As the reinsurance industry finds itself changing to meet the growing demand for cedents' expanding appetite for risk, a study questions whether current underwriting practices could one day expose reinsurers to a financial debacle.
A report on the reinsurance industry released late last week, commissioned by the Insurance Intellectual Capital Initiative—a consortium of organizations associated with the Lloyd's insurance market—wrapped up a three-year study of the changes taking place and the issues facing reinsurers and insurers today.
The report, titled “Beyond Borders: Charting the Changing Global Reinsurance Landscape,” was written by Paula Jarzabkowski, professor at Aston Business School and Marie Curie Fellow at Cornell University.
In an interview, Jarzabkowski says that the major change the reinsurance industry is experiencing today is the bundling of risks, especially catastrophic risks. Previously, purchases were made from local reinsurers with close association and in-depth knowledge of the local risks.
Today, cedents are purchasing reinsurance “on a corporate level” utilizing models to offset risk exposures and bundling an insurer's exposures into a single reinsurance program.
The strategy, Jarzabkowski says, is that an insurer determines it can cover initial losses with its own reserves and save the big losses for the reinsurer.
This practice poses two problems, she says. One, local markets are not getting premium for business. Two, the risks are not subject to the experience of underwriters who “provide local judgment at the local market” level.
The bundling practice, she explains, relies heavily on modeling, which is a necessary component for underwriting, but does not replace the expertise of the local underwriter.
She says if the assumptions used in the models are wrong, the industry could be in for a big loss that could throw into question the solvency of some companies.
In large programs, Jarzabkowski says individual risks get lost in the bundling of the other risks, analogous to what happened with the bundling of asset-backed securities and credit-default swaps that were a major cause of the great recession of 2008.
“What you are really underwriting is the quality of each policy in each region,” says Jarzabkowski. “I think reinsurance and insurance are actually very ethical industries and really do try to underwrite in a high-quality way. I think it is a real lesson for the finance sector that we realized, when we started studying this industry, how carefully people really try to understand the risk.
“It really bothers us to see this trend that moves away from that very high quality judgment base,” she observes.
She does not see the practice of bundling risks going away. However, reinsurers need to work more closely with their cedents. For those reinsurers that underwrite in niches, they will need to begin working in teams of experts to review programs and make sure bundles consist of similar risks.
“This will be a significant change for the industry,” says Jarzabkowski.
The report presents itself as “a call to arms, exhorting cedents, reinsurers and brokers to re-evaluate their trading practices and more clearly define their sources of competitive advantage.”
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