Reinsurers must prepare for the inevitable soft market. By Andy Giffin and Rick Shaw.
our recent paper, The Next Catastrophe Risk/Excess Reinsurance Market Cycle, presented at the Annual Seminar of the International Insurance Society in New York in July 2003, we likened the reinsurance market participants to frogs in a pot of boiling water. The paper addressed the issue of whether companies would be able to jump out of the water before being cooked. Here, cooked means becoming one of those companies unable to survive the possibly inevitable softening of the reinsurance markets.
The current hard market, when the water is cool, means it's not too hard to return underwriting profits. However, now is the time to research and implement strategies suitable for a softer market, as the heat is turned up.
We have reviewed the results of the survey of reinsurance executives reported in that paper and have identified several steps reinsurers, can take to avoid being cooked.
Enhance and integrate analytical tools used for underwriting, pricing, portfolio management and capital management
Many companies, particularly those in the Bermuda market, have developed sophisticated modeling tools to help evaluate and price risks. Risk portfolio aggregation models are standard for property catastrophe business. Thus, property catastrophe specialists are able to assess the impact of a prospective new risk on their existing risk portfolios, capital requirements, expected returns, etc.
Opportunities remain to improve analysis in per risk excess property covers. Here, information is often incomplete. In casualty lines, information deficiencies and limited development of critical assumptions hamper active model use. It appears that marine and aviation lines may be less amenable to modeling, and have not been influenced significantly by modeling tools to date. It is our belief that reinsurers will profit from further development of models in these areas. More work is needed to get to grips with significant underlying risk volatility, along with the unpredictable factors of tort law change, jury awards, as well as natural and man-made loss exposures.
Companies and company groups also need to improve their understanding of aggregate portfolio risk, both to avoid undue exposures and to take advantage of countervailing risks. As noted, property catastrophe specialists constantly evaluate new risks against the existing portfolio. This is much more complicated for multi-line companies, particularly those that mix insurance and reinsurance. For these, it may be more feasible to use a scenario-based approach to analysis. The baseline would be the existing risk portfolio. Once risk dynamics are identified, the impact of potential additions of new risks can be tested to better understand how changes in portfolio composition are likely to change results.
Widely-used commercial software allows monitoring of property catastrophe exposures. However, it may be of some concern that the market moves as a whole with these models, indicating uncritical acceptance of the model outcomes.
Company management will certainly be interested in absolute exposure; what event will have discernable impact upon capital levels? Management will also be interested in exposure relative to competition and the wider industry. To monitor relative exposure requires some measure of competitors' exposures.
Scenario testing is a useful technique for assessing aggregation risk. For a multi-line insurer, robust scenario testing will require the collection of exposure data across a number of dimensions. Initially, it may be possible to use a model office construct and/or group risks in a manner that allows scenario testing while data are being collected.
Designing appropriate scenarios can indicate any deficiencies in existing data. Scenarios should range across all potential perils, depending on the lines of business written, including for example political, financial and legal perils, as well as natural or man-made disasters.
Capital management is another increasing concern as new capital arrives in the market with high expectations for significant returns. This concern will grow as markets soften from their current relatively hard state. Price competition will require sacrifices in return. The challenge will be to determine the minimum acceptable return level, and to have the discipline to sacrifice market share by turning away unacceptable risks. This will require a good understanding of investor expectations and attitudes toward risk.
Capital management includes both the allocation of capital to lines of business and the selection of target returns that reflect the relative risk of portions of the business. Allocation of capital must take account of minimum regulatory requirements and capital expectations of rating agencies. It should reflect the company's tolerance for risk of failure or observable downturn in fortunes (e.g., reduction in capital, reduction in stock price). It should reflect differences in the inherent risk of blocks of business (e.g., line of business, geography). A balance must be struck between significant differences in risk and the practicality of managing the number of risk pools into which the portfolio is divided.
Capital management will also consider target returns. Target returns will reflect the return expectations of company shareholders, including different expectations of different shareholders (e.g., short-term investment partners). Target returns will be used in setting pricing targets by line of business.
