Supply (noun) The law of supply and demand is the most basic economic principle.

Simply put, demand tends to decrease as the price of a commodity (or 'bespoke solution') rises. Likewise, supply tends to increase as profit margins grow. In a perfect market, the right price can be found at the point where the curve of increasing supply crosses the curve of declining demand. However, as everyone inside the industry is painfully aware, the reinsurance market is far from perfect.

You need not be Walter Bagehot to understand the implications of supply and demand on the reinsurance market. If, when returns are attractive, supply increases faster than demand, prices will fall as reinsurers cut their rates to underwrite their slice of the pie. But if demand outstrips supply, prices rise, as happened after Hurricane Andrew in 1992 and the World Trade Center loss in 2001, when reinsurers withdrew and insurers realised they needed more cover.

This behaviour has a knock-on effect. When demand outstrips supply, reinsurers grow their book, and capital floods the industry. Likewise, they leave the game - sometimes involuntarily - when prices are low. The reinsurance pricing cycle is the result.

The cycle

Bagehot was the first economist to iterate the idea of the business cycle.

He argued that periodic commercial slumps were not mere interruptions of sustained growth, but rather were the unpleasant constituent of a relentless repetition of boom-and-bust. This Victorian theorem has by no means won universal support among economic pundits, and to this day many dispute the existence of economic cyclicality. Clearly these anti-chartists haven't looked closely at reinsurance, for the peaks and troughs of its fortunes constitute the financial world's most naked example of a business cycle.

Demand helps fuel the cycle, and losses drive demand. French insurers have bought much more reinsurance since 1999, when the storms Lothar and Martin both burned egregiously through the reinsurance layers of companies which based their PML on the 1990 loss Herta. The 1997 floods in Czech Republic had the same effect: when the 2002 event occurred, reinsurers picked up 97% of the tab. Theoretical losses can also create demand, as happened last year, when RMS changed the assumptions in its US wind model.

A reinsurance buying spree followed, as US insurers, urged by the model, opted to avoid ending up like French insurers after their storms.

Supply too is a critical factor in the reinsurance equation. All the conventional rules apply, but in a perversely acute way. When reinsurers are willing to supply abundant amounts of reinsurance, the price falls, according to the normal rules. But if it is cars or houses or loaves of bread that are falling in price, people don't go out and buy a great deal more of them. Not so in reinsurance, where price is an acute driver of demand. 'Opportunistic buying' occurs when so much cheap reinsurance is available that companies buy cover for risk they would otherwise happily retain.

According to the laws of supply and demand, when prices rise, new supply emerges. In reinsurance, a frightening negative selection phenomenon occurs concurrently, as happened in the former reinsurance capital of the southern hemisphere, Sydney, in the mid 1990s. Na've underwriters saw other people's huge profits, and ended up assuming other people's lousy risks. Like a cheetah pouncing on an injured gazelle, brokers dumped risks into Australia that no-one in an established market would even consider writing. It is part of the self-correcting mechanism of supply and demand that drives reinsurance market cyclicality.


Budgets too are a major driver of reinsurance supply. Very often, even today, managements want underwriters to meet income targets, for many good and sensible reasons (like covering the cost of overhead). But in a market of declining prices, it is impossible to meet those budgets without writing more business, which may well mean competing at lower prices.

Despite talk of technical prices and a willingness to lose billions from the top line, the cycle drives onwards. The ease with which this is done is compounded by the reality that the cost of goods sold - the most basic of accounting principles - is unknown to reinsurers until well after the sale is completed.

Finally, there is something about the mentality of reinsurers, at least the generations that have existed in the previous market cycles, that allows them to continue to increase supply even when the price is falling.

In his treatises about Lombard Street of the 18th and 19th centuries, Bagehot wrote: "Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness." In reinsurance, this feeling is alternately evident in both buyers and sellers, firing the pronounced cyclicality of the market, and making the tenet of supply and demand truer than true.