The use of traditional reinsurance for the customary benefits of financial stability, risk transfer and increased capacity is declining, according to a recent analysis of insurance industry information performed by Gallagher Re. Indeed, Gallagher's analysis of industry data since 2001 provides strong evidence that the landscape has changed.

Reinsurance provides many functions to an organization. The textbook definition of the benefits--spread of risk, protecting solvency margins, increasing profitability and developing capacity--makes the implicit assumption that the risk of loss is transferred to a third-party, non-affiliated company.

Not all reinsurance, however, is placed with non-affiliated companies. Indeed, a significant percentage of reinsurance is placed with affiliated organizations.

Publicly available U.S. statutory accounting information can be used to analyze trends in the use of reinsurance. The accompanying statutory underwriting and investment exhibit provides written premium information on a direct, assumed and ceded basis. Assumed and ceded premiums are further classified between affiliated and non-affiliated transactions.

The affiliated transactions are those made with entities that share a common ownership with the ceding company. Affiliated transactions include both U.S. and non-U.S. companies.

At first glance, there does not appear to be a significant decline in the amount of reinsurance used.

At a high level--ignoring the distinction between affiliated and non-affiliated transactions--the use of reinsurance, when measured by the ratio of ceded-to-gross premiums, has declined only slightly since 2001. In that year, total ceded premiums represented 22 percent of gross premiums (direct plus assumed premiums). In 2006, the comparable percentage is 19 percent.

In dollars, the total amount of ceded premiums in 2001 (both affiliated and non-affiliated) was approximately $98 billion. The amount in 2006 was $106 billion. This is an increase of $8 billion over five years.

In 2001, however, approximately $70 billion of the $98 billion in total ceded premiums was ceded to outside organizations. This amount actually decreased in 2006, when only $64 billion was ceded to non-affiliated organizations.

In a period where total gross premiums increased 27 percent, with steady growth in overall writings, the amount of premiums ceded to non-affiliates did not keep pace. Indeed, instead of growing, the use of outside reinsurance has declined.

This decline is evident when we compare premiums ceded to non-affiliated companies to direct written premiums. This ratio was 18.5 percent in 2001. The comparable amount for 2006 was 13 percent.

This is a substantial reduction in the use of reinsurance for traditional risk-transfer purposes, and the decline has been consistent over that period--each year the ratio has reduced by one-to-two percentage points.

If the ceded activity in 2006 was the same as it was in 2001, the amount of premiums ceded to non-affiliates would have been about $92 billion. The actual amount was $64 billion.

In other words, nearly $30 billion has disappeared from the traditional reinsurance market.

Similar results can be derived by analyzing more refined measures of reinsurance usage. An analogous decline is apparent, for example, when we compare non-affiliated premiums ceded with gross premiums that are also net of affiliated transactions.

Refining the analysis even further, by removing not just premiums ceded to affiliated companies but also cessions to mandatory pools from total ceded premiums, we can get closer to the impact on "pure" traditional risk transfer reinsurance.

The accompanying chart titled "Measuring Traditional Reinsurance" sets forth numerical details.

The decline is not uniform for all statutory lines of business. However, no major line of business saw any growth in the ratio measures of reinsurance usage we analyzed.

In general, lines of business classified as property or multiperil--including allied lines, homeowners, commercial multiperil, fire and inland marine--had the smallest decline.

As a group, the amount ceded to non-affiliates was relatively stable, with the total ratio varying from 19-to-22 percent over the five years. (The ratio cited here is the ratio of the premiums ceded to non-affiliated companies to gross premiums net of assumptions from affiliates.)

The decline in non-affiliated reinsurance is more evident for the casualty and auto lines of business. This group includes workers' compensation, other liability and medical malpractice as well as private passenger and commercial auto liability and physical damage.

As a group, insurers reduced their use of non-affiliated reinsurance transactions in these lines, as evidenced by ratios falling from 14.5 percent to 8.6 percent from 2001 to 2006.

The largest drop was in the "other liability" line--from 35 percent to 20 percent.