Concepts from utility theory, integrated into simulation models, are now being used to allocate capital and set target rates of return. Market attitude to risk, as reflected for example in rating agencies' capital guidelines, is inevitably important for determining overall capital levels and allocation among business units. Insurance is the business of buying and selling risk, and companies are encouraged to develop models which reflect the peculiarities of the business actually written, and management's attitude to risk, which hopefully is more appropriate on an individual company basis.
It is becoming increasingly clear that underwriting, pricing, risk portfolio and capital management analysis must work together to account for a constantly changing situation. Underwriting and pricing models must adjust to market and risk conditions. Risk portfolio analysis must adjust to the flow of business that changes the internal dynamics. Capital management is also a balancing act that responds to market conditions and changing judgments of effective capital deployment. Target returns might be adjusted downward if the choice is taking a lower return or not deploying capital. Thus, in addition to further development of the individual parts of this system, coordination of the parts is an important component of improving the value of the intelligence produced by these analyses. This requires both model coordination and an integration of management activity to use the combination of models effectively.
Develop sound internal company/group level profitability analysis, based on actuarial appraisal values
The insurance and reinsurance industries have always had a problem convincing the financial world (including many of their investors) that they have a consistent, reliable measure of profitability. Actuarial valuation models provide the means to understanding the underlying financial dynamics of companies, allowing management to better understand and explain results reported in traditional accounting formats. Statutory and GAAP accounting measures of profitability and financial strength do not always provide management with a full view of the drivers of profitability. Actuarial valuation offers an appreciation of the factors that drive profitability. These drivers can then be traced to areas of operations providing the best opportunity for improving results.
Actuarial valuation follows cash flows over time to understand the dynamics that drive the business. An overall model of the company can bring together all the elements of the underwriting, pricing, risk portfolio and capital management analysis so that the combined results can be seen, both in ultimate results and in their interactive parts.
Variance analysis can help to identify profit driver sensitivity to changes in cash flow patterns. Sometimes, relatively small changes in these factors can result in large changes in company value. Variance analysis illustrates these changes, allowing management to concentrate on actions to control these critical profit drivers.
Reinsurance has historically been a relationship-based business, where it is understood that cedants will stick with reinsurers through subsequent good years to allow recompense for a year of high losses. Such an approach implicitly reflects the stochastic nature of the risks being sold; it may be more appropriate to consider capital and reserving levels over a number of years, rather than treat each year in isolation.
Improve communications between underwriters, actuaries, financial managers and general managers
Use of models in underwriting has required better communication between underwriters and actuaries in the underwriting process. Work remains to develop this into regular, coherent communication that combines the best of both disciplines. In prior cycles, managers have been warned by actuaries that competitive prices were not technically adequate. Many managers ignored the warnings.
This communication must also be extended to financial analysts and company managers in portfolio analysis, capital management and profitability analysis. Company policy, and profitability results, will be best served by cohesive input from the range of insurance professionals in an integrated management process.
It is sound practice to separate the reserving function from the pricing function, but the two units need to work consistently. In practice, there is and may always be some discontinuity between the two functions. For example, most of the actuaries in Bermuda are involved in underwriting and are not responsible for reserving.
Extend well-focused corporate strategy, establish underwriting discipline
The ultimate question posed in the survey reported in our prior paper was whether, with all the analytical tools and knowledge of the past, there would be any change to prior patterns, i.e. a hard market, followed by a gradual slide into price inadequacy, until some major event causes sufficient damage that some market participants do not survive, and significant new capital brings in shiny new players to feed the next cycle. Most survey respondents agreed that if the available tools were used effectively, the market could avoid a repeat of history. However, most saw a significant risk that history would repeat itself once again despite the available tools and knowledge.
It is easy to say that discipline will hold when companies have the luxury of a hard market. It is now that the ground rules need to be set for putting on the brakes as the market softens.
The success stories of the past two cycles suggest some guidelines. First, establish a clear strategy of what parts of the market you will participate in, even if prices soften. This may be very narrow or fairly broad, so long as the right resources and controls are in place to make the most of whatever is chosen. Then underwriting capabilities, pricing processes, portfolio risk management, capital management and supporting human resources must be in place that will support the strategy. Of course, regular review is required to keep the strategy effectively tuned to changing market conditions.
