Reinsurance and the future of trading large-scale risk. Prof Paula Jarzabkowski

Transcription

1 Reinsurance and the future of trading large-scale risk Prof Paula Jarzabkowski Tom Bolt, Lloyd s Clem Booth, Euler Hermes Prof Mike Power, LSE

2 Once upon a time We observed a market that worked but was going through rapid change A Market for Acts of God A Market for Commodities

3 Ethnography: The power of cultural norms 3 years: 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

4 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

5 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).

6 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)

7 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)

8 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)

9 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

10 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)

11 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)

12 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).

13 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 (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)

14 Additional risk transfer 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) 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 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)

15 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

16 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)

17 What is the future of trading in large scale risk? From Acts of God to commodities. The underlying risk remains the same