Grahame Millwater explains how brokers can provide more than the `new model' added value to their clients in hard market conditions.
The past decade has seen extensive scrutiny into the roles played by all professionals in the financial services sector. This has been more far-reaching and more comprehensive for intermediaries than for principals, and reinsurance brokers have been no exception to this trend.
Indeed, in some respects intermediaries have had to reinvent themselves as a response to this process. Pure transactional capabilities have been supplemented by wider advisory capabilities. The `new model' reinsurance broker has had to evolve rapidly into a professional practice with skills as diverse as risk management, balance sheet structuring, catastrophe and other risk modeling, accountancy development planning and security development guidance, to mention just a few.
It would be foolish to believe that this period of transition is over, for there are further and more far-reaching changes to come: the implications of the largest man-made disaster on September 11 have yet to make themselves fully apparent; consolidation continues to affect every area of the insurance and finance world as a whole; and vastly increased regulation of all financial sectors promises to create a quite different business environment.
Central to all the above issues is the nature of the new capital coming into the market: over $17bn of new capital has entered the reinsurance market since September 11. This large inflow raises many questions about the long-term risk appetite of this new capital and the speed of return that investors are seeking. It is also very striking to note the sharp focus of the new money: gone are the days when shareholders handed out funds to management with a broad-spectrum mandate to cast their net generally into the insurance sector. The new money, being channelled principally into Bermuda, is predominantly targeting the modeled property catastrophe sector. New money aimed at casualty classes is highly conspicuous by its absence.
Both pricing and coverage market cycles appear to have shortened. Reinsurance product development of an innovative and sustainable form remains elusive. Regulatory authorities, having been disappointed by the effect of some `innovative structures' which have disguised the parlous conditions of some carriers, are beginning to limit the scope for alternative solutions. At the same time, investors should not expect to achieve returns similar to those achieved by the last large capital inflows of the 1980s. As a side note, it is interesting to note that intermediaries' share prices have tended to outperform those of insurance and reinsurance carriers since September 11.
Focus on role
These recent market developments have re-emphasised the broker's role in a hard market - to identify sources of capacity to deliver the best possible price for their clients at appropriate levels of credit security. Hence, while the `new model' skills have become an essential part of the reinsurance broker's armoury, they have by no means superseded the transactional skills: long-standing business relationships retain their enormous value. The modern reinsurance broker has to have the older transactional skills as a sine qua non, supplemented by many more sophisticated capabilities.
These more sophisticated skills emanate from a wider awareness of the economic world inhabited by the insurers. Chief among the pressures driving change for insurers and their reinsurance brokers are the recent (and shortly prospective) regulatory and accounting developments.
There have always been arguments for and against the increased regulation of insurers, reinsurers and their brokers. The historic trend, however, has been inexorably in one direction. Until recently, ratings agencies have acted as de facto regulators for the reinsurance industry. While they are subject to market forces, many believe that the problems at stake have outgrown the ratings agency framework. Around the world, regulators are starting to apply to reinsurance the same attention they have until now reserved for insurers' net balance sheets. In a more complex development in some countries (notably the UK), the regulation of insurance is being integrated with that of the banking sector. This is going to increase the disclosure requirements surrounding reinsurance transactions, requiring brokers to understand a broader field of compliance. It will also create a less predictable environment, where the regulator will be addressing both the asset side of the balance sheet and the liability side with equal attention.
More specifically, the Financial Services Authority (FSA) in the UK is moving towards an environment where brokers themselves will be subject to a completely new level of scrutiny. Internal risk management, accounting controls, disclosure procedures, covernote sign-off practices and so on will all be subject to new techniques. Even client relationships will change - the era of enormous client relationships governed by no more than a loose understanding and the generality of market precedent is soon to be a thing of the past.
