Losses (noun, plural) Losses present a conundrum: without them there would be no need for insurance, the conventional wisdom informs us, but in the presence of too many losses, the whole industry would disappear.
Consequently, some understandable confusion exists in parts of the reinsurance sector (which presumably is also pointless in the absence of losses) over the importance, value and role of losses.
Loss distinctionSimply put, risk carriers are supposed to take losses, not make them.The distinction is all important. Those companies that can take losses but stay consistently profitable are favourites among investors, who are not all that keen on losses of any sort. Unfortunately, the nature of the reinsurance business means that when insurers are taking losses they are likely also to be making them. On the other hand, when reinsurers are taking few serious losses, as they have been in the past two years, their making of losses also declines.Historically, an absence of losses such as has just been experienced causes reinsurance buyers to demand lower prices from their reinsurers, since they see the cash flow going all one way. Such periods have also tended to lead to feelings of infallibility among reinsurers, who typically will concede by granting discounts. Some even adopt this as a strategy called 'growing into the soft market'. This is akin to a retailer losing 2% on every sale, but trying to make up for it through volume.Unfortunately, it is impossible never to take any losses. Nature, mother or human, eventually intervenes. For example, current rumblings in the aviation insurance market about a permanent change in the loss pattern are wildly optimistic, and made up by those who want lower prices (see above). The simple fact that losses were unusually low for two years does not mean they are suddenly average. Ultimately and inevitably in any line of cover, the backlog of losses, which statistically everyone knows is overdue, will suddenly slam down upon underpriced risk portfolios, creating the other kind of losses.The secret, then, is to have losses of only one kind at a time. Since any company that makes losses while taking none is quickly abandoned by its capital providers, the trick must be to take losses but not make them.Fortunately, the entire insurance sector has pledged to do this in perpetuity, which will come as a great relief to the people who own it. Reinsurers have finally got religion. From now on they will practice 'technical underwriting'.They will resist the pressure from brokers and clients to lower their prices. They will never again rely on investment income to make up for underwriting losses (at least not very much). Henceforth reinsurers will not make losses... except for the old ones they are still paying for.Technical underwriting is a simple concept. Reinsurers will banish financial losses by looking very closely at the source, scale and frequency of the other kind of losses to understand risks thoroughly, and will collectively charge enough premium to cover them. Alas, in practice this has always proved the most difficult challenge they have ever faced, even though, intuitively, it is fundamental to their business. In fairness, the underwriters and actuaries should not be forced to shoulder all of the blame for this lack of historic success. Even managers' occasionally flawed strategies are only one part of the problem. Some blame has to be placed on the reality that, with even the best information, it is not easy to predict losses.
Accurate data requiredIf reinsurers are to banish losses, they need sufficient, accurate data to calculate the right price, and a stable set of conditions on which to pass judgment. Unfortunately both have been elusive. Take three examples.The number of aeroplanes in the world is too few for the actuaries to predict with accuracy how many will fall out of the sky each year, let alone how many very expensive US lawyers will be aboard. The sophisticated catastrophe models that software companies produce for the reinsurance industry have a tendency to appear slightly flawed until the wind next blows or the earth shakes (did anyone buy less under RMS 4.3?). A disturbing ratchet effect seems to operate on the world's laws of the land, to the disadvantage of reinsurers; since the invention of insurance, no society anywhere has magically become less litigious.Many other tangible obstacles to technical pricing make the challenge difficult. Add to them the industry's seemingly insatiable desire for growth (or at least consistency of size), the often overwhelming temptation to price with the market regardless, and the gently returning comfort of investment income, and it may seem nearly impossible to sustain. But since the losses keep rolling on, those reinsurers that want to stop making them had better figure out how to take them.