Article, Reinsurance – May 2009
Insurance / Financial Lines
Ben Hobby examines issues of trust in the reinsurance market.
The film Touching the Void, which documents two friends' descent down Siula Grande in Peru, draws an unlikely parallel with the modern reinsurance market. The 2003 film tells the story of the efforts of one of the climbers to transport his injured friend down the mountain by lowering him 300ft ahead on a rope, knowing that one mistake by either of them would lead to both their deaths. A further disaster strikes the pair during the descent when the injured climber slips down a 150ft ice cliff: does the healthy climber allow himself to be dragged to his death or does he cut the rope and leave his injured friend to die?
The predicament of the climbers, bound together by rope, brings to mind the delicate balance of the reinsurance market in which all players are interconnected. Fundamental to this type of relationship is trust, which can be affected negatively in times of economic hardship.
Trust is defined as reliance on the integrity, strength and ability of a person. Using the above example, neither friend would have attempted the climb had they not trusted the other; the same principle applies in the reinsurance market - a reinsurer is unlikely to accept a risk if it does not trust the reinsured.
In the case of treaty reinsurance, the reinsurer will not necessarily know the underlying risks to which they have been exposed. The reinsurer therefore trusts the reinsured in its underwriting of the underlying risks, the attaching of risks to the treaty and its calculation of premium and claims payable between the parties.
It is well documented that the LMX spiral of the 1980s nearly destroyed the Lloyd's market. Commentators have noted that one of the key factors in the LMX spiral was that the market participants did not fully understand the risks that they were writing, a clear example of what can occur where trust is misplaced or has not been earned. Yet, what can reinsurers do to gain trust in their reinsureds?
Reinsurers need ultimately to trust the information that they receive from their reinsureds. However, to rely on it, they need to understand where it comes from.
The process of preparing this information has changed significantly as technology has progressed since the days of the LMX spiral. In established markets, these systems are well developed and the process of producing the information that is provided to reinsurers will be automated.
However, in emerging markets, the investment in systems may not necessarily have kept pace with the growth of a reinsured's business and consequently there may be a large amount of manual intervention involved in preparing information. This level of intervention increases the risk of the information being inaccurate, incomplete and therefore unreliable.
Trust can often be eroded when what actually happens differs from perceived expectations. In reinsurance, this difference in results can be attributed to expectations being based on information that is wrong in the first place or when the circumstances change from those that were expected at the time of placement. In the current economic climate, circumstances are changing on a daily basis and the outcome is uncertain.
A common feature in an economic downturn is an increase in the number of insolvencies. If a company goes out of business then its creditors will explore all avenues to recover what they are owed, including any possible claim against the company directors.
Therefore, during a recession, reinsurers can expect an increase in the number of directors' and officers' cover claims: currently, this is evidenced in the US by the increase in the number of securities fraud class-action filings in recent years - 119 in 2006, 176 in 2007, 227 in 2008 and 51 as at March 2009.
Expectations for the performance of a reinsurance treaty will be formed prior to its inception. For example, reinsurers will have formed an expectation of the loss ratio for a treaty based on the historical data presented to them at the proposal stage. Where claims and reserve information provided after inception differs from this, reinsurers are likely to question the accuracy of the information provided.
Similarly, reinsurers will form a view of the likely period of runoff for claims under the treaty. If claims of significant value continue to be presented to reinsurers outside this expected runoff period then reinsurers will be concerned about why this is happening and what their ultimate liability will be.
Trust, therefore, is also about managing expectations and key to this is communication - particularly in changing circumstances.
A well-designed method of review that is implemented with a reinsured can result in a reduction in the risks of reporting issues for reinsurers. It also allows reinsurers to place an increased level of reliance - or trust - on the reporting by reinsureds.
In addition to the above, reinsurers can increase the level of confidence that they have in their underwritten risks because they are known and fully understood. This will be assisted by timely and appropriate communication between the parties to ensure that expectations are managed correctly.
The benefit of this is improved long-term relations between reinsurers and their reinsureds and, potentially, an increase in profit for all parties.
As appeared in Reinsurance, May 2009.