U.S. Reinsurers Can Rise Above Profit Challenges

The number of reinsurers active in the U.S. market has steadily declined. The number of reinsurers reporting results through the Reinsurance Association of America has decreased from 115 in 1980 to 70 in 1990 to 30 in 2004. (Statistics for 2004 are inclusive of the new 2001 market entrants.)

Six markets have exited the business in the last two years.

Of the U.S. reinsurers remaining, many of those active in the market prior to 2001 have recorded significant reserve increases in the years since 2001.

Reserve additions have continued into 2004. While 2002, 2003 and 2004 are viewed as profitable underwriting years, reserve additions led to unexpectedly high calendar-year losses in 2002 and 2003 for the U.S. reinsurance industry as a group, and the jury is still out on 2004.

Faced with a constant change in the composition of the industry over the past five years, buyers are starting to reexamine the place of reinsurance within their risk management strategy. Some buyers are questioning not only the ability but also the willingness of reinsurers to live up to their obligations.

In some cases, buyers are responding by moving to reduce their dependence on reinsurance and/or attempting to guarantee eventual recoveries by imposing new collateralization requirements within reinsurance contracts.

In the face of this environment, some industry observers are starting to question whether the current business model for U.S. reinsurance will allow it to be profitable in the long run, with the implication being that a reasonable, long-term level of profitability is required for a stable industry.

PartnerRes view of the U.S. reinsurance market continues to be optimistic. We believe that reinsurance provides fundamental value to insurers. Thus, we believe there will always be a demand for reinsurance.

U.S. reinsurance markets must demonstrate that they can and will provide stable capacity in order for reinsurance buyers to feel confident they are paying for a service that will, in fact, materialize.

In order to provide stable capacity, however, the U.S. reinsurance industry does need to be profitable over the long term, at a level of profitability fair to both buyer and seller.

Certainly it is true that the prolonged soft market of the second half of the 1990s, affecting both insurers and reinsurers, created a difficult environment. However, through promoting underwriting "best practices," it is possible for reinsurance companies to maintain profitability and to perpetuate the strength of the reinsurance product over the long term, even in challenging market conditions.

Recognize and respect the complexity of the transaction.

Reinsurance treaties are large, highly complex transactions. They are, without exception, manuscripted, individualized documentsusually the result of months of analysis and negotiation. The reinsurance transaction will ultimately work out to the mutual satisfaction of the parties on both sides of the transaction only if both have done their homework.

Whether a reinsurance company positions itself as a "lead" or as a "following" market, each reinsurance company needs to take control of its underwriting process by investing in the infrastructure needed to thoroughly analyze each transaction.

In addition to investing in infrastructure, reinsurers need to make a commitment to underwriting rigor. The reinsurance underwriter, while taking responsibility for the overall integrity of the underwriting process, leads a team of professionals in evaluating each transaction.

In order to lead the team, the underwriter must thoroughly understand the cedents underwriting operations and direct the technical analysis provided by supporting professionals so that client-specific issues are recognized. A high level of skill is needed to accomplish this task. (See infographic.)

Obtain sufficient information to evaluate the transaction.

Reinsurers must recognize the major differences between ostensibly similar transactions. They cannot provide reinsurance capacity to clients in the absence of critical information, such as historical gross rate changes and triangles of historical loss data, or full knowledge of critical contracts (for example, MGA contracts). It is almost impossible for a reinsurer to accurately price a reinsurance transaction without this information.

One way to develop the knowledge base to evaluate the reinsurance transaction is through rigorously performed reinsurance audits. Audits provide an opportunity for reinsurers to improve their understanding of an insurers underwriting operations. Through the audit process, insurance company management has the opportunity to meet and explain their underwriting strategy to reinsurers.

Audits provide an opportunity for reinsurers to confirm compliancethrough individual file reviewswith the underwriting guidelines presented during treaty negotiations. Audits also provide an opportunity for the reinsurer to provide value to the client through constructive feedback.

All parties to a reinsurance transaction should view a reinsurers request for additional information in a positive light as the reinsurer is simply trying to gather enough information to make an informed underwriting decision. When a reinsurer offers capacity to an insurance company, the profitability of the reinsurer will be dependent on the success of the insurers underwriting operations. Therefore, reinsurers need to thoroughly understand their clients underwriting operations so that they can make informed underwriting decisions commensurate with their risk appetites.

Understand the nature of the partnership.

PartnerRe believes that the partnership between the cedent and the reinsurer is fundamentally one of economics. The transaction, at its most basic level, consists of the reinsurer providing capital to an insurer in support of its operations. To operate as a profitable, ongoing entity, a reinsurer must obtain an economic return on the committed capital commensurate with the risk assumed.

Reinsurance underwriters focus on identifying and building relationships with insurers who demonstrate superior underwriting operations. Reinsurance buyers focus on reinsurers with the financial strength and expertise to understand and honor the reinsurance obligations. If reinsurance rates, terms and conditions prove to be inadequate in one year, the underlying strength of the business and the relationship built between the principals should allow for needed corrections in the future.

Fundamentally though, reinsurance underwriters should not provide reinsurance capacity for prices, terms and conditions that they suspect will not generate sufficient economic returns. Providing capacity at prices and terms that produce insufficient economic returns may work to some degree for short-tail business, where price inadequacies can be quickly and undeniably recognized and adjusted for by both sides of the transaction. However, history would suggest that it will not work for long-tail business, such as most casualty lines.

Without sufficient infrastructure, reinsurers may not recognize long-term price inadequacies for years. Over time, the price inadequacies will manifest through unexpected loss emergence, resulting in loss reserve strengthening and erosion of the financial resources committed to support the reinsurance obligations.

Viewing the partnership as fundamentally economic does not mean that there should be any less of a commitment to service. The quality of the relationship between the reinsurer, the reinsurance broker and the client will always be of paramount importance in the transaction. However, a good relationship cannot overcome fundamentally bad economics in the long term.

Destructive cyclical behavior can be avoided.

Each reinsurance company owes it to all of its stakeholdersowners, customers and employeesto maintain a profitable book of business. The recent history of the U.S. reinsurance market shows that a reinsurance company that forgoes profitability to gain market share, even for a limited period of time, hoping to make up for inadequate premiums sometime in the future, will likely not be successful.

A strong commitment to recognizing and responding to the economic fundamentals of the business will be required of any reinsurer aspiring to be successful over the long term. Adherence to underwriting "best practices" will help create a platform to sustain profitability over a market cycle, resulting in a financially strong reinsurance partner that will be well positioned to meet its reinsurance obligations to clients and provide an appropriate return to shareholders.

PartnerRe believes that reinsurance companies with the infrastructure and the willingness to maintain rigorous underwriting practices and good communication with its clients will succeed.

Robin M. Williams is the chief underwriting officer of Partner Reinsurance Company of the U.S. in Greenwich, Conn.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 3, 2004. Copyright 2004 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.