Improve efficiency in analytic and operating processes to assure robust analysis when there is less price margin to support such costs
Intense risk analysis is much easier to justify when prices are fat. As prices become more competitive, robust analysis is even more important. Yet, there will be the temptation to cut back on analysis as a cost-cutting measure to keep costs within declining price parameters. It is now, when there is room in pricing, when effort is required to upgrade and streamline analytic and operating processes, i.e., get more bang for the buck. This will have the short-term impact of improving the quality of the analysis and will prepare for the inevitable deterioration in pricing.
Establish a robust asset-liability management capability
Today's requirement is to profit from underwriting, without relying on investment returns. As economies recover, and the recent slump in investment markets turns around, we will need strong asset-liability management tools to avoid unwarranted price concessions based on unfounded assumptions about the effects of investment result improvements. The interaction between assets and liabilities can offer countervailing risk advantages, leading to competitive pricing opportunities, but these must be well understood to avoid the damages incurred in the last cycle.
If the option of unitising risks ever takes off, with the main barrier seeming to be clarity of product and frictional costs, understanding the relationship between assets and liabilities may become more sophisticated. The market for liabilities has the capacity to then become a lot deeper than is currently the case.
Improve satisfaction of customer risk management needs while maintaining risk portfolio balance
Insurers and reinsurers understand that they need a more complete picture of the risks presented by particular customers. This means getting closer to customers, and obtaining better information. At the same time, insurers and reinsurers need to avoid ending up with risk portfolio imbalances from excessive accommodation covers to meet good customer needs. Brokers can help to manage the process of finding alternative markets for some customer exposures for the benefit of all entities involved. Despite an expressed need among ceding companies to smooth out long-term exposures, concerns about accounting and tax treatment have limited the use of finite solutions that can address these needs. We must find cost-effective methods for combining insurance and financing solutions to meet these long-term requirements.
Leverage the evolving role of brokers as ceding company and reinsurer advisors
Brokers have developed consulting skills to help ceding companies prepare data needed by insurers and reinsurers to evaluate risks. Brokers are also actively developing alternative solutions to risk management needs, including retention strategies, self-insurance and reinsurance options. Reinsurers need to leverage this expanded capability to get help in assessing risks and determining appropriate reinsurance solutions.
Evaluate the potential for entry and/or exit through acquisition or sale of units
Merger and acquisition activity in reinsurance has been limited recently. Declines in stock values have restricted equity currency for making acquisitions, and those seeking acquirers have faced concerns about legacy exposures. Yet the reinsurance market continues to consolidate, along with new capital entry, often with experienced staff. Maintaining a viable strategy often requires either offloading units that no longer fit and/or acquiring units that leverage a growth area.
Part of the refinement of corporate strategy is consideration of how such units can be sold or acquired with the risks minimised. This may require credible assessment of any legacy exposures. It will also require careful valuation analysis to be sure that business acquired can be made to achieve expected returns.
Reinsurance account and claims management is usually an inefficient process. Complex retrocession arrangements for account and claims management compound the costs, delays and recoverability risks involved.
As part of the preparation for life with lower pricing margins, it is important to invest in efficiency efforts to improve account and claims management. Some companies are renewing efforts to develop standardised processes, and some are outsourcing to third-party service providers which offer some standardisation.
Reinsurers, new and old, are enjoying an unusual period of adequate, and in some sectors still rising, prices. This is the time to prepare for the inevitable market softening.With more effective risk assessment tools in place, and more efficient processes, reinsurers will be better prepared to avoid the loss of discipline that has spelled disaster for many in past cycles.
It is hard to ignore the fact that, despite past efforts to improve risk selection and management, risk portfolio management and capital management, softening reinsurance markets have repeatedly led to severe dislocations in the industry, with many failures, departures and then new entrants.
Today, we have access to much better tools and a clearer sense of what needs to be done to head off another similar cycle. The question is whether reinsurers will take the steps needed now to ensure that the apparent determination to exercise the required discipline will be applied this time. Will they develop underwriting models in other lines similar to those now in place for property catastrophe? Will they properly account for risk portfolio aggregates?
Will they establish and adhere to clear benchmarks for capital requirements and return targets? Like the frog, will they jump out of the water before it boils, or be cooked?
Andy Giffin is a Principal in Tillinghast-Towers Perrin, located in New York. Rick Shaw is Office Manager of Tillinghast-Towers Perrin's Bermuda office.