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Which comes first: underwriting or reinsurance?

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By Michael Drayton, RMS

I hope that after a year like 2020, the summer break offered time for you to pause and reflect. A time to ask questions such as which comes first: underwriting or reinsurance? Let me explain.

Are underwriting premiums determined by the totality of the risk or are they just an allocation of the reinsurance cost? How is the reinsurance cost established?

Modellers catering for the annual reinsurance purchase cycle quantify hazard and risk for individual locations for individual perils, calculate premiums location by location, roll up into a portfolio, determine return period losses; an entire production line to structure an appropriate reinsurance program.

But this cycle doesn’t stop – reinsurance is only placed once per year whereas individual policies renew every day. Reinsurance requirements need to be estimated for the next twelve months, not last month, and once purchased, the reinsurance cost needs to be covered.

The Australia/New Zealand market buys some of the largest reinsurance programs in the world. These costs are large, a result of a highly consolidated market, almost saturated insurance penetration and low retentions.

This consolidation and penetration provides relative year-on-year stability for insurers’ books. From one year to the next, the probable impact of natural disasters on the market is also fairly consistent even as models evolve with new peril insights. Reinsurance pricing, on the other hand, is subject to global events and local shocks and therefore changes year to year.

Reinsurance pricing was rocked temporarily after the Canterbury earthquake sequence in 2010/11. A market which hadn’t suffered a major loss for decades had to then grapple with introduction of specified sums insured and risk-based pricing – standard practice around the world. The changes exposed anchoring bias – where the cost of the risk equalled the premium that had always been paid.

Overall, the premiums coming in need to balance the claims and reinsurance costs going out, however the premiums are assigned. The debate about risk-based pricing versus community-based pricing is starting to change the public’s expectations of insurance. Regulatory changes including IFRS17 are driving more detailed quantification of each approach. There is no “right” or “wrong”. Transparency is key.

Anecdotally, insurance brokers are demanding more details when placing a policy, though modellers use bulk editing functionality when portfolios are analysed. Where does the detail go and, if the data differs at the point of underwriting and point of portfolio analysis, what if you’re not buying the right amount of reinsurance?

The shock of the Canterbury earthquakes did not lead to widespread insolvencies. That and the ongoing stress of high weather-related claims suggest that the overall reinsurance spend may not be too far out but also that it’s not quite right and isn’t sustainable. So, what’s going to change?

Will it be tightening regulation, government pressure over affordability, climate change, changing customer expectations or will it be competition? There is little doubt the industry will change in the next few years and that change may be difficult for some companies.

It’s just a matter of which trigger will cause the disruption. Nimble companies with agile IT systems may find it easier to select the better risks and exacerbate the challenging trends for their competitors. Why wait to find out what triggers the disruption? Do it on your own timetable – before everyone else does.

It isn’t a matter of whether underwriting or reinsurance come first. It’s a matter of being consistent.

*Michael Drayton is a New Zealand-based Consultant at catastrophe risk modeller RMS.