As well as growing regulatory intervention, there is also the potential for a truly enormous change in financial reporting. The International Accounting Standards Council (IASC) has proposed a system of accounting known as Full Value Accounting. Both the European Union and the Australian accounting supervisory body have agreed to implement this by 2005. In Full Value Accounting (FVA), the emphasis lies firmly on full disclosure of the net present value of all items on the balance sheet - that is to say, the discounted value of all assets and liabilities at the time of the accounts. While these standards undoubtedly increase the transparency and clarity of a company's accounts, they are not without opposition. Certain larger companies believe that to be forced to reveal the precise current value of everything on their balance sheet at any given moment will often paint an inaccurate picture of the company's progress and prospects. This may lead, in turn, to unnecessary fluctuations in the share price. Clearly there are valid arguments for both systems, but it is of paramount importance that some global consensus is reached on this matter. In the meantime, insurers, reinsurers and their brokers need to plan on the presumption that the FVA principle will hold.
A third area where the landscape is rapidly shifting, and where the role of the reinsurance broker is swiftly evolving, is reinsurer security. Recent turbulence in global stock markets has served to underline the critical importance in the reinsurance purchasing process of the quality of reinsurer security. Insurers and their brokers are devoting increasing resources to the analysis of security issues, but the speed with which the rating agencies' opinions have recently been changing must be a matter of serious concern for the future.
Fourthly, reinsurance brokers have taken major strides in recent years to develop models to assist in cash flow forecasting, loss forecasting, risk and catastrophe exposures, and many other technical support capabilities. This trend is likely to intensify. We at Willis have invested heavily in our `Willis iFM', an internet-based financial modeling tool that enables reinsurance programme optimisation analysis. Another typical example lies in the Turnbull findings on corporate governance; insurers have to adapt to new standards in this field, and the reinsurance broker with the appropriate advisory capabilities here is bound to strengthen client relationships by being able to deliver the requisite services as a natural cross-sale.
There must be many more examples of this same general trend, as clients call for an increasingly comprehensive advisory service across an increasingly sophisticated range of roles. One obvious area where matters appear to be spiralling upwards in technical complexity is the casualty field.
The great difficulties of accurately analysing casualty exposures, combined with the sheer logistical complexity of writing reinsurance casualty business, have always made capacity in this field scarce. New risks such as toxic mould, electro-magnetic fields (EMFs), cyberliabilities and terrorism are continually emerging to join longer-term risks such as asbestosis and the litigious environment of the US. For the reinsurance broker, the emphasis here has to be two-pronged.
Firstly, brokers must be experts on existing hazards and ever vigilant to the emergence of the new, ensuring clients are kept abreast of any and all the latest developments. Secondly, brokers need to employ this expertise to make the issue as transparent as possible for the risk carriers. This places the emphasis in all interactions heavily on complete clarity of disclosure.
One of the consequences of the drive for brokers to attain a more complete range of skills is that only a small minority of firms can hope to be competitive where such a broad range of capabilities is required. Insurers will find themselves inevitably attracted towards dealing with a much smaller pool of professionals with the required levels of technique.
This is a far cry from the typical questions that occupy brokers looking at the state of the market. Given the unique reasons behind the current market conditions, it is extremely difficult to predict future developments with any degree of accuracy.
To what extent will rates continue to harden? How long will they remain hard? And if, as some market commentators predict, the hard market endures until the end of 2003, will the subsequent soft cycle be longer or shorter as a result? The greater the real uncertainty in this type of issue, the less the value that can be brought to the holding of an opinion unless it comes from an authority commanding the highest of respect. As with the stock market, true `gurus' in reinsurance are becoming harder to find, and their opinions will be increasingly sought after.
Brokers have thrived for the past 170 years. But they have only done so by never forgetting that they only exist because they add value to a financial flow between two other parties. New areas of service have been added in areas of financial and risk modeling.
Perhaps for the first time, technology is starting to drive the services that can be delivered. But perhaps the fundamental lesson when looking at the next decade is that success in serving clients better can only be based on understanding their needs better. However sophisticated analytical services and market technology become, they add little value unless applied to solving real, current client issues. Just as out of understanding comes knowledge, so better client service can only come from a deeper and more responsible understanding of clients.
By Grahame Millwater
Grahame Millwater has been with the Willis Group for 17 years, and is currently chief operating officer of Willis Re globally, a post he was appointed to in 1998. Prior to this, he was managing director of the non-marine international operations. In January 2002, he was appointed to Willis' Group Executive Committee, and he is a director of the Willis Lloyd's broking subsidiary, Willis Ltd.