Mitigating the way out of a soft market

25-08-2016

Mitigating the way out of a soft market

We are in a soft market and, according to a recent report by Standard & Poor’s, reinsurers are looking to both retrocession and ILS to mitigate the negative implications of that soft market on their profitability, says Clive O'Connell of McCarthy Denning.

We are in a soft market and, according to a recent report by Standard & Poor’s, reinsurers are looking to both retrocession and ILS to mitigate the negative implications of that soft market on their profitability.

This is neither surprising nor really news. This is what reinsurers have always done when premium rates have fallen. The novelty is, perhaps, that ILS now features as an additional tool in the mitigation process.

Of course, such a strategy does not come without risks to either the reinsurers or their retrocessional or ILS partners. Past soft markets have produced considerable problems, either on a market wide basis or for individual companies or pockets of companies.

A wag commented during the last major soft market of 1997-2001 that “the only way to make money in this market is to write as much business as one can at whatever price and then to reinsure it out for less.” This was not just said in jest. Many embarked upon seemingly profitable arbitrage strategies which then left them and others in years of litigation.

Innocent reinsureds and retrocessionaires found themselves facing considerable legal costs and either no recovery or massive bills for unexpected losses. Less innocent participants also faced calamity and sometimes ruin.

The problem was that, encouraged (or sometimes duped) by intermediaries who were seeking to maintain their commission based income in times of declining premium volume, some reinsurers sought to preserve profits from business that was simply not profitable. The results were often devastating.

Of course, today, we are blessed with more effective regulation and by enterprise risk management. We have better models and more controls. But this is not enough. Many of those who lost considerable sums after the last soft market were careful, conservative institutions who were the innocent victims of the avarice or incompetence of others.

Rogue individuals within large organisations can cause huge damage, sometimes for personal gain; sometimes through misguided enthusiasm. Remember, banks have been under considerable regulatory and compliance scrutiny for many years but still manage frequent costly scandals. Insurance and reinsurance companies and the intermediaries who serve them, are not immune from human nature.

The news that some reinsurers are looking to retrocession and ILS as a way to maintain profitability is not news that should create panic. It is a natural step in the context of a soft market. It is a development, however, that should raise the level of caution. The level of due diligence conducted by ILS fund managers before the inception of deals needs to be high.

The soft market can offer many opportunities and will help to grow the market for ILS as insurers and reinsurers explore ways to protect their business and their profitability. It is important that this expansion is done with the lessons of past soft markets in mind and not in ignorance.

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