Paradoxical industry may miscalculate risks
The reinsurance industry is characterised by paradoxes at the moment. Rates are softening despite strong evidence that suggests the world is becoming more dangerous; cedants are buying less coverage despite capacity being cheap.
That is the perspective of a puzzled Michael Papworth, head of facultative and marine treaty reinsurance at broker Miller. Both these dynamics, he said, defy logic.
“We are in a situation where there is overcapacity and prices are declining in our industry,” Papworth said.
“Yet if you look at what is going on in the wider world and the macroeconomic climate that is one hell of a paradox. From the rise of nationalism, to rising greater terrorism threat, to the slow economic recovery, the world is not in a good place. Yet our industry is charging less and less for risk.”
On the second point, Papworth echoes a common theme in the industry for several years—that of the world’s bigger insurers buying less and retaining more risk on their own balance sheets.
At a time when reinsurance is so cheap, he believes, this makes no sense. What is more, he speculates that if their risk models are inaccurate, some players could be vulnerable to substantial losses in the future.
“It is basic economics that when a product is cheap, buyers buy more. Yet that is not happening. Cedants are buying less coverage than ever, which is countercyclical and counterintuitive.
“Insurers say that they have confidence in their own risk models and ability to retain more risk. But, for me, this can only mean one of two things. Either they are very clever and are using very sophisticated financial models I am not able to understand. Or there is actually an irrational set of behaviours playing out here.”
Papworth draws comparisons with the way in which credit default swaps were regarded for many years before that market collapsed, taking some of the world’s biggest financial institutions with it. “People thought those were clever structures yet people failed to grasp the true risks,” he said.
He is especially concerned because, he argues, history shows that the risk models used by the reinsurance industry are almost never accurate when a truly big event occurs.
“With every single very big loss such as hurricanes Katrina, Sandy or Wilma or the 2011 Japanese earthquake and subsequent tsunami, the actual losses have been very different to the modelled losses. The models have failed to take into account something important in each instance,” he said.
“Yet you have these companies taking large amounts of risk on to their balance sheets based on these models and at a time when reinsurance, which has been tried and tested as a solution for 300 years, is very cheap and very available. That makes no sense to me.”
Part of the problem, he admits, is that the entire industry—insurers and reinsurers alike—has been lulled into a false sense of security in recent years by a very benign period of big losses. “The industry has entered a comfort zone,” he said. “But that will not last. Even a few moderate losses might be enough to remind the industry of what can happen.”
He is also sceptical of the stomach some short-term investors entering the industry by providing alternative capital will have for such losses when they do occur. He believes this could change the dynamic in the industry.
“Much of the new capital is speculative and it also has an exit strategy,” he said. “That has not been tested by a big loss yet. With traditional reinsurers, there is always a willingness to do the right thing on claims even if the legal wording might not be quite right.
“With these new investors, they are operating purely on the basis of legal contracts. That needs to be tested. Perhaps I am wrong and they will pay, but it needs to be tested. People should be cautious.”
