Could underwriting discipline be in danger of collapsing as increasing competition, benign cat activity and softening markets puts pressure on pricing? ask Benjamin Gentsch and Marco Circelli.
Underwriting discipline and the profitability of key business are very much in vogue in the reinsurance industry. Opportunistic underwriting and targeting market share are not. Reinsurers are occupying the responsible high ground of the financial markets, committed to providing steady and consistent results to shareholders. Such talk is, of course, much easier in the hard markets we have seen in recent years. As some lines begin to look a little softer (even if global markets still look attractive overall), will reinsurers remain committed to underwriting discipline? Assuming there are no major catastrophic events, will reinsurers become increasingly tempted to compete - maybe irresponsibly - over their prices, or their terms and conditions?
Increased competition in certain lines has caused some softening; but there are compelling reasons for thinking underwriting discipline is not about to go out of fashion. The shifts in recent years in the legislation and supervision of the industry will no doubt discourage irresponsible practice. Partly in response to external legislation and continuing class action suits in the US, internal risk controls within reinsurers have been beefed up considerably, reducing the scope of underwriters to undercut competition. Increased internal risk controls have also raised awareness that there are no one-way bets to be made on investment income. Moreover, losses in recent years on prominent long-term lines have prompted new thinking into how reinsurers should understand their underwriting results (and hence pricing discipline) independently of their investment results.
The reinsurance market is not about perfect competition. Supply and demand count but they do not freely interact to find equilibrium. The market is a syndicated one - there are price leaders and there are price followers. Deals are done behind closed doors, information flows are restricted. Long-term relationships continue to take precedent over finding the most attractive short-term deal, despite some shift to the latter in recent years. The reinsurer is caught between two stools, seeking both to maximise return for its shareholders, and at the same time optimise the level of risk on the books, so that long-term returns are not adversely affected. Added to direct influences on industry prices are environmental factors. Growth in an economy, rising interest rates, or climbing equity markets can all have negative effects on underwriting discipline. Within the profusion of differing signals, it is no wonder that underwriting discipline often becomes something of a psychological game. Reinsurers watch and wait for what their competitors might do, seeking to double guess the wider market.
Changing regulatory landscape
There are a number of developments that suggest reinsurers' games are becoming more predictable as underwriting discipline becomes more entrenched. Accounting standards are becoming globalised, and accounts are becoming more transparent. A key development of the International Financial Reporting Standards (IFRS) for the reinsurance industry is the removal of equalisation reserves, a practice that for years has allowed the industry to cover losses over one time period with gains from another. The concerns of the authorities were that equalisation reserves were too opaque, their ownership not clear, and their taxable position uncertain (although there are very good reasons for retaining equalisation reserves, albeit with greater transparency). Losing the reserves however will increase potential volatility of results and ultimately returns within the industry. Underwriters can no longer sign "cheap" cat business and bet it will even itself out over the long-run.
IFRS is one example of increasing activism on the part of the authorities in regulating the reinsurance industry, as are cases such as the Spitzer investigations and the focus on procedure introduced by Sarbanes Oxley reporting. In lieu of a more methodical global approach, however, the rating agencies have de facto increasingly assumed a partly regulatory role in the reinsurance industry. During the first five years of the last decade - 1997-2001 inclusive - Standard & Poor's downgraded nine reinsurers, and upgraded 11 (see figure 1). Over the subsequent five years to 2006 there were 27 downgrades and 12 upgrades. These figures can be rationalised - 16 of the downgrades occurred in 2002 and 2003, as reinsurers struggled with their reserving levels after the bursting of the global equity bubble, and not just a product of increased rating agency activism. However the very fact that the number of downgrades trebled over the last half a decade, compared with the first half, has raised the importance and significance of ratings to the industry (all the more so with certain national authorities having effectively made writing certain lines of business contingent on the reinsurer having the minimum of an "A" rating). It may be difficult to look into the black box of the rating agencies' evaluation systems, but underwriting discipline is certainly no fad. Rating agencies are far warier of the reinsurer promising rapid and quick growth, than the reinsurer emphasising an approach based on a long-term risk/return principle.
The pressure of external agencies is being replicated, sometimes at the direct insistence of the rating agencies, in the internal structures and behaviours of reinsurers. Risk departments have grown in prominence within companies. The latest example of the spreading influence of the chief risk officer is the emphasis placed on enterprise risk management by the rating agencies. Actuarial and pricing specialists, always gathering data from recent large industry losses, are gaining status in the underwriting process. Underwriters do not operate with quite the same internal autonomy as they may have done in previous decades. Any "undisciplined" underwriting could only be undertaken with the acquiescence of a large number of parties within the company.
Isolating the underwriting result
It was much more tempting to steer towards less disciplined underwriting when there was something to fall back on, namely a steady income stream from elsewhere. This was very much the case in the 1990s, when reinsurers made huge returns on the back of the long bull-run in equities. As with others in the financial community, reinsurers to some degree became myopic at the long rise of global stock markets. It simply did not matter if underwriting was not making money - markets were exceptionally soft during most of the 1990s - when investment income would cover any underwriting losses. The global stock market erosion that started as of spring 2000 sobered up investors of all hues. Reinsurers know they will probably not see a bull market run of the 1990s again in their lifetime and many counted the cost of subsequent downgrades as their equity base was hit by asset impairments.
The decade did leave behind some interesting questions with regard to underwriting results however. Investment results are part of the reinsurance business. Understanding the short-run financial health of a reinsurer, both underwriting and investment, can still be easily shown through the combined ratio. However, the combined ratio does not give an accurate representation of long-term liabilities on the reinsurer's reserves. Some of the most damaging losses to the reinsurance industry have come through long-term policies, the most notorious of which has been asbestos. Understanding liabilities, particularly long-term liabilities, are central to the performance of a reinsurer. Matching reinsurance assets to liabilities is very much the other side of the coin to underwriting discipline. Assets need to be assumed, so that they negate excessive currency or interest rate risk, and that they reflect the duration of the liability portfolio on the reinsurers' books.
If the combined ratio is considered too imprecise for assessing the overall health of the reinsurer (in terms of short- and long-term liabilities), that would suggest that more stress will be put on separating the underwriting result (and ultimately underwriting discipline) from the overall corporate results. Combined with the oversight of the regulatory authorities, the rating agencies, and reinsurers' own risk departments, there is growing pressure against ill-disciplined underwriting. There will be soft markets in the future, but with underwriting discipline becoming more entrenched, prices will be stickier going down, and the underwriting cycle will be smoothed.
- Benjamin Gentsch is executive vice president for specialty lines, and Marco Circelli is head of investor relations and market research, at Converium.
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