New Paradigm for Reinsurance
By James Vickers
Reinsurance News, November 2021
The global reinsurance industry has been battered by several years of underperformance. It has been hit by natural catastrophe losses, both modeled and unmodeled, social inflation, declining investment returns and diminished reserve releases and has faced an unprecedented globally systemic loss in COVID-19. Have we now reached the point where the global reinsurance market can morph into a new paradigm, allowing a more responsible and sustainable market to emerge? Or are we seeing a reworking of old approaches that have failed to deliver the sustainable, efficient solutions that primary insurers, policyholders and society needs to ensure the efficient working of the global economic model?
Moments like this do not come often. Arguably, the last opportunity for a reset was 20 years ago in the aftermath of the 9/11 tragedy. So, what has gone wrong, and how can we build back better?
The harsh fact is that, with a consistent weighted cost of capital in the 7 percent to 8 percent range, the global reinsurance industry has not covered its cost of capital for the last six years. A prolonged soft market has led to under-reserving on many long-tail lines, a problem that is being exacerbated by longer term social inflationary pressures as well as immediate inflationary concerns. Overreliance on increasingly sophisticated pricing models that have proved unreliable when measured against actual losses has led to unsustainably low pricing, which eventually requires disruptive correction.
Despite the unsatisfactory performance, capital has continued to flow into the global reinsurance market, most notably in the very significant expansion in insurance-linked securities (ILS) over the last 10 years, but also through the retained earnings of existing reinsurers, which have been bolstered by investment returns. Without the constraints of capital limitation to control excessive competition, the inevitable result has been underperformance as reinsurers have chased top-line growth at the expense of profit in an historically cyclical business.
Fortunately, the reinsurance industry remains well-capitalized, with capital levels above the end of 2020. Because capital constraint is clearly not going to limit pricing competition, we must look elsewhere for drivers that will help to put discipline and structure around achieving sustainable, adequate returns.
Investment income offers a potential solution. Unlike previous hard markets, when investment rates were much higher, current investment rates remain pitifully low, and are likely to remain so in the mid term because nearly all governments are still pursuing fiscal expansion as a result of COVID-19. Since most reinsurers’ investment holding periods are four to six years, and they have to face the reality that low investment returns will continue.
Faced with the loss of the investment crutch, reinsurers have no option but to concentrate on improving underwriting results to generate enough margin to service their capital. With a 7 percent to 8 percent cost of capital and return-on-equity (ROE) targets of 9 percent to 10 percent, reinsurers now need to run combined ratios in the low 90s, something the industry has not achieved for many years. This requires a back-to-basics underwriting approach to ensure that each unit of risk accepted is appropriately priced within a reinsurer’s overall portfolio. This approach inevitably means rate increases, along with changes to terms and conditions, neither of which will be easy to achieve in a global environment where many policyholders are under significant financial stress.
Reinsurers have a delicate path to navigate, but the strong capital position should let the industry ensure that risk is appropriately differentiated, and pricing corrections are applied on a case-by-case basis in a sustainable fashion that clients can manage and crucially afford.
Unfortunately, whilst stricter underwriting controls largely aimed at adding exclusionary language restricting cover along with premium increases may be necessary for (re)insurers to manage their own long-term financial viability, such approaches are exaggerating the issue of affordability. Setting prices that original customers cannot afford is the key long-term risk to the private global reinsurance market. There is already a well-recognized widening gap between economic losses from natural catastrophe and manmade perils and insurance recoveries. In even the most sophisticated and mature markets pernicious under insurance is a continuing issue that is considerably worse in emerging markets. Lack of affordability not only helps to drive under insurance but encourages government intervention as individuals look for governmental support that many populist politicians with short-term election horizons are happy to indulge.
Adding to the challenge of affordability is the increasing threat of climate change driving secondary perils that have not yet been fully recognized by the (re)insurance industry as well as new emerging risks arising from technological innovation and new ways of working. The greater pressures on adherence to environmental, social and governance issues is providing yet more challenges to the management of reinsurance companies particularly in areas of transition risk. For some the temptation of taking the easier route of restricting cover and withdrawing from difficult lines of business can be overwhelming, but if enacted, will ultimately lead to the global reinsurance industry fading into a financial backwater.
Whilst facing a myriad of challenges the global reinsurance industry must not shrink away from risk taking. Instead it should seek to apply and share the extensive knowledge, data, and skills that it has accumulated over many decades and find ways to engage more deeply in the global financial eco-system and through this support society as a whole.
Reducing under insurance through increased insurance penetration and improved affordability is the bedrock to the wider societal role reinsurance can and must play. Under insurance is a complex and multifaceted problem mixing individual cultural and behavioral issues along with those of affordability, distribution, and trust in the insurance industry. It is naive to assume that the reinsurance industry can help solve all these problems, but it can make a considerable contribution by working together with other partners. The reinsurance industry has invested heavily in sophisticated models that are being constantly updated and refined as academic research advances. Too often this knowledge is held as being proprietorial and when shared couched in language that only a narrow field of experts can understand and act on. There is a key role that reinsurers can play in helping to share their knowledge to help inform policyholders in simple intuitive ways that can allow them as individuals to better understand the risks that they are facing, and which may increase through their own actions. Supporting the raising of risk awareness thereby demystifying the entire underwriting process so individual policy holders can see the direct financial benefit accruing to them of certain actions, is another way to help promote individual risk mitigation and stimulate long-term demand.
In addition to increasing awareness at an individual level the reinsurance industry needs to further improve its own lobbying efforts and profile with policy makers. This requires long-term commitment and education, as too often relationships between policy makers and the industry can verge on the adversarial particularly in areas of coverage disputes that can undermine the numerous recent efforts to improve in this area. Achieving this will require dedication, long-term vision and the ability to build partnerships with organizations that the reinsurance market has never interacted with before, many in innovative public-private partnerships.
The opportunity to build back a better reinsurance market is clearly before us. The test will be whether reinsurers can develop transparent solutions and new approaches that can bridge the gap between capital that requires reasonable sustainable returns and the new risks that threaten society. If the reinsurance industry fails to grasp this opportunity, it will be doomed to suffer the fate of so many, with the current generation repeating the mistakes of their predecessors.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
James Vickers is chairman, Willis Re International. He can be contacted at James.vickers@willistowerswatson.com.