioned since supply and demand economics dictate the cost of reinsurance rather more than modelled data does. In such cases the client's ability to manage gross exposures becomes the dominant factor in the reinsurance strategy.

The effects on the cost of capital have become vital to clients and their advocates, the brokers, in strategy negotiation. When there is a capacity shortage then the strategy may vary. In these instances the ability of the broker to find capacity becomes invaluable.

- Terry Masters is managing director at Aon Reinsurance Solutions.