How should reinsurers price the exposures they are assuming? Lucas Beckmann gives some guidance

During the last two years the insurance industry has experienced the most difficult market since the liability crisis of the mid-1980s.

In 2001, just as the market was slowly beginning to harden again, the events of September 11 triggered off what was to have a lasting impact on insurance markets. Drastic price increases in the re/insurance markets were the rule, and it was extremely difficult in many cases to place high-exposure risks on the international market. However, as regards price development, this hard market is, compared to earlier crises in the industry, a long way from its historical peak levels (Figure 1).

The year 2003 was particularly striking with the danger of terrorism flaring up again due to the armed encounters in Iraq and the threat of a pandemic outbreak of the Severe Acute Respiratory Syndrome (SARS) virus, which kept the world on tenterhooks last year. The impact on both the global community and the insurance industry was, however, restrained and has to date not led to the consequences that were feared.

The absence of catastrophic losses and the fact that subsequent reserving for the disastrously adverse development in long-tail claims had to a large extent already been made in 2002 (especially for liability business in North America - however, the recent reserve strengthening of the Converium Group shows that there might still be some reserve deficiencies). This gave underwriters the ability to focus on the quality of risks rather than just price during the last renewal period.

The terms and conditions in property managed to remain relatively stable, but there was a marked increase in price pressure. This was due to the excess capacity available (especially in natural catastrophe) and the non-occurrence of major catastrophic claims. This situation, however, might be reversed due to the comparable large number of hurricanes that hit the Caribbean and the North American continent recently. Even if these events do not have a dramatic catastrophic impact, the unforeseen frequency might help to keep the rates at a stable level.

In contrast, the liability market remained stable with no strong pressure on the rates in the reinsurance markets. On the direct side, however, especially in the US, the pressure on casualty rates is increasing. During the last renewal, capacity was ample, even for highly exposed industrial risks. However, the prerequisite for this was an attractive price and the presentation of meaningful information about the reinsured portfolio.

Whereas pure price negotiations and limitations in the scope of coverage had dominated previous years, 2003 and 2004 both saw an emphasis on transparency in the reinsurance portfolio.

This shift in the quality of reinsured portfolios transparency could be seen in pricing and exposure when underwriting a reinsurance treaty.

While in previous years pure loss triangulations were often used to find the right price using the experience/burning cost method, today a lot more information for the pricing exercise is considered. Treaty underwriters take a much deeper look into the exposure to evaluate the possibility of loss frequency and severity.

Exposure pricing

The portfolios of some cedants who write large limits but 'luckily' never had a huge loss are now more accurately priced using the exposure pricing method. To apply an exposure rating, the reinsurer needs detailed information about the underlying portfolio in the form of limit profiles. These limit profiles show in bands how many policies expose the various reinsurance layers and the corresponding original premium per limit band. Furthermore, if the insurer also writes pure excess policies or policies with high self-insured retentions (SIR), the profile should also include information about the original attachment points.

The underwriter and the actuary use this information to establish an exposure curve, which in turn influences pricing and the exposure evaluation.

How strong this influence is depends on the structure of the reinsurance programme.

Blending the experience pricing method with the exposure pricing method enables the underwriter to weigh the influence of each pricing method on a case-by-case basis. In general, low working layers, where the underwriter has sufficient and reliable loss information, are less impacted by the exposure pricing method, but for higher catastrophe layers with basically no loss history the impact is much stronger. Beside the pure loss experience, the blending is also impacted by the nature of the risks, the policy structure and the premium rate.

However, to establish meaningful exposure curves and analysis, another piece of information is needed: the risk profile. This risk profile reflects the client's portfolio segmented in different trades. To be able to work with this information, the trades should be sub-segmented to a workable number of segments. These segments could be personal liability, retail, wholesale, light and heavy manufacturing, construction, utilities, etc.

Using this risk information, the limit profiles can be weighed with the individual exposure of the segmented trades, meaning different curves can be applied to the different trades. This way the underwriter achieves a fair and actual view on the exposure of the underlying portfolio.

The risk profile also gives the reinsurer a good picture of the composition of the book. If those risk and limit profiles are provided for some years, a shift of the underwriting philosophy and strategic changes in the market approach of the client are clearly visible and can have a positive impact on the pricing and underwriting decision.

In addition to this pure figure-driven information, detailed information about the underwriting approach of specific classes is also more often requested, especially for highly exposed risks such as genetically modified objects, pharmaceutical manufacturing or compounding, railways, electromagnetic fields and of course terrorism. The reinsurer wants to have a clear understanding of the cedant's handling of these risks. This encompasses not just information about the number of risks per segment, but also about the wording structure, applied exclusions, etc.

Also, US exposures of the original risks are closely reviewed. As a result of the growing globalisation more small and medium-sized companies export their products to the US or even open a sales office. Regional and domestic insurance companies in continental Europe are more frequently confronted with this kind of exposure. However, some insurers still underestimate the associated complexity and hazardous legal environment.

The reinsurer therefore requests information about the underwriting experience and the existing guidelines of the cedant in respect of this exposure.

Furthermore, the original pricing approach for the US exposure is also a very important point, as some products, which might be seen as a light or medium exposure in continental Europe, are extremely hazardous in the view of the US legal system and experience, for example ladders or household appliances.

Other points of interest are the so-called embedded exposures, especially in the case of small to medium-sized insurance companies that do not buy separate reinsurance treaties for lines such as professional indemnity, medical malpractice and general third-party liability. In cases where professional indemnity/medical malpractice are only written to a small extent, the general liability treaties of European cedants also cover the professional indemnity/medical malpractice risks. However, the information requested in respect of this part of the portfolio has risen dramatically.

For example, coverage for hospitals has been identified as one of the exposures that should be monitored very closely. Losses for this coverage show a steady increase on the whole continent.

This positive shift in the quality of underwriting information gives reinsurers deep insight into a portfolio such as detailed information about risks and limits used for the covered original contracts. All this additional information about the portfolio helps in studying the exposures inherent in the treaty.

This development is being fuelled further by the continued weak investment markets that are forcing all players to completely abandon the cash flow underwriting of the late 1990s. Today an underwriting profit is imperative to achieve the return on equity1 required by shareholders. Ultimately a close analysis of business in force has become essential because of the European Union's Solvency II2 project, which calls for a differentiated consideration of the equity required for the operation of insurance and reinsurance businesses.

It will be interesting to see what the future brings. The insurance market is very cyclical and prices will fall again at some point. However, it seems that the market still needs some time to recover from the adverse events of the past and to create the appropriate structures and risk management systems necessary to generate the sustainable profitability so badly needed.

To attain this objective and avoid making the same mistakes again it will be necessary to concentrate on disciplined and result-oriented underwriting.

1 For more information, please also see EXPOSURE 13, "Return on Equity and its Application in Performance Measurement, Corporate Management and Rating Basis,"
2 For more information, please also see EXPOSURE 11 "Solvency Challenges for EuropeanInsurers,"
- Lucas Beckmann is the product leader for the European liability and personal accident treaty business at GE Insurance Solutions Property and Casualty Reinsurance unit, Munich, Germany.