David Rainbow looks at multinational insurers' reinsurance buying strategies

The re/insurance marketplace is in a constant state of change. Over the last ten years, Bermuda has come of age, 'AAA' security has become a rarity, Lloyd's has reincarnated itself, and, of course, there was the impact of 9/11. During this time, following their advent during the 1980s and 1990s, multinational insurance groups, with leading positions in many if not all principal markets around the world, have been going through their own metamorphoses in an effort to become fully integrated global groups.

Such major multinational insurers have succeeded in rapidly evolving single, global commercial brands, but most would accept that they still have some way to go to becoming truly global, aiming for the ideal of a single identity and culture, embedded across the full spectrum of their business.

Optimising and integrating

As they have worked on consolidating their purchases and mergers, such groups have had to confront the tough challenge of drawing together geographically and culturally diverse operations often of extreme sizes - some massive, some tiny - into a cohesive integrated organisation. In this process, reinsurance purchasing has not always been the priority. But increasingly, these groups are now addressing the issue of how to rationalise, optimise and integrate their reinsurance-buying strategies worldwide.

This is no easy task. Very often, multinational groups will have a holding company or head office at the centre, and then a multitude of operational entities each running as a separate profit centre, typically with each operation having its own local retention and reinsurance treaties. There are cases where as many as 500 separate insurance programmes are purchased within the same group.

So, what are the key objectives, options and issues that the multinational group global reinsurance manager must consider in developing a truly global reinsurance buying strategy?

Before starting, it is essential for the multinational group global reinsurance buyer not to underestimate the complexity of the challenge. It must be recognised too that there is no perfect solution, thus the reinsurance manager must identify what strategy best matches the objectives, style, culture and perhaps most importantly, shareholder expectations of the group represented. To expand, an investor seeking low volatility/low returns will require a very different reinsurance buying strategy and structure to the investor who is willing to live with high volatility/high return results.

In its simplest terms, the ultimate objective is to balance the most efficient use of the group's capital against that of the reinsurance market.

The buyer, often considered as the global group's own risk manager, can easily be distracted from this fundamental goal, but it really must underpin every strategic decision taken.

The buyer must then consider at what level - locally or centrally - capital is exposed, volatility managed and reinsurance purchased. The buyer must assess how this will impact on the group's control and evaluation procedures, particularly to ensure that the desired levels of local entity underwriting and profit disciplines are maintained.

Centralise or decentralise?

This raises one of the most sensitive areas and biggest battlegrounds for testing management: how centralised or decentralised a method should be adopted by the group? At one extreme, a single global reinsurance programme may be purchased by the head office to protect all entities within the group. At the other extreme, a group may decide that, whilst coordinating what is purchased, the head office will instruct each entity to buy entirely local protections. Experience indicates that the optimal solution for many groups will be somewhere in between these two extremes.

If everything is centralised, there is the danger that local needs are not reflected or satisfied. At the same time, local expertise and advantageous relationships with local reinsurers may well be lost. On the other hand, if buying is completely decentralised, there may be overlapping or even duplication of cover, lost economies of scale, no common identity and contradictions in marketing strategy.

With the issues of capital management and the degree of centralisation of the buying strategy now identified, the group reinsurance manager is able to embark upon a detailed study of the main implementation options and issues to consider.

Structural options

Structurally, legal requirements in many local host countries will oblige global groups to operate with distinct and separate legal entities in each country in which they seek to do business. This in turn necessitates that each operation has its own reinsurance treaties. These may be either transacted 100% 'internally' with the group in the case of a fully centralised strategy or placed 100% 'externally' with third party reinsurers in a totally decentralised scheme, or a mix of the two.

Although each group has its own specific characteristics, most viable strategies will comprise the five following components, albeit in varying degrees.

At local level:

- local operation self-retentions;

- local operation external reinsurance; and

- local operation internal reinsurance with the centre.

At group level:

- group self-retention at the centre; and

- group external reinsurance from the centre.

The level and mix of these five elements are determined by a number of considerations at both local and group level.

At local level:

- what are the risk appetite, profitability targets, capacity requirements and amount of capital allocated at the local entity level? These elements will determine the retention level and amount of reinsurance to be sought; and

- should the local operation buy reinsurance with local reinsurers, or with the centre, or both? Is the local entity authorised to put the two in competition? To 'win' the business would the centre then be expected to undercut the open market and thus assume underpriced exposures?

At group level:

- by effectively reinsuring the local treaties from the centre, the group may assume a diversified portfolio of at least partially non-correlated exposures, enabling the group to optimise the use of its own capital.

This benefit is not automatic and will vary depending upon the different branches and the geographical make-up of the group's portfolio. The degree of risk diversification will have a major impact on deciding the optimal reinsurance strategy;

- above what is considered the optimal level of retention at the centre, the group may then benefit from buying a combined global protection for its peak exposures in the various geographical regions and branches, ensuring the most efficient use of external reinsurers, and the maximum use of the group's buying power. Again benefits are not automatic. A group must carefully weigh up the pros and cons before buying global cover, since forcing such 'catch all' covers onto reluctant markets can be very expensive or even plain unplaceable; and

- the group must ensure that it carefully manages its retained portfolio of exposures, net of any global protections. Risk retained at group level will need commensurate risk capital to be deployed, and the group must ensure that it does not either subsidise the local operations with cheap reinsurance, or inadvertently make a false profit at their expense.

