Smoothing the Edges: SQUARING OFF

Last fall, when discussions around contingent commissions fuelled the headlines of all insurance magazines, the industry was forced to inform their clients that they had been overcharged mainly because of unacceptable business practices. Further complicating conditions, because the industry’s top line began to face a steady decline, all additional associated business processes costs saw a considerable increase. Sarbanes Oxley compliance, with significantly enhanced documentation standards is now consuming a fifth of potential net income for additional process upgrades and thus guiding net incomes down. Above all, the industry’s factor has increased to an extent that requests to deliver RoE’s not far off those requested from venture capital funds. RoE of some 7.5% to 10% did not discourage investors, but now they are asking for no less than 10 % to 15 %, at least one third higher.

As a completely unique industry, insurance is an A- (rated) industry and it follows that it should provide capital in excess of RBC (BBB by S&P), which dilutes performance.

Should insurers complain or should they have a recipe to commensurate with this dilemma?

TAKING CONTROL

The sustainable investment return declined steadily by approximately 300 plus base points in the last few years thus forcing the insurance industry to deliver combined ratios that were better by at least 7.5 points (100 bps force an improvement of 2.5 combined ratio points). This in turn meant that primary writers have had to avail themselves of all possible ways and means to reduce costs with an accent on processes. Electronic systems and sales garnered by general interest rather than through overly expensive sales forces may soon be a commonly accepted standard for commodity business. The customer will not allow prices to be increased on commodity insurance products.

Speciality business has caused shock waves through the insurance market, mostly caused by the fact that unknown, in-assessable exposures were priced in an inadequate and blunt fashion. Insurers were too willing to assume these exposures as this meant they would not have to accept the fact that most exposures were genuine business risks that should not have been insured.

The industry has finally reacted and is committed to only insure exposures they know (although some notable exceptions exist, such as nano-technololgy) or request margins commensurate with these high-risk circumstances. A request for a profit margin of 15% to 25% is common now, it is also integral as three out of 10 risks deliver unpleasant surprises and only strong earnings potential on each can deliver the necessary result.

Reinsurance by nature is a speciality business. Commodity reinsurance does not exist and those reinsurers who approach their business with a commodity attitude are bound to fail. A reinsurer must “collect” high risk exposures, with cat-business at the top, that are ideally unrelated and then price them no differently than a hedge fund would. The reinsurer needs a sizeable basket of high risk exposures as only managing a few exposures will create too much volatility and thus unduly expose the capital or require simply too much capital which in turn will likely see diluted performance.

It may seem unreasonable and unachievable but a reinsurer has to shoot for a 90% combined ratio when quoting and pricing business. Adding the usual mishap’s, the unknown, the reinsurer will target for a 96 to 97.5% combined ratio, acceptable to investors (who expect RoE between 12.5% to 15%), acceptable to rating agencies (who include performance as a major component) and to our customers (who appreciate a reinsurer capable and willing to pay claims).

TRUE TODAY

“The year of truth” will define 2006 Canadian insurance market”. After so-called hard markets, during which customers and reinsurers share the fortunes of adequate primary rates, markets tend to be tested for a disproportionate sharing of fortunes. An attitude that primarily considers technical prices on primary rates and then shares them with the reinsurance community, even by means of non-proportional contracts, should be the one and only way forward in partnership.

At Hannover Re, discussions of partnership interpretation and continuity with customers are ready for the table – the motivation is increasing transparency and openness toward technical dialogue.

“The year of truth” will pave the way for all reinsurers and insurers, to change the industry’s perception whilst maintaining highest performance standards. Finally, the square will fit into the circle.