Angling for Market Discipline

In a world of volatility and unpredictability, it is heartening to know a cadre of professionals is fixing their gaze on the future, modelling their best expectations of what might happen. Marshalling our collective knowledge and experience, the reinsurance industry has made some extraordinary strides, improving the modelling of catastrophes with more granular data and more sophisticated analytics.

Models are providing more stability by way of enriched data, but those who protect against the risk of financial calamity must have a sustainable system on which to operate financially.

Consider the insurance value chain — a system of interdependency in which the actors hold as much risk as they can tolerate and hedge what they cannot. What their balance sheets cannot handle, they pass along to capacity providers that have the financial means and the balance sheets to accommodate the risk. Such a system must rest on a foundation of rationality and sustainability rather than a short-term view.

HISTORY LESSONS

One lesson of the recent past is that risks are not lessening; they are increasing. The hurricanes that struck the U.S. southeast and Gulf coasts in 2005 demonstrated there is more to a storm than wind and rain. Experience also taught us the costs of recovery from such a catastrophe are considerable, including factors such as demand surge and business interruption. What’s more, Nature’s fury often packs a second punch in the form of storm surges.

A few years ago, these additional exposures were not fully understood. Today we have a much better appreciation of and respect for the collateral damage of storms.

In addition, we can hope the models keep pace with a changing world. We are accumulating more assets. Construction and development is changing the very nature of our cities and smaller communities. At a basic level, the physical properties insurers underwrite are expanding.

Development and asset accumulation are only part of the equation, an equation that looks something like 1+1=3. Putting more development in the path of severe storms creates an exponential growth in exposure. Much of this is due to the spectre of climate change, which has been scientifically linked to an increase in volatile weather.

Perhaps lulled into a false sense of security because we live in a land of relative tranquility, we need only to look at recent history to see that weather-related disasters in Canada are also on the increase. Risk exposures are growing and changing weather patterns increase volatility.

Reinsurers must therefore adapt and spread their risks globally. Diversification across geographies and business lines is the prerequisite for a viable reinsurance industry that is able to manage peak exposures and sustain major catastrophic losses.

ENLARGING THE RISK TRANSFER MECHANISM

Securitization of insurance risk is emerging as a viable complement to traditional forms of risk transfer. In 2006 alone, Swiss Re placed nearly Cdn$3.6 billion out of total non-life issuance of approximately Cdn$5.7 billion. Despite this significant transfer of risk to the capital markets – a market that is expected to continue to grow significantly in the next decade – reinsurers continue to hold a great deal of global peak risks, taking massive exposures on their balance sheets.

Canadian reinsurers enjoyed a profitable year in 2006, with an industry-wide return on equity (ROE) hitting a six-year high at just above 17%. Still, viewed over a longer time horizon, reinsurance as a whole clearly lags behind other financial services industries, including the primary insurance industry. To attract and retain capital, the reinsurance industry needs to be able to produce sustainable results over the long run. Rating agencies have slightly improved their outlook for the industry, but they require companies to manage against more conservative risk estimates. They also expect reinsurers to secure underwriting discipline and to manage market cycles in an intelligent way.

In Canada, the story is not all about abundant capacity. The promise of adequate capacity is a fleeting and tenuous thing when one considers the environment in which we live today. Consider that Canada is no longer immune to the inflation-of-loss costs that has dogged insurers in the United States. Canadian commercial liability claims growth now outstrips growth in the nation’s gross domestic product.

SHARING THE RESPONSIBILITY

The world is changing and the global risk landscape is becoming increasingly complex. As an industry, we need to lead change by anticipating events and emerging risks and by being prepared for catastrophic events.

Reinsurers have a major responsibility in this context. They will need to manage their assets diligently and allocate and deploy their capital based on expected returns. In other words, risk-adjusted pricing will continue to be a prerequisite for a viable reinsurance market in Canada. Should future market cycles not allow for sustainable industry earnings, the best alternatives for reinsurers will be to consider more promising business opportunities elsewhere or ultimately to return capital to their shareholders.