Cautious optimism surrounds the January 1, 2020 reinsurance renewals, with expectations that the anticipated hardening of rates might be realized – to a modest degree at least.
Reinsurance underwriters who can harness technology to conquer historic risk assessment challenges – including robust marginal impact analytics, and create the space for innovation can build customer relationships that are resilient to future market rate oscillations.
The capital influx to reinsurance markets, triggered by low market returns globally, has led to increased limits and more generous terms being offered without commensurate increases in rates. This trend can only last for so long before having dire effects on reinsurer profitability.
Profitability in the primary insurance markets has been helped by innovation, with new product offerings linked to enhanced risk assessment techniques like telematics. But while the insurtech wave has propagated hundreds of companies and ideas focused on primary insurers, progress in “reinsure-tech” has been limited, due primarily to the current soft market. These market conditions have constrained resources available for speculative investments and has limited the reinsurer’s ability to pursue potential upside in the fast-moving tech space.
Almost ironically, in response to the market conditions, companies have instituted cautious underwriting approaches still rooted in low-fidelity risk assessment techniques, which haven’t evolved to capitalize on the technological advances made since the market softened at the start of the decade.
Advanced technologies present opportunities to eradicate historic analytical shortcuts. Companies can move beyond flawed marginal impact calculations to real-time portfolio aggregates, rate blending and more. These new tools will allow more sure-footed underwriting approaches, where diversification is encouraged. Varied product offerings for new and existing markets coupled with a focus on diversification – enabled by proactive vigilance of the evolving portfolio and quick access to reliable marginal impact metrics – will allow innovative reinsurers to truly optimize their return on capital.
Sensible and relevant diversification into new, but maybe less known risk areas will be a central tenet of this modern, technology-driven strategy. The challenge of diversification is in selecting risks that are not highly positively correlated to other risks that are held. Holding these partially uncorrelated risks together rather than apart allows for less total capital being needed to support them. This in turn frees up capital and capacity for several potential applications such as ratings upgrades or targeted growth initiatives.
The balancing act of managing profitability of individual treaties alongside their impacts to aggregate portfolio positions typically falls to the treaty underwriter. These are the individuals who decide which deals to participate in and what share of each deal to take on. One of the underwriter’s many challenges in this role is to quickly and accurately assess the marginal impact of taking on the additional risk in order to ensure that the entire portfolio is priced correctly.
Adding to this difficulty is the fact that a reinsurer’s portfolio is incrementally constructed as inward facing and outward facing deals are signed. This means that the target of the next diversifying portfolio component is a constantly moving one. Marginal risk metrics are the tool of choice for the technical underwriter facing this challenging task.
Measuring What Matters
A risk measure is a function that distills the full distribution of a random variable down to a single number. If the random variable is for instance, ceded loss to a reinsurance treaty, then one might summarize all the possible values by just the mean. While the mean captures the expected scale of loss outcomes, it ignores all of the information concerning the shape of the loss distribution.
If an individual is more concerned with the tail of the distribution, they might elect to use a single percentile point, or probable maximum loss (PML), as the summarizing risk measure. A slightly more technical approach might be to give targeted, variably weighted consideration to the entire gamut of outcomes using a member of a class called spectral risk measures.
Due to the variety of available risk measures as well as the fundamental differences in risk appetites, companies will have different collections of these metrics that they actively monitor and use to manage their risk. Quantifying the marginal impact that a prospective new deal has on this collection of relevant risk measures will help a company understand how that deal would move the needle for the entire portfolio.
It is possible, given the right combination of deal and portfolio, that taking on the new opportunity could in fact reduce certain risk measures calculated against the portfolio’s profit distribution. This reduction in risk would represent diversification in action and is in many ways the underwriter’s holy grail. We will look to produce a more technical evaluation of these various risk measures in a future blog post.
Cutting Out Shortcuts
The utility of marginal risk measures is broadly understood but implementing them systematically into the underwriting process has often proved the stumbling block. A lack of computational firepower behind some underwriting software solutions has led to a reliance on less intensive statistical shortcuts, such as calculating a deal’s tail-value-at-risk as a proportion of a static equivalent for the portfolio, which compromises the reliability of the measure. Compound that with a lack of flexibility to accommodate multiple risk measures, and the result is often a complex, slow and fragile collection of underwriting tools producing flawed insights.
In order to be successful in their quest, treaty underwriters must find a robust and multifaceted solution. It must offer the freedom to assess a wide range of risk measures that align with their specific tolerances as well as the ability to simultaneously assess the new opportunity using multiple lenses. They must be able to determine both the independent profitability of the deal as well as the impact that the deal has on the enterprise position. The interaction of these two views is not trivial but getting it right is essential.
It is only through granular analysis that underwriters will be able to guide a reinsurer forward with safe, effective and ultimately profitable diversification strategies.