Retro: Its Only Cat Business After All

Despite the capacity crunch, global buyers opt to spend $1 billion or more annually on retro premiums, according to studies conducted by the London-based Lloyds broker Alwen Hough Johnson and work carried out by Benfield Group in London.

Every reinsurer believes that its retro cover is (relatively) expensive, but illogically, very few reinsurers are willing to exploit the situation by writing the class!

There is reluctance by many to enter what the former chairman of Kiln, Colin Murray, wittily described as "the red light district of the reinsurance business." Nevertheless, 12 years ago when he made that comment, he approved the formation of a new retrocession syndicate to exploit the newly hard market at the time.

His view is obsolete given the fundamental changes in the retrocession market place over the last 10 years. These changes have made retrocession a legitimate, and potentially highly lucrative, form of risk transfer. For example, the advent of increasingly sophisticated catastrophe modeling techniques has led to both the retrocession buyer and the seller having a much clearer idea of the value of the risk transfer.

Following the collapse in 1989 and 1990 of the old London Market Excess spiral (where Lloyds syndicates and the company market reinsured each other for the same losses and lost very large amounts of money over several years), demand for retrocession cover significantly outstripped supply.

In this environment, successful retro players were able to adopt a radically different approach and impose high standards throughout the transaction process.

Three factors in particular were highly significant in restoring a profitable market:

1) Detailed aggregate information enabled exposures to be quantified adequately for the first time.

2) Retrocessionaires began exposing their capital gross.

3) Increases in retentions in each tier reduced loss penetration dramatically. For example, Hurricane Andrew was a major retro loss, while the Northridge Earthquake, only 18 months later, was not a major loss to the retro market.

Retrocession rates peaked in 1993, as did first-tier catastrophe rates, but did not subsequently fall as fast. Retrocession rates reached an even higher peak following Sept. 11, 2001, and have settled at approximately 27 percent above their previous high.

Many of the retro writers now apply model-based rating techniques to retrocession pricing, often using clients output to establish the retention. However, unlike first-tier catastrophe underwriting, there is no recognized industry standard. The major writers who control the bottom end of program structures tend to be risk-averse and focus on cash flow and a limited downside at high rates on line.

Higher up on the programs, where exposure rating becomes more important, there can be extreme variations in pricing for the same exposures. A retro rating model developed by Alwen Hough Johnson analyzes worst-case exposure to 27 extreme events and applies a consistent rating methodology to each identified exposure, using market rating and loss experience data recorded over 13 years.

A study of 75 programs run through the model indicates that the variation in program pricing can be as high as 800 percent.

In other words, one group of buyers, which thinks its programs are (relatively) expensive, is getting exceptional value, while another group, which thinks its programs are (relatively) expensive, is absolutely right.

This hardly seems fair, and is incompatible with the current emphasis by all partiesretro sellers and buyerson "portfolio optimization techniques."

Using the AHJ methodology, it becomes apparent that security ratings are not a critical factor in pricing. For example, one program provides worldwide protection for a Lloyds syndicate that buys up to only 28 percent of its peak zone probable maximum loss and is heavily exposed throughout by other territories. Nevertheless, this syndicate pays an average of 30 percent of the benchmark adequate rate with commitments from "triple-A" markets.

On the other hand, a different program is purchased by a company buying up to 45 percent of its peak zone PML. This one is exposed only to three named loss exposures. This company pays up to 250 percent of the benchmark adequate rate with lower-rated paper.

According to a recent market survey conducted by Alwen Hough Johnson, retro rates will stay at current levels into 2004. Retrocession capacity is still very limited, with a maximum of $250 million to $300 million of traditional capacity routinely available per program. In practice, only about two-thirds of that figure might be available, although much bigger limits can be pieced together using a full range of alternative risk transfer mechanisms.

One of the largest structures placed is around $1.5 billion for one event, including as much as $450 million of traditional cover.

London has been, for many years, the major center for the transaction of international retrocession business. Historically, the major market leaders were concentrated here, but today, its status is due more to the concentration of broking expertise than underwriting capacity.

Currently, something in excess of $5 billion of catastrophe limit (roughly 80 percent of which is traditional layers, 20 percent Industry Loss Warranties), and $1 billion of premium emanates from, or passes through London annually, according to AHJ and Benfield studies.

However, an increasing proportion is being placed into the international markets led by Europe and Bermuda.

For the knowledgeable underwriter, there are excellent opportunities in retrocession underwriting for the foreseeable future. Some rates are at an all-time high with good terms of trade, information is highly transparent, coverage is clearly defined, capacity is tight, and demand will continue to exceed supply by a considerable margin.

And, to quote Colin Murray again, "Its only catastrophe business, after all".

Peter Butler is technical risk analysis and strategy manager for Alwen Hough Johnson, the London-based Lloyds broker. He has spent over 30 years in the London market as an underwritermost notably with RJ Kiln, the Lloyds managing agency and Hannover Re.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 7, 2003. Copyright 2003 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.