economic environment. After all, you only find out who is swimming
naked when the tide goes out.”
While Buffett’s warning was at the time aimed at the re/
insured, given the fact that much of the retrocessional capacity
today is from collateralised vehicles, perhaps the warning should
now also be aimed at the investor. If investors hope to achieve a
reasonable return for risk, they must not only be well-informed
as to the nature of said risk, but also be able to fully assess the
underwriting and administration capabilities of the fund manager
and underwriter.
Complacency over pricing
A long benign period for losses seems inevitably to lead to some level
of complacency with regard to accumulation control and pricing, at
least for as long as all are enjoying attractive profits. But it’s when
that accumulated profit is wiped out from a single loss that the
underwriting flaws are ultimately revealed.
An underwriting track record of excellence should be the prerequisite
for any investor. Putting money in the hands of capable risk-takers
keeps the market rational.
Given all that has transpired, finally it appears that TPC providers and
traditional reinsurers both held capacity back at the midyear renewal
for US and Japanese programmes. But this newfound discipline is once
again being driven by the same old supply/demand equation as much
as by pricing models.
It was apparent at the last January renewal that pricing for property
catastrophe and longer-tailed classes of business remained weak
despite the series of losses that had previously transpired. At the time,
the rationale for the status quo on pricing was ample capacity despite
losses, rather than acceptable return for the risk. The next question
that arises is: how sustainable is this newfound underwriting discipline
and how will market participants react if overcapacity begins to push
pricing back to irrational levels?
Over the longer term, the failure of some reinsurers to adapt
to changing market dynamics has resulted in AM Best’s Global
Reinsurance composite producing a five-year average combined ratio
of 97.6 (Figure 1) and a five-year average return on equity of 6 percent
(Figure 2), hardly a reasonable economic return on capital considering
the risk. Pockets of profitable business have dwindled in recent years
and the subsidy they provided through favourable reserve releases to
less profitable classes is running out.
Third-party capital (TPC) has been around for well over a decade,
but over the last five years it has proliferated more rapidly as investor
interest has increased and reinsurance structures have become more
varied in form. What is clearly transpiring through this aspect of the
market’s evolution is that TPC is becoming more closely aligned with
traditional reinsurance capital.
Nat cats challenge reinsurers two years in a row
The spate of natural catastrophes in 2017 and 2018 clearly illustrated the
increased participation of TPC in these losses, mostly through the use
of collateralised retrocession placed by traditional reinsurers. While
this form of alternative capacity served to insulate the traditional
market from excessive losses, it also delayed an adequate response to
obtain higher risk pricing following the 2017 catastrophe losses.
The catastrophe events of 2018 may have further exacerbated this
fact, but the loss creep, particularly from 2017’s Hurricane Irma,
showed how the overall market failed to recognise and price for
the fundamental changes that had occurred both operationally and
structurally in the Florida property market.
The 2018 wildfires in California and Typhoon Jebi in Japan also
caught many underwriters and capacity providers by surprise due
to a failure to appropriately manage and adequately price for the
actual underlying risk. The industry continued to rely on existing,
inadequate models and underwriting tools that failed to keep pace
with the changing dynamics of the true exposure.
In all these circumstances, one can point to a complacency that had
built up during previous years of benign loss activity. It proves that
models are no substitute for individual risk underwriting and relying
solely on modelling can be a recipe for disaster.
TPC investors rightly felt disturbed by events that unfolded
following the initial impact of the 2017 losses. Perhaps some of the
subsequent surprise can be attributed to timing, but clearly more
emphasis must be placed on improved risk selection, mitigation,
and pricing by the underwriter or—in many cases today, the fund
manager.
The 2017 and 2018 catastrophes point back to the warning that
Warren Buffett made in his 2001 letter to shareholders, which
followed the devastating events of 9/11: “When a daisy chain of
retrocessionaires exists, a single weak link can pose trouble for all. In
assessing the soundness of their reinsurance protection, insurers must
therefore apply a stress test to all participants in the chain, and must
contemplate a catastrophe loss occurring during a very unfavorable
43
November 2019
Bermuda:Re/insurance+ILS
AM BEST
“Models are no substitute for individual risk underwriting and relying solely
on modelling can be a recipe for disaster.” Scott Mangan