November 10th, 2009

Reinsurance Brokers: Orderly Markets and Optimized Results, Executing the Transaction

Posted at 12:30 AM ET

klein_chris_bioChris Klein, Global Head of Business Intellience
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The primary role of the reinsurance broker is to help insurers move risk out of their portfolios, most often — unsurprisingly — via the purchase of reinsurance. Cedents have three basic objectives for the use of reinsurance: reduce risk held, optimize the productivity of capital and manage earnings. The first is clear — reinsurance entails the act of transferring risk to another party. In doing this, the cedent gains flexibility in deploying the capital it has on hand, which produces revenue, market share and market capitalization growth opportunities. Insurers also use reinsurance to remove some volatility from their earnings. Consequently, reinsurance is much more than a tactical risk management tool; rather, it is of strategic value to every cedent in the marketplace.

Completing a reinsurance transaction is not as simple as finding a willing reinsurer and signing a contract. The process involves the efforts of a variety of contributors to ascertain which risks to transfer, in what amounts and to which reinsurers. In addition to the analysis of the cedent’s portfolio, the reinsurer must be evaluated to ensure its reliability. Analytics, counterparty credit risk analysis and relationship management converge on every reinsurance transaction.

Perhaps the most fundamental role of the reinsurance broker is to help insurers find capital for risk transfer. Typically, this involves scouring the reinsurance market for the companies willing to assume a particular risk and capable of supporting it. Different reinsurers focus on specific areas, with the larger among them having separate groups to handle certain risks. Their requirements vary, and the reinsurance broker helps the cedent navigate this maze to determine the most appropriate reinsurers to use.

Of course, one source of capital is not necessarily as good as another. Market security has always been a priority for cedents, and the recent financial crisis has increased its importance. The reinsurance broker may start with a reinsurer’s rating and balance sheet, but there are new techniques emerging by which a reinsurer’s financial strength can be evaluated between quarterly snapshots. At Guy Carpenter, for example, we are using market capitalization, equity market volatility measures, credit default swaps and other leading indicators to help insurers understand their changing levels of counterparty credit risk on an ongoing basis.

The importance of market security was highlighted a year ago, as the financial crisis destroyed shareholder value and drained reinsurers’ balance sheets by 18 percent, as measured by the Guy Carpenter Global Reinsurance Composite. Though no major reinsurers were at risk of insolvency (and only one minor company failed), the instability of financial markets around the world caused insurers to take a closer look at counterparty credit risk and work with their reinsurance brokers to analyze potential reinsurers more carefully. A return of capital to the industry in 2009 has not led to complacency, as market security continues to be a priority and likely will be at the January 1, 2010 renewal.

Included in the market security effort is reinsurer diversification. The same principle at work in portfolios in all financial services industry sectors applies to the placement of reinsurance programs. As an insurer diversifies the risks it assumes, it should seek to diversify its panel of reinsurers. This adds another layer of protection to the traditional and dynamic market security measures currently in use. In addition to reducing the risk of recovery in the event of a reinsurer insolvency (which is uncommon), this approach also mitigates the effects of reinsurer rating downgrades and demonstrates a cedent’s commitment to preserving its capital for the widest set of risks conceivable.

Even with capital lined up from a variety of sources, an insurer has to understand the potential risks it faces — not to mention the capital implications of a variety of scenarios. The process by which a cedent decides to transfer risks — and to which source of capital — tends to involve a considerable modeling effort. In addition to evaluating the possible risks and their impacts (e.g., through catastrophe models), the capital side of the equation is simulated, as well, in order to ascertain what an event would mean for a carrier’s balance sheet. This process is meant to inform: bringing data to bear on a capital management problem to ascertain the most effective allocation.

The role of analytics has become even more pronounced with the industry’s long-term shift form proportional to non-proportional reinsurance. The former entails the sharing of profit and loss by the insurer and reinsurer, while the latter rewards careful and diligent risk and capital management practices. Since non-proportional reinsurance (e.g., excess of loss) requires that retention levels and attachment points be determined, the extra layer of analysis is crucial, as it can influence the insured losses sustained and their impact on company earnings and market value. A reinsurance broker’s advanced analytical capabilities, therefore, can affect profoundly a cedent’s financial performance, especially with the increase in non-proportional cover used worldwide.

The reinsurance transaction may be a single event, but it is fed by many complementary efforts. When integrated to support a cedent’s transfer of risk, the result is the optimization of capital — not merely the removal of risk from a portfolio. The reinsurance broker’s role in this process, as the cedent’s advocate, also involves an upside for the company on the other side of the transaction. The discipline that an intermediary brings to its client actually facilitates the reinsurer’s capital management efforts, as well.

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