Obstacles and challenges

As the buyer moves from the drawing board to implementation, inevitably some problems will need to be addressed, mainly relating to push from the centre and pull from the local entities. Amongst the most common are:

- Strong local operations - very often, constituent parts of a global group were previously very powerful companies in their own right, used to doing the pushing themselves, including taking decisions on how much reinsurance to buy, at what price and with whom. Furthermore, demand at group level for stronger local entity accountability translates very often into local operations being judged by the centre on their net results.

So local operations will almost certainly feel frustrated if the centre imposes conditions not benchmarked in the open reinsurance market. Such difficulties will be accentuated where local operations have minority third-party shareholders to satisfy. In addition, local operations know their business best and very often are able to get tailor-made, wider and sometimes cheaper reinsurance conditions than are available on a global basis.

- Quality of central reinsurance management team - the centre needs a well-experienced team which can command the respect of the local entity reinsurance buyers. If purchasing is centralised, this team must overcome the dangers of dilution of knowledge from local entities and minimise duplication of roles.

- Insufficient group culture - a clear group culture and strong sponsorship from very senior management are critical to the implementation of any group-wide, integrated global reinsurance strategy. Without these, any push from the centre will likely fail, causing embarrassment all round.

- Group retention management - any retention of exposures at the centre needs very careful management and its own performance must be measured.

This has often been somewhat overlooked in the past. Any system looks great when more premium is retained so long as there are no large claims.

But if there are losses to the group through the retention at the centre, from whose profit and loss account will they be paid? This is not as simple as it appears, since if the group balance sheet becomes an operational risk taker, it needs to be understood who pays the losses and a conscious decision must be taken as to how much capital is to be allocated to this exposure, and from where.

- Data consistency - determining group capital exposure and combining various reinsurance protections require portfolio information to be on a uniform basis. This is often a problem, because the likelihood that the group will have gone through several mergers and purchases over the year means there is likely to be several different inherited computer systems, each collecting data in a different format. There has been enormous progress in recent years in this respect, but there is a lot still to do. If consistent data is not available, decisions are more difficult to make internally and a lack of transparency is invariably penalised by the reinsurance market.

Recommendations

Establishing a group reinsurance strategy provides an excellent way to enhance and reflect a global group's identity and culture. Conversely, though, it should not be the method used to introduce or impose such a culture on the entities. Management should be bold and firm but flexible.

Excessive rigidity can reflect ignorance and a lack of management strength.

When bogged down by the complexity of the challenge, common sense, too, is vital.

It is unwise to try and change everything at once, and the challenge should not be undertaken without the help and knowledge of a reinsurance broker. Well-managed and properly motivated, brokers can bring key ingredients to success. Most importantly, each global group only knows itself, whereas brokers have the experience and increased perspective of a multitude of cedants' circumstances and protections. Plus, through their depth of resources and constant contact with reinsurance markets, major brokers know best what can and can't be done in a given market, on a global basis. Furthermore, in the quest to convince local operations that the centre is doing the right thing at the right price, reinsurance brokers can bring an objective third-party, independent perspective and viewpoint on decisions.

Communication needs to be clear. Outwards protections are a group's shop window to the reinsurance world. A well-managed, well-communicated, cohesive and coordinated strategy which translates into a reinsurance plan that is understood by the marketplace and gets the market on the group's side, with optimal continuity, will pay strong dividends. Easily said, but difficult to achieve.

Reinsurers see all this. If a global group's outwards strategies appear badly managed, this will reflect badly on the group's activities. So, while the strategy must be clear, it still must be communicated effectively.

Conclusion

Once a global reinsurance buying strategy is established, it's not all over, of course. To the contrary, it's just started. In fact, the strategy will evolve almost constantly in the quest to find the right balance between retention and cession of exposures.

As one group commits to more centralisation, another is busy decentralising in the endeavour to optimise the use of the group's size, diversity and capital strength while also maximising local level perspective and efficiency.

At the same time, many other forces will oblige the strategy to adapt.

Global groups do not stand still, instead changing size and shape all the time, expanding here, downsizing there. Shareholder expectations will evolve too, with available capital increasing or diminishing, as corporate priorities and performance change around the group - all putting new demands upon the reinsurance management and buying strategy. Plans will also be modified according to where the reinsurance market is in its pricing cycle.

In a hard market, the global group will incline towards higher retentions and in a soft market, the opposite. Finally, a major loss will test the system and particularly the group's appetite for retention at the centre.

Whatever strategy is adopted to meet the constantly changing environment, internal tensions will remain, but the trend towards going global with the centre playing a larger role will continue.

- This article contains general comments based upon the views of its author, which are not necessarily those of the Willis Group.

David Rainbow is an Executive Director at broker, Willis in London. Email: david.rainbow@willis.com.