Shifting sands: Assessing the current reinsurance marketplace

Throughout the modern world, we are seeing impacts from the rise of technology. Cutting out the middleman is a common theme wherever companies can efficiently offer products direct to consumers through superior technology.

Even reinsurance brokerage operations are not immune to this digital disruption. The reinsurance brokerage segment is in danger of disintermediation due to the disparity between frictional cost and value received in broking services.

With the reinsurance marketplace largely dictating pricing, it’s no wonder that brokers are more and more seen as vendors. Reinsurance brokers must rid themselves of this vendor label and continually demonstrate that they can effectively block and tackle. The insurance industry will suffer the long-term consequences of disintermediation, and for the sake of primary insurance companies, reinsurance brokers need to make sure they’re seen as trusted advisors.

Digital disruption in reinsurance

Disintermediation of reinsurance markets is nothing new. Back in the middle of the 20th century, many reinsurance placements were done directly with large reinsurance carriers (so-called direct writers). Many of today’s large reinsurers write directly to primary insurers without going through a reinsurance broker.

The reason why some primary insurers are reverting back to this model lies within the disparity between frictional cost and value received. What sort of frictional costs are we referring to? The referenced frictional costs concern brokerage fees paid by primary insurers to the reinsurance broker to represent the primary insurer’s interests in the market.

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These fees are paid either directly to the reinsurance broker by the primary insurer or indirectly by including the fee into the total reinsurance premium. Many brokers justify their fees by touting proprietary in-house analytics that their teams have devised. However, services are often bundled together and are unnecessarily expensive to the client.

For example, some primary insurers could be interested in an analysis of their portfolio for optimization or catastrophe modeling. Other primary insurers may feel that they have sufficient in-house resources to handle both functions. Tailoring these services a la carte, at a price that primary insurers are willing to pay, provides the best value for primary insurers. These solutions are not “one size fits all” as each primary insurer has its own unique set of goals and strategies to maximize profits.

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Primary insurer-reinsurance relationship

In addition to the imbalance of frictional cost and value, primary insurers have another hurdle to contend with: reinsurance markets and their pricing. After all, the brokerage fee is only a small fraction of overall reinsurance spend for a primary insurer. When quoting a primary insurer’s reinsurance tower (different layers of reinsurance cover comprised of many reinsurers), the reinsurers all bid on the percentage and price for their portion of the deal.

When a broker presents a primary insurer’s deal to the various reinsurers who want to participate (known as the panel), they are all competing against each other, and therefore quoting blindly, to establish a consensus price for the deal.

While the consensus price is being formed, primary insurers want the lowest price possible, but they can’t go so low as to discourage reinsurer participation. Meanwhile, reinsurers are incentivized to quote high to bring the consensus price higher. Skilled broking is a must when dealing with these market dynamics.

Reinsurers are constantly under pressure to obtain substantial returns on their capital and prevent dramatic rate decreases. However, reinsurers are facing resistance due to the sheer amount of capital in the system along with the advent of insurance-linked securities (ILS). ILS is a method to connect third-party investors with non-correlated risks, thus infusing more capital into the reinsurance marketplace.

Learning by example

A popular example of ILS is the catastrophe bonds that many Florida primary insurers incorporate into their reinsurance program designs as an alternative source of capital. Despite the downward pressure from ILS, catastrophe reinsurance is often a reinsurer’s most profitable segment of business. After successfully weathering the catastrophe-ridden year of 2017, it looks like these sources of alternative capital are here to stay. That being said, it does beg the question of how much these arrangements truly can withstand.

While some primary insurers feel that they have the ability to control pricing through what is perceived as a “soft” market, what happens when the market “hardens” again? What if a series of disasters dries up traditional capital from reinsurers while simultaneously discouraging investors from placing their money into alternative insurance-linked investments?

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It’s not that far outside of the realm of possibility when you look at the effects of climate change and the many natural disasters that continue to occur. Should bleak times like this arrive in a world of disintermediation, companies will have to navigate this unfavorable environment alone without an experienced broker to negotiate and advocate on their behalf. Reinsurance brokers need to start bringing more value to the broking equation independent of analytic capabilities.

How can brokers do this?

Advocate and negotiate on your clients’ behalf and don’t accept the market status quo. Otherwise, a market that already dictates pricing will be left almost entirely unchecked in the absence of reinsurance brokers. For the sake of primary insurers, reinsurance brokers cannot forget that they are trusted advisors, not just vendors of reinsurance and analytics.

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E.W. “Ted” Blanch is the Chairman and CEO of COIN Re. He can be reached at ted@coinreinsurance.com.