The Return Of The 'Risk Culture' In Reinsurance

In order to appreciate these changes, we need to understand the wider phenomena affecting the industry both from the "inside" and from the "outside."

o Increased External Competition

The first is a form of "external competition" resulting from new sources of capital entering the reinsurance sector in search of portfolio diversification and above-average returns on invested capital. This capital is currently weighted toward financial instruments and other assets which are correlated tightly to economic cycles and macroeconomic conditions. Reinsurance, exposed as it is to natural perils and other non-economic event types, provides such portfolio diversification for this "new capital."

We are living in a period when investment returns are historically low and, in particular, when equity and fixed-income market activity and returns are relatively flat. This has helped to drive the formation of "hedge funds" designed to find above-market returns in sectors regarded as "high yielding" by investors in "non-traditional" financial services arenas like reinsurance.

One effect of this new influx of "hedge fund" capital has been that traditional reinsurers have found themselves facing competitive pressure in certain industry sectors–often unexpectedly. "Hedge fund reinsurers" are known to have been active in classes of business including energy, marine, aviation and whole account reinsurance, in addition to property catastrophe business.

o Withdrawal of Past Techniques

The second phenomenon is the broad withdrawal of the plethora of "low risk/low cost" reinsurance products that had been so prevalent in the industry only a few years ago.

Many techniques, such as "finite" or "structured" reinsurances, that have long held favor in the industry have come under ever-increasing scrutiny from regulators and judicial inquiries on both sides of the Atlantic. These products are being dropped by buyers and sellers alike at the moment, and this process has exposed some "gaps" and weaknesses in the industry which are being rapidly redressed.

o More Market Competition

The third phenomenon is that of "declining revenue."

Industry experts are now reporting that the hard reinsurance market, which has held sway since 9/11, is starting to soften in many sectors. Rates are beginning to decline, and revenues are starting to fall. The industry is therefore responding by both buying and selling a new class of risk-transfer devices.

Sellers are beginning to seek new sources of revenue from high-yielding classes, which do not risk undermining rate adequacy in their "core" business. Buyers are seeking new sources of risk transfer in a time of rate uncertainty.

o Regulatory and Reserving Changes

Regulatory and reserving changes are another phenomenon affecting the reinsurance industry. Accounting changes and changes to the regulatory regime for insurers and reinsurers–particularly in Europe–have brought the industry's risk factors into high focus. This is driving increased interest in a variety of risk-transfer mechanisms, and in "traditional" reinsurance, in particular.

o More Volatility

Finally, it appears the benign "trough" in catastrophe activity that the industry has enjoyed over the last decade or so is now at an end. Several recent studies have noted the climatological reasons for this increase in cat activity. But most experts appear to agree that the industry will soon experience an increase in the frequency of severe events.

This increased catastrophe frequency, combined with all the other phenomena affecting the industry, points to the potential for more pronounced swings in the fortunes of insurers and reinsurers.

Return of the "Risk Culture"

An important by-product of these recent trends is the return of the "risk culture" in our industry.

Buyers of reinsurance are now returning to the market seeking real risk transfer mechanisms that provide significant economic and cash flow benefits to their businesses.

Sellers are seeking high-risk/high-reward business to meet revenue and profitability targets. Underwriters who only a year or two ago were actively seeking low-risk/low-margin business have identified the new opportunity and stepped into the breach, offering serious risk transfer for a commensurate rate.

This, in turn, has led to a rash of new products such as systemic loss protections, one of the "hot issues" in the industry at present. Systemic losses are losses which affect whole industries at once, cropping up suddenly and unexpectedly, and constituting a true catastrophic loss very quickly. Recent financial "scandals" in the United States have thrown this risk into high relief, driving demand for this type of protection.

Others include cat bonds with attachment points and covering classes of business hitherto thought impossible in the capital markets, and an increasing interest in buying and/or selling credit protection and other types of protection for the "enterprise risks" associated with running a reinsurance company or an insurance company in the current operating environment.

This may be a "return to form" for the industry, but it is certainly not a reversion to the past. These solutions are a new and innovative response to the problems outlined here, in many cases using as-yet untapped, non-traditional markets for the transfer of risk. Such "non-traditional markets" may include hedge funds, or even individual private investors who work with banks or hedge funds to do "private placement" deals in the reinsurance sector. With change, of course, it remains to be seen if more attractive investment returns come back into the financial market.

They also employ sophisticated structures and quantitative techniques that simply did not exist in our industry ten, five, or even three years ago. For example, the industry's burgeoning awareness of the credit risk inherent in outstanding reinsurance recoverables, and its adoption of "Value at Risk Modelling" techniques from the "holistic" perspective of Dynamic Financial Analysis tools, demonstrates how far the industry has come in terms of its risk management sophistication.

To capitalize on the opportunities presented by the return of the "risk culture" means embracing the underlying phenomena that have created this industry trend and developing innovative responses.

As has historically been the case, the reinsurance broker market is leading the charge in combining traditional market capabilities with the new operating environment. We know from our own development efforts that many of the new risk-transfer products in the market are broker-designed, and more are in the pipeline.

One point is clear: the insurance industry can only benefit from a return to "risk culture" because risk transference has always been the bedrock skill of the business.

Erik Manning is Head of Research and Development at RK Carvill & Co Ltd.

The return of the 'risk culture' may be a 'return to form' for the industry, but it is certainly not a reversion to the past. New and innovative responses may use as-yet untapped, non-traditional markets for the transfer of risk, or employ sophisticated structures and quantitative techniques that did not exist even three years ago.

Erik Manning