Workers' comp and medical malpractice also had dramatic declines, as well as the auto lines. And the decline has been consistent over that period. Each year, across all of these lines, there has been a drop-off in the amount of reinsurance ceded to non-affiliates.

The data indicates there has been a drop in the use of traditional risk-transfer reinsurance, especially in the non-property lines. However, care must be used in interpreting statutory accounting information.

The behavior of a few large companies can distort the results. Or there may be an increase in reinsurance ceded to offshore non-U.S. affiliates--who may then shed the risk to an unaffiliated party. Changes in the use of offshore captives and pools may also have an effect.

Still, the consistent decline each year across almost all lines is apparent. If premiums ceded to non-affiliates are a measure of how much U.S. insurance companies use reinsurance for the "pure" purpose of shedding risk to third parties, then companies have shown an increasing appetite for retaining risk this decade.

What accounts for the increased retention of loss?

A number of factors may provide an explanation, including:

o Consolidation:

Over the past few years we have seen increased consolidation of companies in the primary market. This may explain why the property lines have held steady while the casualty lines have declined.

In the casualty lines, consolidation provides a larger capital base to absorb the spread of risk. Consolidation in the property lines, however, can lead to increased accumulation of catastrophe aggregates.

o Reinsurance price levels:

Currently, many reinsurers are enjoying record-setting profits. This is due to significantly higher premium rates for catastrophe-exposed business, tightened terms and conditions, and the lack of major catastrophe losses. The hard market leads to increased retentions by insurance companies.

o Strong insurer financials:

Insurance companies themselves have recently experienced record favorable combined ratios in the United States. Stronger company balance sheets also give primary insurers the option of retaining more risk.

o Better models and management:

The success of predictive modeling in ratemaking has also allowed companies to feel more comfortable in retaining risk. The increased focus on enterprise risk management--and the role of corporate risk officers--may also be a factor.

o Increased scrutiny of reinsurers:

Insurance companies have a heightened awareness of reinsurance credit risk--in terms of both their ability and willingness to pay their obligations. Rating organizations like A.M. Best and Standard & Poor's have been subject to extensive criticism for failing to predict the insolvencies of a number of well-known companies. In response, the rating agencies became much more conservative in their ratings.

This has led to a "flight to quality," but this approach has its limits.

The highest quality reinsurers have no reason to take unnecessary risks on questionable programs or startups. Thus, programs with potential problems may find it difficult to find reinsurers with the highest ratings. As a result, insurers are more willing to retain the risk, rather than transfer it to a company with a less-than-top-tier rating.

o Capital markets competition:

The use of capital markets has only increased this decade--a trend unlikely to be reversed. The capital markets directly compete with the reinsurance market for the classic reinsurance role of transferring risk to a third party.

In 2006 and 2007, we have witnessed a number of new ventures that combine reinsurance and capital market techniques.

An example is Gallagher Re's initiative with the New York Mercantile Exchange to create catastrophe risk derivatives. In addition, over $6 billion in catastrophe bonds have been issued this year already. This comfortably surpasses last year's total which was itself a record year for issuance.

A changing marketplace creates challenges and opportunities for insurers and their advisers.

Companies have become more proactive in the identification, quantification and management of enterprise risk. As a result of competitive pressures and rating agency scrutiny, insurers have become increasingly sophisticated in their treatment of risk.

Reinsurance intermediaries have responded by offering alternative risk-financing vehicles, such as contingent capital, insurance derivatives and other capital market products.

Insurers demand--and intermediaries provide--sophisticated advice on enterprise risk management, dynamic risk analysis and catastrophe management. Reinsurance companies and intermediaries will continue to develop solutions to meet the challenges of a changing marketplace.

No one expects the market for third-party reinsurance to be stable. Use of the market has gone up or down over time, depending on the underlying dynamics of the insurance industry.

There will always be a robust market for traditional reinsurance that offers the benefits of financial stability, risk transfer and increased capacity. But the ongoing, year-to-year decline in third-party reinsurance across most lines of business has been striking.

What remains to be seen is if this is part of a normal cycle, or a permanent shift away from third-party reinsurance.

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How Did Nearly $30 Billion 'Disappear' From Traditional Reinsurance Market?

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