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Leveraging the hard market.

In any reinsurance transaction, the amount of leverage each negotiating party has depends largely on the state of the market cycle (hard or soft) and on which side of the table they sit (buyer or seller). Over the last three years, many reinsurance buyers may have felt somewhat helpless as they watched their rates increase and terms and conditions tighten. Some believed all they could do was to sit back and wait until things improved and the market swung back in their direction. After several years of dismal industry results, many reinsurers finally saw underwriting profits again in 2003. They view the rate and term changes over the past few years as a necessity for stability and growth. How can both buyer and seller help each other to smooth out these market cycles? Below are just a few of the strategies and tools available to risk managers and other buyers of reinsurance--and primary insurance as well---to manage the cost of risk.

Premium as Leverage

Theoretically, the more business a buyer has with a single company, the greater the leverage at renewal time. But more often than not, buyers' efforts toward building this type of relationship are thwarted by their reinsurers' structure. Many of the new reinsurance players have a mono-line approach to business. They may specialize in excess workers' compensation or property catastrophe cover. This makes it difficult to aggregate premium if your reinsurer does not want your other lines of business. Other reinsurers offer multiple lines of coverage but are small net line players. Buyers may aggregate premium with these markets only to find that they have little leverage at renewal. The real decision makers are the retrocessional reinsurers standing behind these small net players, holding the majority of the risk and dictating terms. Larger net line reinsurers with multiple product offerings are often organized by line of business and their profit centers follow. At the end of the day, the buyer could have $20 million worth of business with one company, but because it is spread across several lines and profit centers within the reinsurer, the buyer still has no leverage.

On your next renewal, look into how your reinsurer has structured itself. Companies that can handle all of a client's business in a single profit center are more inclined to view your business as meaningful regardless of the actual premium size. Also ask how much risk they actually retain net. You may have nothing to negotiate at your next renewal if terms and pricing have already been set by your reinsurers retrocessional markets.

Syndication

Hard market pricing combined with the large number of reinsurer downgrades has given many buyers pause when selecting reinsurance partners. Some buyers want to avoid being the big fish because of the added credit and pricing risk of being with one market. For them, the best way to gain leverage is through syndication. The theory behind maintaining multiple reinsurers--syndication--is to increase competition for the buyer's business, while limiting pricing swings and security risk. Having multiple reinsurers each write a small portion of the overall risk program can protect the buyer from excessive price swings on the part of one reinsurer, as well as protect against reinsurer downgrades and unexpected or hasty market exits.

The trick to syndication is to know how to slice the pie so the reinsurers are satisfied with their reduced share of the premium. With syndication, buyers run the risk of not attracting the serious interest of the major, more secure markets when they are offered only 10% or 20% participation. A reinsurer bringing A-rated capacity and technical expertise to craft your program will not give you serious consideration if you plan to share their expertise among several markets. The only winners (in the reinsurer's view) are their weaker peers, who reap the benefits of the lead reinsurer's strength and expertise.

Increasing Retentions to Reduce Cost

Buyers who believe they are getting squeezed on price without prior-year losses to justify the higher premium can raise their deductibles, self-insured retentions or participation in their captives in order to reduce costs.

Too often buyers dismiss this option because of the collateral problems it poses combined with the possibility of a terrible loss year. Their reinsurers are usually just fine with that approach because they tend to take a short-sighted, "more-premium-for-me" view. Enlightened reinsurers encourage clients to grow by offering products that enable them to assume more risk while minimizing the impact to their balance sheets. Examples of these products include loss corridors, swing plans and retention buy-downs.

Loss Corridors. These can be used for companies that want the benefits of an increased retention without significantly increasing loss potential. For example, a captive increases its retention from $250,000 to $350,000 for each loss. Its reinsurer could include a loss corridor in the policy, which for a price, agrees that if there were a number of large losses (the number dependent on the client's loss history) excess of $350,000, the retention will drop down to its original level of $250,000, thereby mitigating the impact of a bad loss year.

