Faced with rate reductions across most classes of reinsurance, companies are addressing the problem of how to manage the softening insurance cycle. Stewart Mitchell takes the temperature of the market.

Towards the end of 2007, an Ernst & Young survey of chief operating officers in the London reinsurance market showed that, almost without exception, the management of the softening insurance cycle was at the very top of their agenda.

A further survey of major insurers in the London and Bermuda markets earlier this year looked at technical pricing and rate monitoring processes and how these were used to manage the impacts of the softening market. While the survey focused on London Market insurers, many of the trends we identified can be translated to reinsurers.

We are currently in an interesting situation: the softening cycle, coinciding with a general downturn in the economy could present a double whammy challenge for many businesses. Such conditions not only exacerbate the impact of soft rates, but they also increase the frequency of claims – including an increase in fraudulent claims.

To some extent, the underlying direct insurance rates are driven by the rates that insurers have to pay to their reinsurers, and these reinsurance rates are driven by the supply of capital in the reinsurance market. Direct insurers are currently benefiting from competition in the reinsurance market but this may quickly change as we enter the main hurricane season.

Alternatives to traditional reinsurance also tend to suffer in a softening market. The ‘hot topics’ of a few years ago, including cat bonds and index linked securities, are cooling with the continued softening of the reinsurance market. Undoubtedly, they will become more fashionable when the market turns and hardens.

Recent broker reports paint a similar picture of reductions across most classes of reinsurance of up to 10%. Willis commented that rate reductions on July renewals were similar to those of January in both property and professional liability classes; while Benfield observed that Lloyd’s syndicates had reported rates being off between 2% and 8% in the first three to four months of 2008 dependent on the class of business. In addition, it said that international reinsurance rates were down 5%, and US reinsurance rates fell between 5 and 10% for nationwide cover but were down by as much as 15% for some regional exposures.

A larger loss in the order of between $40bn and $50bn is often quoted as necessary in order to trigger a return to a hard market; otherwise a continued softening of rates is expected until capital is impaired by a more attritional level of claims.

how is the market feeling?

Most respondents to our latest survey – ‘The price is right? Technical pricing and rate monitoring in a softening market’ – felt that they would manage the effects of the current soft cycle better than in the past. The introduction of more rigorous controls into the technical pricing and rate monitoring processes with peer review by other underwriters, internal audit functions and external advisors are all helping to help weather the potential disruption. In addition, the technical input into these processes has also increased with most reinsurers now having an in-house actuarial capability.

Worryingly, almost 75% of respondents estimated that the management information (MI) coming out of their rate monitoring process underestimates the true underlying rate reductions. There are a number of reasons for this. Firstly, new business is not being monitored (and is assumed to be worse rated than the renewal book); secondly, not all of the portfolio written is being monitored for rate movements; thirdly, underwriters may possibly be optimistic when populating the required MI fields.

Potential under reserving is a key impact of this underestimation of rates movements. Typically, the ultimate loss ratio for the current year will be based on the previous year’s ultimate loss ratio rolled forward for the impact of rate movements. If the loss ratio selected for 2007 is 85% and rates are off 10%, according to the rate monitoring MI, this would indicate a loss ratio for 2008 of 94%. However, if rates are actually off 20%, then the loss ratio for 2008 becomes 106% - a significant challenge for any business.

Our research found that while some insurers recognised this issue and subjectively amended their 2008 loss selections, others did not adjust them.

COMPETITION AND T&CS

There was general consensus that, to date, competition has been on price but in future the softening of the market will continue with deductibles and terms and conditions coming under greater scrutiny. The energy market is already seeing a reduction in deductibles for business interruption, while the D&O market is allowing previously excluded coverage in renewed policies.

Fierce competition on price continues in certain classes where new entrants are driving prices down. Some energy risks, deemed marginal last year, are being renewed with 40-50% discounts.

The changes in terms and conditions (T&Cs) will hurt reinsurers more than shaving a small percentage off the price of a risk. For example, some reinsurers have been badly hit in the 2007 underwriting year by several large risk losses impacting a particular reinsured, following the introduction of an aggregate deductible into the renewing policy.

Audit committees, management boards, external advisors and regulators are among the stakeholders interested in the quality of the technical and rate monitoring process. But variations exist in the level of assurance given to and required by these stakeholders. It is not clear how assurance over current reserve levels are derived in cases where underestimated rate reductions are used to roll forward loss ratios. Similarly, stakeholders don’t always realise that rate monitoring MI may be based only on half the portfolio of business written. Around half of respondents monitor less than 75% of their portfolio.

How many stakeholders realise that new business may not be monitored at all? And, if it is, are they aware that the MI may be so unreliable as to be deemed unusable?

Lloyd’s has introduced minimum standards for the underwriting process which include guidance for technical pricing and rate monitoring processes. The Financial Services Authority does not have similar detailed minimum standards; but entities operating in both the Lloyd’s and company markets tend to adopt the Lloyd’s standards for both platforms, seeing them as best practice.

Does data get worse in the soft market? Intuitively, one would think so, because it is easier for brokers to place risks than when capacity is harder to come by. However, most respondents didn’t think this was the case. In fact, most said the quality of data remained the same as the market softened. It will be interesting to see if this trend continues.

The strong position of the underwriter was evident in the survey mainly because they are ultimately responsible for committing the company to risk. However, there is a wide range in the operation of control frameworks around the underwriting process. This ranges from peer reviewing every risk prior to it being bound, to underwriters conducting their own technical pricing exclusive of the in-house actuarial function.

There is also a range of actuarial resource within technical pricing and rate monitoring processes, ranging from an embedded large actuarial team physically sitting with the underwriting teams, through to actuaries and underwriters sitting on different floors or even in different buildings.

So who will be the future winners in this competitive reinsurance market? Our survey painted a clear picture that they are likely to be those organisations combining the experience and judgments of the underwriters, supported by technical input from a statistical/actuarial function operating within a robust risk and control framework.

Stewart Mitchell is a Senior Manager within Ernst & Young’s Insurance and Actuarial Advisory Services.

Topics