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The competition for markets: reinsurers vs. primary insurers.

UNTIL RECENTLY, PUBLIC IGNORANCE of the reinsurance market allowed reinsurers to work discretely behind the scenes as an "invisible hand" hidden from the scrutiny of consumers and insurance regulators. The commercial liability crisis that occurred between 1984 and 1986 lifted the veil that was drawn around reinsurers. The public is now much more aware of the economic role and importance of reinsurance markets, and consequently state regulators and Congress are trying to exert more control over reinsurance operations.

Industry experts have charged that the reinsurance market can substantially dictate how primary insurers operate and compete. However, since the market has an international scope and many independent, highly competitive players, such allegations give an unrealistic view of the power of the reinsurance market. Reinsurance can increase capacity, stabilize profits, assist growing insurers through cash flow and accounting benefits, provide protection from catastrophic losses, as well as facilitate market entry and exit. In addition, 40 percent of the total worldwide property/casualty reinsurance premiums are written by the reinsurance-assuming departments of primary insurers, according to Swiss Reinsurance Co. Indeed, reinsurance can be a profitable source of business that spreads risk and diversifies an insurer's portfolio.

During the liabiliy crisis, reinsurers changed terms and conditions of reinsurance contracts at renewal and withdrew from some long-tail liability markets. In addition, reinsurance coverage was restricted and its price often substantially increased. Primary insurers claimed they were unable to continue offering many coverages because available and affordable reinsurance was scarce. Because primary insurers are frequently constrained by rate regulations that set maximum allowable prices, their rates must sufficiently cover all of their economic costs, including reinsurance costs. Therefore, if rate constraints imposed by regulators prevent covering all insurer costs, insurers will likely withdraw from the market rather than write additional policies at an unprofitable rate.

In the mid-1980s, reinsurance underwriters at Lloyd's began to encourage primary insurers to write liability policies on a claims-made basis. Reinsurance to cover occurrence-based policies also became difficult to find and may have contributed to the liability crisis. Unless reinsurers could economically justify their contract changes and/or withdrawal from the market, they could not make a significant impact on the primary market due to the large number of international reinsurance competitors. It is difficult to gauge the actual number of those competitors because the field includes primary insurers, risk retention groups, Lloyd's and many other firms that can easily supply reinsurance. In 1985, Swiss Reinsurance Co. reported there were 376 professional reinsurers and 10,803 direct insurers worldwide. These numbers do not include all the captive insurers, risk retention groups and other potential reinsurance competitors.

In a highly competitive international market, it is unlikely that all the players could collude to artificially restrict reinsurance availability in the United States. The same problems associated with liability claims that caused primary insurers to raise their prices and restrict coverages also affected reinsurers. In addition, losses and legal defense costs forced prices to rise and encouraged primary insurers to reduce the scope of coverage for difficult loss exposures.

Competing in Primary Markets

MANY REINSURERS HAVE developed sophisticated staffs that specialize in various lines of reinsurance and can convey knowledge of market conditions, coverages and rates to potential new insurers. This transfer of underwriting knowledge enhances competition in the primary market by making entry into a particular line of insurance easier than it would have been without the removal of these information barriers.

In the 1970s and early 1980s, it was commonplace to speak of "innocent" reinsurance capacity. Apparently, some reinsurers naively trusted the underwriting practices of the ceding companies. However, growing losses and falling interest rates in the reinsurance industry changed this trusting attitude. Several prominent insurers and reinsurers became insolvent. As a natural economic response, the "survivors" underwrote insurance and reinsurance contracts more restrictively and raised their prices considerably. These higher costs for primary insurers were then passed on to their customers in the form of higher rates if reinsurance was used. Nobody was forced to purchase reinsurance, even though it was probably prudent to do so. Moreover, intense competition in reinsurance markets was strongly influenced by the availability of high investment returns in the early 1980s. Thus, reinsurance appears to have been underpriced due to optimistic expectations about future cash flow in some liability lines and the entry of many new competitors who expanded capacity and supply.

The reinsurance market is highly competitive, so it is unrealistic to think that a few reinsurers could dominate the whole property and liability insurance market in the United States. In 1987, A.M. Best Co. reported that there were 139 professional reinsurance companies in the United States. There are also over 3,700 property/casualty insurers in the United States that could easily provide reinsurance for other insurers if high prices signified potentially large profits. If some reinsurance companies decided to pull out of the market, or raise their prices, many others could nonetheless write reinsurance. Moreover, if the price increases could be justified, then it would not be surprising to see most reinsurers raise their prices and restrict or narrow their coverage. Some might even refuse to write reinsurance for certain long-tail liability lines if uncertainty about future losses made the accurate pricing of reinsurance difficult. Reinsurance availability and affordability problems during the liability crisis were clearly affected by falling interst rates, poor underwriting and great uncertainty regarding the evolving liability standards in the United States.

When sound economic reasons exist for raising prices, primary insurers are cautious about purchasing comparable reinsurance at much lower market costs. This is because reputable reinsurers must price their reinsurance properly to have enough claims payment funds on hand. It is difficult to accurately estimate future liability claims, especially in long-tail liability lines. However, if a few reinsurers set their prices considerably lower than the rest of the market for comparable coverage, the underwriting practices and future solvency of such reinsurers could be questioned.

Competition among reinsurers is subject to fewer regulatory constraints than what affects the primary market. For instance, reinsurers do not have to use standard forms or rates that apply to primary insurers competing in the admitted market. This allows reinsurers to offer a greater choice of coverages. Without form and rate regulation, reinsurers' competitiveness is increased and freedom of choice for primary insurers is enhanced. The point is that reinsurance markets do not control insurers any more than primary insurance markets control any other business requiring insurance. Underlying economic, legal and social factors -- not reinsurers -- are the chief influences on primary insurers and their policyholders, who must pay the higher cost or have difficulty obtaining liability insurance.

