Reinsurance and the future of trading large-scale risk · •Erodes collective wisdom: shrinking overall pool of larger reinsurers •Erodes expertise versus model •It’s becoming

Prof Mike Power, LSETom Bolt, Lloyd’s Clem Booth, Euler Hermes

Reinsurance and the future of trading large-scale risk

Prof Paula Jarzabkowski

“Once upon a time …”

A Market for Commodities

We observed a market that worked… but was going through rapid

change

A Market for Acts of God

© Professor Paula Jarzabkowski, 09/06/2015

Do not share without explicit permission.

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Ethnography: The power of cultural norms …

3 years: 2009-2012

• 935 Observations

• 146 social events, feedback meetings etc

• 432 interviews

• 22 reinsurers

• 3 brokers

• 35 insurance firms

• 17 Countries, covering the main reinsurance trading hubs

Cultural norms: What people do, and how they give it meaning



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A Market for Acts of God

•The risks being traded are largely

• Unpredictable

• Uncertain, albeit high, value

• Unique and individually tailored

Markets for High Severity, Low Frequency

events have few opportunities to learn

Market stability is thus critical



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“Those were the good old days”

“The price of those covers, once

they're impacted, will then go up

to get renewed. The market wants

the payback!’ (Broker).

Why cycles enable stability

• It is hard to establish the ‘price’ of unpredictable risk in advance

•Cycles generate longer-term stability:

• Payback post-loss

• Stabilizing the flow of capital between buyers and suppliers across the cycle

•Cycles depend on annual renewals in the context of long-term relationships

“We first consider the

cedent, the

relationship. And not

the relationship of

today but the

relationship of the

past and the prospect

of the future” (Reinsurer)



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Price discovery: The wisdom of crowds

Difficult to price: “It’s crazy that

we’ve been drilling in the North Sea for

40 years and talk about 1-in-500 year

return periods. How the f*** am I

supposed to know [whether this model

is accurate]?” (Reinsurer)

Market as a sense check : “We are

quite fierce competitors but at the same

time you have respect for certain

people. You’ve got people and you sort

of think well yeah, he’s in a similar ball

park, okay, I feel like I’m getting that

right.” (Reinsurer)



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What does this give us?

• Collective bearing of risk

• A broad base of

reinsurer-driven

expertise

“I don't have differing terms on a deal

for different reinsurers, so I don't have to

worry about a loss; is someone going to

pay or not pay? Everyone’s in the same

boat with me.” (Insurer).

“The model was completely out of …

it was completely wrong. And

probably those reinsurers that were

correct were those that had analysed

on site” (Reinsurer)



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A market that works because

• Cultural norms of ‘mutual skin in the game’, based on

• Cycles

• Collective pricing and bearing of risk

• Relationships + contracts

• Despite

• Unpredictability

• Uncertainty

• Severity



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Rapid (unprecedented) change

• Driven by buyers

• Consolidation

• Globalization

• “Too big to fail”

• Regulation

• Optimization

“The regulators are requiring insurers from

a capital standpoint to think like reinsurers.

And one of the consequences of that … in

the long-term if you understand risk capital

and how it works, then you do, you keep

more of your risk yourself” (Insurer)



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Bundling of risk

So what?

• Efficient purchasing

• Greater understanding of their

own risks by multi-nationals

• Drives down costs to

shareholders and consumers

“It’s about the way you utilise

your capital, your investment

strategy, you know, it’s a whole

package. Our CEO’s a very

clever guy and he looks at

reinsurance as one of our

largest expenses, what I can do

to make it more efficient, you

know” (Insurer)



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Bundling of risk

Changing norms?

• It’s Big!

• It assumes risk can be accurately

defined and measured

• Erodes collective wisdom:

shrinking overall pool of larger

reinsurers

• Erodes expertise versus model

• It’s becoming multi-year

• Erodes cycles

From tangible and local: “We have

engineers that go out and do an

onsite inspection so we can

determine what the fire risk is, what

the wind risk is, what the quake risk

is, what the flood risk is…we do not

depend on the model to say here's

what our exposure is” (Insurer)

To abstract and global: “All our

risks are graded between 1 and 10; 1

being best, 10 being bankruptcy. So

we have an average grade of the

portfolio, that today is 4.2” (Insurer).



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ART: From alternative to additional

• Creep (reported $60Bn)

• Beyond modelled US Property

Cat

• From ILS to collateralized

reinsurance

So what?

• Diversified pool of capital

• Timeliness and liquidity of capital

• Drives price down

• Wider pool of insureds

“Non-traditional market participation

continues to increase with total

capital at USD58.6 billion, an

increase of more than 18 percent

since year end 2013.” (Aon Benfield,

2014)

“We are committed to the use of capital

markets and getting catastrophe bond

protection. We like it because it’s a

diversified source of protection because

it’s not only traditional reinsurers but a

lot of investors who are not traditional

reinsurers” (Insurer)



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Additional risk transfer

Changing norms?

• Very specific and narrow: Risk as a

commodity that can be accurately

measured and priced

• No incentive for relationship based

trading

• Drives price down

Tokyo

“For a cat bond to trigger, you need a

bull's-eye to be hit instead of a general

shot in the right direction.” (Tom

Keatinge, JP Morgan Chase)

“You can’t make too many

exceptions anymore – because

there’s not enough margin there to

to just say ‘Yes. It’s OK. In a few

years we’ll all be in the black

again”. (Reinsurer)



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A market where the cultural norms are eroded

A changing web of practices

• From unpredictable and uncertain to specified and precise

• From a broad base of expertise to a narrow focus on what can be

measured

• From a mutual game to a transactional game

• From market cycles to ‘lowest cost’ provider

Some parallels to sub-prime mortgage market

• Changing base of expertise

• Changing focus of risk

• Overconfidence in models



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What is the purpose

of risk transfer?

• To ensure payment in

times of loss

• Commodities:

measurable, tradable,

“sanitized” risk

• Acts of God:

unpredictable, uncertain,

often severe (and

increasing) risk

“I keep on seeing unmodelled events.

The unknown unknowns, and that's what

we have to think about. You know, we're

buying, we’re buying out what we don't

know, we’re buying out what we don't

understand”. (Insurer)



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What is the future of trading in large scale risk?

From Acts of God to commodities….

The underlying risk remains the same



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Documents

Reinsurance and the future of trading large-scale risk · •Erodes collective wisdom: shrinking overall pool of larger reinsurers •Erodes expertise versus model •It’s becoming