Swing Plans. Swing plans give buyers up-front pricing credit for exposure or underwriting changes that the buyer expects will improve their loss experience going forward. If the improvements do not pan out as expected, the reinsurer can collect additional premium to cover losses that occur in a prearranged excess layer. The swing plan approach has also become popular where the buyer's prior loss experience is often unavailable or has outdated loss runs due to the buyer's prior fronting carrier going out of business. Reinsurers like swing plans because they can increase premiums if losses develop poorly. Swing plans also benefit both buyer and seller because they encourage better risk management practices because pricing is loss sensitive.

For example, consider a captive that writes $4 million in gross written premium of auto liability. It assumes the first $250,000 of each loss. In the prior five years they experienced a number of losses above the $250,000 layer (see loss history chart below). During the current year, however, it made significant underwriting changes. They ask their reinsurer to again provide $750,000 excess of $250,000 protection and because of the client's poor prior year results, the reinsurer quotes 24% or $960,000, versus an expiring rate of 17% or $680,000. However, the captive believes the underwriting changes it made will significantly improve its results and minimize their losses above $250,000 going forward. The reinsurer proposes a swing plan, in which it keeps the expiring rate at $680,000 as long as the excess layer remains loss free, as the client intends. If the client's underwriting changes are not effective and there is loss activity within the layer, then the rate will swing to $1.1 million.

In this example, the captive gets to keep the expiring rate, but the reinsurer is also protected because it can collect additional premium if the client's underwriting changes do not work. This dramatic example highlights the mechanics of how a swing plan works. Terms for swing plans are usually negotiable, as are most loss-sensitive products.

Retention Buy-Downs. Using a retention buy-down is another way for a buyer to increase its self-insured retention level or deductible while limiting the impact of a bad loss year. Rather than forcing the buyer to choose between a higher premium and a higher retention at renewal, the retention buy-down offers a middle ground. This design allows for incremental increases in the captive's retention, while offering protection against a bad loss year.

For example, consider a captive that writes auto liability, general liability and workers' compensation with a $250,000 retention for each line for the last five years. Their reinsurers' renewal pricing for $750,000 excess of $250,000 is $2.5 million, which is a 25% increase over expiring. However, the reinsurer can offer the captive $700,000 excess of $300,000 for a renewal price of $2.1 million, which would save the client 16% from the first option of a straight price increase. This hypothetical client had one or two losses per year in excess of $250,000, as indicated in the chart below. The client decides to increase its retention at renewal to $300,000, generating a $400,000 cost savings over the $250,000 retention. However, to limit losses in the event of a significant loss year, the client buys a retention buy-down option, limiting the captive's exposure to four limits losses within the $50,000 excess of $250,000 layer. This option cost $200,000, giving the client an ultimate savings of $200,000 (the $400,000 savings from the increased retention minus the $200,000 cost of the buy-down).

The reinsurer was removed from the frequency layer, so it benefited. The captive, meanwhile, received the cost benefit of an increased retention, while being protected against a bad year. The client achieved cost savings without putting considerable strain on existing capital.

Achieving Balance

These options, though fairly well known and well understood also tend to be seldom used because of the associated administrative burden. Buyers need to know that these options are available and evaluate the alternatives and their financial implications.

All companies need to achieve profitable growth to stay in business, and they often use whatever leverage they can to do so. Problems arise in a relationship, or even in an industry, when companies abuse their leverage. Many insurers and reinsurers have been accused of this during the current hard market, and insurers and reinsurers held a similar view of buyers in the last soft market. In fact, they claim that severely reduced prices during this period resulted in their dismal results and therefore their subsequent need to raise rates.

The question, then, is how firms can use their market leverage to attain the optimal results without contributing to further price swings. Insurers and reinsurers need to continue to be creative in developing options that allow each party to achieve the best possible terms and conditions while attaining a balanced relationship and, hopefully, a more stable market.

Gregory P. Lang, CPCU, ARM, AIAF, is a senior vice-president of Munich-American RiskPartners, a division of the American Re-Insurance Company in Princeton, New Jersey.
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Title Annotation:managing cost of risk in reinsurance transactions
Comment:Leveraging the hard market.(managing cost of risk in reinsurance transactions)
Author:Lang, Gregory P.
Publication:Risk Management
Geographic Code:1USA
Date:Aug 1, 2004
Words:1710
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