As the reinsurance industry finds itself changing to meet thegrowing demand for cedents' expanding appetite for risk, a studyquestions whether current underwriting practices could one dayexpose reinsurers to a financial debacle.

A report on the reinsurance industry released late last week,commissioned by the Insurance Intellectual Capital Initiative—aconsortium of organizations associated with the Lloyd's insurancemarket—wrapped up a three-year study of the changes taking placeand the issues facing reinsurers and insurers today.

The report, titled “Beyond Borders: Charting the Changing GlobalReinsurance Landscape,” was written by Paula Jarzabkowski,professor at Aston Business School and Marie Curie Fellow atCornell University.

In an interview, Jarzabkowski says that the major change thereinsurance industry is experiencing today is the bundling ofrisks, especially catastrophic risks. Previously, purchases weremade from local reinsurers with close association and in-depthknowledge of the local risks.

Today, cedents are purchasing reinsurance “on a corporate level”utilizing models to offset risk exposures and bundling an insurer'sexposures into a single reinsurance program.

The strategy, Jarzabkowski says, is that an insurer determinesit can cover initial losses with its own reserves and save the biglosses for the reinsurer.

This practice poses two problems, she says. One, local marketsare not getting premium for business. Two, the risks are notsubject to the experience of underwriters who “provide localjudgment at the local market” level.

The bundling practice, she explains, relies heavily on modeling,which is a necessary component for underwriting, but does notreplace the expertise of the local underwriter.

She says if the assumptions used in the models are wrong, theindustry could be in for a big loss that could throw into questionthe solvency of some companies.

In large programs, Jarzabkowski says individual risks get lostin the bundling of the other risks, analogous to what happened withthe bundling of asset-backed securities and credit-default swapsthat were a major cause of the great recession of 2008.

“What you are really underwriting is the quality of each policyin each region,” says Jarzabkowski. “I think reinsurance andinsurance are actually very ethical industries and really do try tounderwrite in a high-quality way. I think it is a real lesson forthe finance sector that we realized, when we started studying thisindustry, how carefully people really try to understand therisk.

“It really bothers us to see this trend that moves away fromthat 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 tobegin working in teams of experts to review programs and make surebundles consist of similar risks.

“This will be a significant change for the industry,” saysJarzabkowski.

The report presents itself as “a call to arms, exhortingcedents, reinsurers and brokers to re-evaluate their tradingpractices and more clearly define their sources of competitiveadvantage.”