April 9th, 2009

Manage the Cycle, Part IV: Different This Time

Posted at 1:00 AM ET

venter_gary_thumbGary Venter, Adjunct Professor, Statistics, Columbia University

The reinsurance market is in an unusual state. The cost of capital increased last year, largely because of discord in capital markets. After five years of solid investment gains, the asset side of insurer and reinsurer balance sheets was hit by credit market calamity that bled into equity markets, as well. A busy catastrophe year, headlining Hurricanes Gustav and Ike in the Gulf of Mexico, caused severe damage. Together, however, these factors were insufficient to force a drastic change in the market. Reinsurance rates rose in pockets, but there was not a consistent universal outcome.

Quite frankly, it was different this time.

The basic outside factors that drive reinsurance rates, profitability, and other insurance and reinsurance financial performance metrics suggest that carriers were prepared for an event that would be considered “off-cycle,” even if they didn’t expect it. Strong capital positions insulated the industry from two severe events — the property catastrophe and the financial catastrophe. Substantial amounts of capital were lost, but not enough to imperil the industry as a whole. Several developments have led to the relatively soft landing this year, from changes in management to volatility reduction. Carriers are watching their portfolios instead of hunting for cycles.

New perspectives played a role in navigating the industry through a tumultuous 2008. Most CEOs have been replaced over the past five years, bringing fresh perspectives from a variety of backgrounds. Further, this new “class” of leaders is not eager to repeat the mistakes of its predecessors. Disciplined underwriting and pricing has become its rallying cry, though there is considerable pressure from competitive forces.

Further, these new executives are being paid differently. Equity-based incentives are playing a lesser role than in the past, as discipline is trumping short-term performance. The result is a stricter adherence to underwriting and pricing standards.

Additionally, the flow of information has improved. Improved technology has shrunk lags and improved response times. The gap between event and reaction is narrowing. But, it will always exist because of the causal nature involved in the relationship between them.

Governance and regulation are evolving alongside the industry … and are better linked to the markets they affect. Regulators appear to be more sensitive to the problem of low prices (though this is still the subject of considerable debate). In the United States, the Sarbanes-Oxley Act (SOX) has made CEOs and CFOs personally accountable for the contents and accuracy of financial statements. SOX has also increased the quality of oversight by boards of directors. The change in the “tone at the top” affected by SOX has led to more adequate reserves and improved coordination among actuaries, underwriters, executives, and other stakeholders.

The implications of SOX have extended to investment analysts. They subject publicly traded insurers to greater scrutiny than they had previously. Rating agencies, which have become de facto regulators, are using tighter standards, too. Capital and reserve adequacy and profitability are playing more important roles in upgrade decisions.

Innovation within the industry has helped carriers manage capital as well. Insurers and reinsurers have an abundance of alternatives beyond issuing debt or equity or buying traditional reinsurance. Catastrophe bonds and sidecars bring additional capacity, particularly for perils that can be difficult to reinsure. Alternative investment vehicles, including hedge funds and private equity funds have developed an appetite for insurance risks, opening another route by which capital can flow to carrier balance sheets. The use of these sources does vary with market conditions, however, as we have seen with the departure of multi-strategy hedge funds from the catastrophe bond market and the increased emphasis on counterparty risk.

All of these factors add up to a renewed effort to manage risk, capital, and volatility effectively. Carriers are preparing to withstand the unknown, a prudent approach, as last year demonstrated. The unexpected, and even the unimaginable, can occur. The job of insurers and reinsurers is to maintain the capital necessary to push through these shocks and return to normal as quickly as possible, regardless of whether they occur regularly.

Gary Venter was previously a Managing Director in Guy Carpenter’s Instrat® Unit

This is the fourth in a six-part series. To have the next installment delivered directly to your inbox, register for e-mail updates.

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