Primary Insurers

PRIMARY INSURERS THAT WRITE reinsurance expand the capacity of the reinsurance market and diminish the concentration and market power of professional reinsurers. If reinsurers attempted to collude and raise prices, primary insurers could assume more reinsurance themselves or vice versa. With 40 percent of the reinsurance premiums already being assumed by primary insurers, the market distinction between some insurers and reinsurers has become blurred in recent years. It is also relatively easy for other non-insurance firms to form a new reinsurance company or subsidiary if there is the prospect of a sufficiently high-risk adjusted return on equity.

A lower demand for risk insurance from primary insurers could translate to lower demands for reinsurance by primary insurers. However, since alternative insurance, such as captive insurers, needs reinsurance and access to the reinsurance market, demand for reinsurance may not decline as alternative insurance markets develop.

In addition, if the direct insurance premium volumes were to decline, this would free up some of the exchangeable capital of primary insurers that could in turn be used to increase their capacity to assume reinsurance.

Another threat to the reinsurance industry developed when captive insurers entered the market to assume reinsurance, as well as to cede it. This resulted from uncertainty regarding the taxation of captive premiums. Uncertainty about the tax-deductibility of these premiums was occurring at the same time that interest rates were rising to extremely high levels. The combination of these two economic forces led to rapid growth in the supply of reinsurance, without a proportional increase in the demand for it. As a result, the relative price for reinsurance contracts was substantially reduced. With the availability of low-cost reinsurance, primary insurers were able to reduce their prices more than what would have been normally possible. Thus, commercial policyholders in the primary market received insurance at low costs because of high interest rates and the increased availability of cheaper reinsurance. In retrospect, many captive insurers now realize that they grossly underpriced their reinsurance for some long-tail liability coverages.

The formation of risk retention groups lowers the demand for insurance and reinsurance from primary insurers. However, most risk retention groups cannot fully assume their own exposures, and therefore they purchase reinsurance themselves if it is available. Of course, if conditions change, risk retention groups could eventually supply reinsurance, just like captive insurers did in the early 1980s when interest rates were at high levels.

Changing Tort Liability Standards

A SIGNIFICANT AMOUNT of reinsurance is for liability coverages that are increasingly important in the primary and reinsurance markets. As the tort liability standards in the United States continue to evolve, the need for liability insurance becomes greater -- particularly because of the increased uncertainty surrounding liability losses in long-tail lines. It is this uncertainty that makes liability insurance and reinsurance very difficult to price.

As liability standards became more volatile in the early 1980s, reinsurers began to raise prices to compensate their owners for greater liability losses. They were also forced to predict future changes in the U.S. liability system.

Reinsurers attempted to eliminate some of their exposures by encouraging primary insurers to write claims-made liability insurance contracts that were less risky for the primary insurer and the reinsurer. A simple economic rationale for such a policy is that it avoids the need to predict losses and liability standards for the distant future under liability policies issued today. The standard claims-made policy instituted by the Insurance Services Office can be converted into an occurrence policy if the insured purchases the supplemental extended tail for an additional charge. In addition, after a claims-made policy has been in force a few years, it becomes somewhat similar to an occurrence policy. Reinsurers must be cautious in their underwriting if they are going to lower their price.

Obviously, as reinsurers (insurers) change their contracts to shift risk back to the insurer (original policyholder), they must also lower their risk charges or relative prices to recognize the shift of risk. If other reinsurers were willing to issue a policy covering an occurrence-based policy, then primary insurers could make their choice based on price and coverage differences.

It is unlikely and economically implausible that most reinsurers could successfully collude to raise prices artificially and reduce the availability of liability insurance coverage. Any attempted collusion, to be successful, would have to include the large number of reinsurance-assuming departments of the primary insurers. Insurers typically lose business when they cannot offer primary coverage due to a lack of available reinsurance and when there is too much competition within the primary insurance market for those insurers to take that risk.

When reinsurers were withdrawing from the liability insurance market in the late 1980s and raising the prices of their remaining contracts, primary insurers demanded greater amounts of reinsurance. The reason for this demand was that the changes in liability laws affecting reinsurers were also affecting the primary insurers and the pricing of their liability insurance contracts. Thus, during the liability crisis, the industry experienced an increasing demand and a decreasing supply of reinsurance. Fundamental economic concepts associated with the forces of supply and demand suggested that this combination would result in higher prices for reinsurance. When the primary insurers had to pay more for reinsurance, they were forced to pass these costs on to their insureds. In the lines where reinsurance became difficult to obtain or unobtainable, many primary insurers were forced to withdraw from the market if they lacked the necessary capital to assume the risk. If insurers did not provide coverage for particular lines then one must assume the risk associated with those lines was too great for any profit-seeking insurer seeking to provide coverage. It does not mean that market participants were colluding to restrict coverage. They were merely trying to avoid potential future losses under what they perceived to be an unpredictable legal system.

Patrick L. Brockett and Robert C. Witt are professors of risk management and insurance at the University of Texas in Austin. Paul R. Aird is a research associate at Insurometrics of America Inc.
COPYRIGHT 1992 Risk Management Society Publishing, Inc.
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Author:Brockett, Patrick L.; Witt, Robert C.; Aird, Paul R.
Publication:Risk Management
Date:Apr 1, 1992
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