Reinsurance efficacy: looking beyond price and capacity

At renewal, much of the conversation around reinsurance focuses on two things: capacity and price. However this narrow view overlooks the most critical consideration of all - if the reinsurance structure is still doing what it was designed to do.

How much capacity is available and at what cost, and whether or not the existing structure can be renewed are important factors. But before negotiating terms, attention must be given to the most fundamental consideration, and that is if the reinsurance programme still meets the insurer's needs.

In practice, an effective reinsurance programme is not necessarily the one with the most capacity, the lowest price or even the most sophisticated structure. It is one that reflects the underlying business. That is, the portfolio being written, the volatility the insurer is prepared to retain, its capital position and, importantly, where that business is going.

Fit for purpose

One of the things we see in practice is that reinsurance structures can remain relatively static while the portfolios beneath them evolve. These changes can take many forms. Premiums can grow, limits can increase, the mix of business can change, geographic concentrations can develop over time, new products or distribution channels might be introduced, or the claims experience can develop differently from what was originally anticipated.

While none of these scenarios mean the existing reinsurance structure is inherently wrong, they do necessitate constant review as to the whether the structure remains effective and appropriate.

A quota share arrangement, for example, may provide valuable capacity, capital support and stability while a portfolio is developing. As the business matures and its premium base and underwriting experience develop, the level of proportional cession may warrant reconsideration.

However, reducing the cession is not necessarily the natural next step. The decision should also take account of the insurer's capital requirements, retained volatility and the overall economics of the arrangement, including commission.

Equally, a conventional per-risk or per-event excess of loss programme may provide effective protection against large losses while still leaving the insurer exposed to significant volatility from repeated losses below the retention.

As these examples illustrate, it is not simply a matter of whether the programme works, but rather whether it continues to work for the changing business as it is operating today.

Exposure and need remain central

The starting point for investigating this idea is looking at what the programme intends to protect, its primary function.

This could be individual large losses, an accumulation of losses from a single event, catastrophe exposure, earnings volatility, capital protection, supporting growth or even increased underwriting limits.

Different objectives can produce very different reinsurance structures. It is for this reason that the structure should begin with the insurer's exposure and objectives, and then move onto the market solution.

This ensures that the insurer's need remains central to the structure. Starting with available market capacity and working backwards, on the other hand, can miss the objective of the programme, rendering it ineffective.

The structure's efficacy can be further interrogated by testing alternative structures against plausible loss scenarios and considering their impact on retained earnings volatility, capital requirements and the overall economic cost of reinsurance.

A lower reinsurance premium may appear attractive, but the additional risk retained by the insurer needs to be understood and evaluated against the potential savings.

Contractual provisions determine loss response

Once the programme has been formulated the next logical step is seeing how it responds in the event of a loss. There are a number of factors that can affect how a structure behaves. Varying definitions of a risk or loss occurrence, event limits, hours clauses, aggregation provisions, reinstatements, exclusions and the interaction between different layers or protections can all influence its response when a loss occurs.

These details may seem theoretical at placement stage, but they come into their own when it is time to claim, as they determine precisely how much protection is available, which parts of the loss are covered, and how the financial burden is distributed between the insurer and its reinsurers. 

Ultimately, contractual provisions determine how a programme will respond when a loss occurs. 

For Reinsurance Solutions, an effective programme also requires the insurer, broker and reinsurer to understand how the protection is intended to operate, with that intention clearly reflected in the agreed contract wording. This shared understanding is important.

Renewal actually a year-round process

We spend considerable time looking at sums insured, occupancies, probable maximum losses (PMLs) and concentrations. But portfolios are not static. Individual risks change and, over time, the characteristics of the overall portfolio can change with them.

If the underlying exposure has moved materially while the reinsurance assumptions have remained the same, a programme that looked appropriate when originally structured may gradually become less so.

This is why sound reinsurance structuring actually starts well before renewal. It should not be viewed as an annual placement exercise but rather an ongoing process.

Insurers should be aware of these shifts, and constantly assess their programmes, as opposed to waiting until a fixed renewal date to consider if the programme is still appropriate. During the year, between renewals, they can look at how the portfolio is developing, look at the claims and what they say about the business and its risk, and examine whether or not the retentions remain appropriate.

Insurers can also look ahead and determine what they expect the business to look like over the next twelve months.

For a broker, it requires more than just taking an existing programme to market and negotiating terms. It requires understanding the business sitting behind the programme, and these anticipated changes the business might go through.

The effectiveness of a programme also depends on reinsurers providing a certain level of protection. Financial strength, the concentration of capacity within the reinsurer panel, claims service and the ability of markets to provide consistent support as the insurer's needs evolve are all important considerations.

Capacity might be valuable, but the quality and reliability of that capacity matter just as much.

A different approach

At renewal stage, instead of simply looking if the existing programme can be renewed and the costs involved, insurers and brokers can take a different approach. We can ask what lessons were learnt over the past 12 months that can now be drawn on as we look ahead to the next year.

We can also consider if we were designing the programme that is currently in place 12 months ago, knowing what we know now, would we have designed it the same way? And would we do the same again now for the year that is coming?

If the answer to these two questions is 'no', there is space to start a new reinsurance conversation around exposure, purpose, and how contractual provisions can be structured to deliver more effective loss response under anticipated market conditions.

This increases the potential for a highly effective reinsurance structure that is better aligned with the business's changing needs and does exactly what it is supposed to do.

Practical Perspectives is a series on reinsurance, UMAs and risk structures based on Reinsurance Solutions' observations on issues shaping risk, underwriting and reinsurance in practice.