Should cedants really be retaining more?

One of the big talking points of this reinsurance renewal season has been that of cedants retaining more risk on their own balance sheets.

In fact, this is hardly a new trend—most insurers say the process has been a gradual one which started some 10 years ago. What is more, it really applies only to the biggest, global, players with balance sheets that can take on more risk in this way.

Yet there are many in the market that see such a strategy as counterintuitive in a market where rates are so soft and risk transfer mechanisms so abundant in a world that also appears more risky than it has been in a long time.

Michael Papworth, head of facultative and marine treaty reinsurance at broker Miller, says some of the dynamics at work in the market at the moment defy logic.

“We are in a situation where there is overcapacity and prices are declining in our industry,” Papworth says. “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 a 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.”

He is perplexed not only by pricing but by the fact that cedants are also retaining more risk. He believes this makes no sense either. 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 says.

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 says.

“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 a tried and tested 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—have 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 says. “But that will not last. Even a few moderate losses might be enough to remind the industry of what can happen.”

Impact of a big loss

Others agree. Manfred Seitz, managing director of international reinsurance at Berkshire Hathaway, believes a very large loss could potentially reverse the trend of large insurers retaining more risk on their own balance sheets.

He adds, however, that it is almost impossible to predict how big a loss would be required to reverse pricing trends—such is the amount of capacity in the market at the moment.

He believes that one reason insurers are retaining more is because they are under pressure in terms of their own earnings. As a consequence, aided by strong balance sheets and very sophisticated risk modelling techniques, they are reducing the amount they spend on reinsurance and reconfiguring their entire approach to risk transfer.

“They are trying to optimise their risk transfer programmes. They are re-examining what they can retain and the areas where they really need protection,” Seitz says.

But he believes a very big market-wide loss could reverse this trend to a certain extent.

“A big loss could have the potential to hit insurers, which could be more vulnerable without the same levels of reinsurance protection that they once had. It would certainly get their attention and give them an insight into whether their risk management is at the right level. That could change things.”

“A big loss could have the potential to hit insurers, which could be more vulnerable without the same levels of reinsurance protection that they once had.” Manfred Seitz

But he added that it is impossible to predict what size loss would be needed to turn pricing in the market. “To speculate about that is a moot point,” he says. “The reason so much money is in this industry is because returns are so poor in other areas of the capital markets. Unless that dynamic changes it is hard to imagine capacity exiting any time soon.”

Against this backdrop of cedants retaining more risk and soft pricing in many lines, Seitz said Berkshire Hathaway is focused on maintaining and strengthening relationships with its existing clients.

“We have been a very stable player in the European market for a long time now,” Seitz says. “Our aim now is to work more closely with our key clients and look at what we can do better and how we can complement them in other ways.

“Insurers are retaining more and becoming a lot more sophisticated. But that is not a bad thing if you are a sophisticated reinsurer. They want more complex solutions across multiple lines of business and there are not many reinsurers that can offer that.”

Stephen Catlin, chief executive of Catlin Group, also characterises the strategies of some cedants as counterintuitive. He says that while he understands that many bigger insurers are more sophisticated than they once were and have balance sheets capable of supporting more risk, he believes the logic still defies basic economics.

But, he admits, it depends on the perspective you are coming from.

“Reinsurers would speak out against it because they are losing business. Brokers would also see it as counterintuitive,” Catlin said. “I am probably in that camp. You would expect insurers to purchase more coverage in a soft market.

“I can understand that the bigger players have bigger balance sheets now. They can take more risk onto their books. Many have a global footprint and a size and sophistication that we have not seen in the past. The risk models they use are so much better. But I would still define such a strategy as counterintuitive.”

Innovation or desperation?

Some reinsurers are offering an increasingly varied array of innovative products and structures to cedants as they attempt to differentiate themselves in a crowded and competitive marketplace.

Speaking as a buyer of reinsurance, Matt Fairfield, the founder and chief executive of ANV Holdings, which operates three syndicates at Lloyd’s, says he has taken advantage of “some very interesting opportunities” offered by reinsurers in recent years.

Since its formation in 2011, Fairfield says, ANV has used reinsurance as an essential means of risk transfer and as a form of capital. He says the firm has built its balance sheet prudently during that time with reinsurance as a cornerstone. He has also been offered some highly innovative structures.

“It has been a difficult time for the reinsurance market. Their clients are also tending to retain more risk so they are coming up with new solutions,” he says. “Some of these strategies have not been designed for us—we are too small to warrant that. But we then get the benefit down the line when these same products are offered to us.”

“For the buyer, it is about establishing the risk-reward balance—ceding profits away versus protecting your balance sheet.” Matt Fairfield

One of these, he notes, is what he describes as a ‘sideways cover’. “This is structured like a traditional programme but has certain other triggers that will give you extra protection against your net,” he says. “For the buyer, it is about establishing the risk-reward balance—ceding profits away versus protecting your balance sheet.”

Fairfield also describes another unusual innovation being offered by around a dozen reinsurers whereby they essentially buy the reserves and liabilities associated with a specific year of business from an insurer.

The insurer receives a one-off payment and also frees up capital while the reinsurer hopes the underwriting profit on that business will be better than anything written in the current market.

“They are doing it on the basis that rates and profitability then were better than they are now. So they see it as a good use of capital,” says Fairfield. “It is not run-off because you are still writing that line and the client relationship does not change in terms of claims. It is somewhat like a commutation but with more variables attached.”

He says that a cedant might accept such a deal either because it wants a one-off boost to its profitability or because it believes it can make better use of that capital targeting opportunities in the market now.

“They say that necessity is the engine of ingenuity and the reinsurance industry is certainly looking far and wide for innovative ways to use its capital right now,” Fairfield says.