Capital Markets Teach Reinsurers Lessons

London Editor

London

A sea-change is occurring in the insurance and reinsurance industries as a result of the entry of capital markets into areas such as catastrophe securitizations, industry executives say.

The capital markets piece is important because it pierces the traditional isolation that has taken place in the reinsurance and insurance industries, said Dennis Kuzak, senior vice president of EQECAT, the Oakland, Calif.-based modeling firm.

“It brings in external pricing and the insurance and reinsurance industry suddenly gets a dose of cold water reality. Hey, this is the price for the risk and were writing it for less than that,” he said.

On any day of the week, the capital markets trade securities in the catastrophe market, he said. “This is a very big development. If reinsurers want to know what the price of a risk is, they can easily find out the bid price on a hurricane bond in Florida,” he explained.

“What that tells them is that if somebody else wants to do a hurricane bond in Florida, or they want to do reinsurance, the reinsurer knows exactly what the secondary market is trading in this risk,” he said.

“This is, in my opinion, the most significant development in the capital markets,” he said. “Its not that capital is now supplementing reinsurance.”

Everybody focuses on the possibility that reinsurers are somehow going to be under competitive threat from the capital markets “and therefore they have to price their product more aggressively,” he said.

“The point is, there is a price put on catastrophic risk for various areas of the world; that becomes a ceiling for reinsurers to do business,” he said.

“All of a sudden now, there is a price that investors are willing to pay to tradeto buy and sell risks,” he said. “The reinsurers now begin to see that–and that is the most influential impact of the capital markets–because now the pricing power of the reinsurance industry is eliminated.”

Reinsurers, in fact, used to have cyclessoft markets and very hard markets, he said. “What will begin to happen is if we get an extremely hard market or we start going to it, all of the sudden, capital markets investors would say, hey, this pricing is really good; Im going to invest in these things.”

Suddenly the price is set by the capital markets investors and reinsurers lose their pricing power, he said.

“The insurance and reinsurance industries, which have to compete with the capital markets, are cutting their prices,” he said.

“Theyre going to people who want to transfer risk and theyre saying, We can do a better price than the capital markets, go with us,” he said.

Traditionally, in the long term, they would lose money on the downside and make money on the upside, he said. “They say, Im going to have four or five years of soft pricing and then, eventually, the markets will get hard and Ill make it all back.”

What has changed now is that the markets may be soft, because of excess capacity, but the expectation that the industry will go back to a fairly long, protracted hard market, is very unrealistic, he said. Now with the capital markets there, when the pricces go up, the investors say these cat bonds are much more attractive than high-yield bonds, Mr. Kuzak said.

There is a cap being put on how hard the market can get, he said, “and the reinsurers cant control that.

“To me, thats the message that has not been conveyed. Yet if you look at what happened to any other commodity in the world, they have gone down this road. Property cat is a commodity, he said.

“You look at what happened to oil prices. In the early 1970s, the big oil companies like Shell, BP and Exxon set the price of oil,” he said. “Then one day OPEC woke up and said, Wait a minute. We control all the oil. Were going to set the price.”

Suddenly there was a crisis when oil went from $2 per barrel up to $30 and $40, he said.

“What really happened was that even OPEC couldnt control the price; they can manipulate it, but the point is, the market controls the price,” he said.

Ultimately, the price of the oil is controlled by supply and demand for oil around the world, he said.

“The pricing power, I would argue today, in a commodity like oil, lead or copper or agricultural products is determined by the marketplace,” he said.

For the insurance market, that has not been the case, he said. “Insurance pricing has been determined historically, particularly in the [catastrophe] markets, by the supply of capital in the insurance business,” he said.

“There is a door opening and that door opening is called the capital markets,” he said. “Theyll take that demand and theyll siphon it off and the reinsurers wont get the prices that they used to.”

That will drastically change the way reinsurers will run their businesses, he said.

“There are many models where this has happened; its happened in the oil markets, the commodity markets in general, industrial metals, coppers, lead, zinc, aluminumall that has been traded,” he said.

The other area where it has happened in the United States is in the mortgage markets, he said.

Twenty years ago, banks used to originate mortgages, he said. “Today all the mortgages are based on prices in the capital markets, because everybody sells their mortgages off.”

So the pricing power in the mortgage industry has gone away, he said, which is why most banks dont hold mortgages any more. “They make money by issuing the mortgage and they sell it off.”

The same thing could happen in insurance, he said.

“It is going to take time. Its not going to happen overnight. But the point is that we can put pricing on risk and have securities priced everyday as opposed to insurance contracts, which are negotiated annually and nobody knows the price,” he said.

This creates visibility and “we couple that with risk assessment, which we do and our competitors do, and all of the sudden people can now make choices about what the risks are,” he said.

The doors are being opened further for the capital markets, he said.

“Clearly, the reinsurance market wont go away; it will be complementary,” he said.

The message here is that the pricing power of the reinsurance industry is going away, he said.

Every year the risk of loss in a certain region doesnt change dramatically from one year to the next for the industry, he said. “Some may have less policies and some may have more. The risk of loss doesnt change.”

Then why should the price change so dramatically? he asked.

“The answer is, it shouldnt. The reason that it does change is because of the availability of capital and the mindset of insurers in the past to price their products on how much they could get. And if there are no losses, then everybody bids down, so the market price drops.”

If a company is buying the insurance or reinsurance, thats terrific, he said. “If youre an insurer or reinsurer, thats lunacy,” he said, “because youre probably writing some risks at well below the expected losses that youre going to incur.”

For every dollar you write, you are going to perhaps lose a dollar and 10 cents of that, he said.

“Any industry that does that for a long time is destined for the scrap heap,” he said. “In fact, if you look at the returns in the property-casualty industry, theyve been well below financial companies and manufacturing companies.”

The insurance industrys returns-on-equity are terrible, he said.

“Thats because of their pricing mentality and the fact that the capital can flow into the business, but its still not so easy for it to flow out because managements dont want to let it go,” he said.

There is no reason that an insurance company should operate any differently than any other financial institution, he emphasized. “They both deal in promises to pay, he said. “In the insurance company, they collect the money first and they promise to pay later. In a bank, they give you the money, then you promise to pay them but its a financial contract; its the same thing.”

David Colarossi, associate director of Swiss Re Capital Markets in New York City, agreed that the entry of the capital markets should bring more stability to the industry.

“When you think about market theorysupply and demandthere is more supply now, so when prices start going up, more cat bond deals will get done and help to keep prices down,” he said.

That doesnt mean way down, it just means lower than they would have gone because there is greater supply of risk-bearing capacity, he said.

Every time cat prices get up high enough, the capital markets will come in and take business opportunistically, which will keep a lid on the peaks, Mr. Colarossi said.

Traditional reinsurers will say that theyre not getting the extra premium on the upside, so they cant afford to go down so low when the market is soft, he said.

“Thats where the reduction in volatility would come from,” he said. “Thats not going to happen in one year; thats going to happen over a period of time [when] people understand how the market is behaving. [I]t could have a stabilizing effect.”

Now, instead of insurers and reinsurers bearing most of the loss, “you have them and a number of investors,” he said. “So now instead of the losses being focused on a few companies, the losses will be spread out over many more companies.

It smoothes the loss a little bit more, he said. “It spreads it out among different people.”


Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, June 29, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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