A Story from the Industrial Revolution

21 April 2017 was Britain's first ever working day without coal power since the Industrial Revolution.¹ If we think about the advanced technologies that old infrastructure has been powering, it is clear that the pace of change can vary significantly across value chains. It is also illustrative of how a core supply can be substituted by new power sources that have adapted to new demands and a different regulatory context.

What about Reinsurance?

Reinsurance has changed relatively little in its fundamental form since it emerged from the Industrial Revolution. It fuelled economic growth by facilitating effective risk transfer. Swiss Re and Munich Re emerged as dominant players in a marketplace built on a combination of trust, underwriting expertise, and a cost-to-income ratio model that rode the cycles of hard and soft pricing. The market has not been without its problems. Similar in characteristics to the later banking crisis, the Lloyd's of London market crumbled because of the punitive damage issues of the 1980s, where a number of Lloyd's investors went bankrupt due to their lack of understanding of asbestos liability claims.² In banking, issues were related to failed electronic trading initiatives, and despite market failures and a series of major natural catastrophes, the reinsurance market seemed built to weather the storms.

This resilience has recently been fundamentally challenged by technological changes and new business models, making some traditional reinsurance practices look as obsolete as coal powered electricity generators. Reinsurers have scrambled to partner and realign themselves with InsurTech startups and alternative risk transfer methods, and the struggle to remain relevant has never been greater.

The foundation of the reinsurance market is based on consensus-led pricing and the diversification and specialization that support a largely effective, if not wholly efficient, market that translates risk into a market tradeable instrument. It is a market that has displayed some incremental innovation over time and now has to address some new structural changes. The development of alternative risk transfer mechanisms, notably Insurance Linked Securities (ILS), with a resulting margin erosion and accelerated industry consolidation with implications for market capacity, pricing, and insurance covenants.

Market Reality

As in any market, economies of scale and economies of scope support large and niche participants. New market entrants from capital markets and a concentration of power have impacted the historic rhythms of the loss and recovery cycles. The ILS deals tend to be fully collateralized and should in theory offer better security than conventional reinsurance.

However, there is no clear correlation between the losses effectively sustained by the reinsurer as the result of a catastrophe and what they might recover from a bond. Catastrophe-related bonds can in turn drive down prices for conventionally written business. What capital markets represent is what the insurance business refers to as “innocent capacity”. I can tell you that sooner or later some of these investors are going to face huge losses and will then wish that they had stuck to treasury bonds, however low the yields. In a worst-case scenario, the disruption of an old model could see the reinsurance market repeating the shortcomings of the subprime mortgage market collapse.

Reinsurance as a Service

If we turn to the insurance market and especially the distribution aspects of personal lines, InsurTech is driving new concepts of digitized mutual risk sharing through peer-to-peer insurance, microinsurance, usage-based services, and a heap of technologies to support digital transformations at different levels of processing – underwriting, distribution, claims management, customer servicing – and stages of the value chain. A buzz of excitement can be heard from China to the US, especially related to non-risk bearing distributors. Whether that is Lemonade, Zhong An, Friendsurance, or Ladder,³ respected commentators as far back as 2014⁴ envisaged that we would be witnessing a transformation driven by InsurTechs that is similar to the time when the PC stack replaced the mainframe. We moved then from vertical integration (where mainframe vendors controlled the whole stack) to horizontal layers (namely Intel, Microsoft, PC manufacturers, and applications).

In this scenario, reinsurance is reimagined as a service from a platform that combines capital, regulated status, geographic reach, and the data and models to support pricing. Some firms, notably Munich Re, have started to work more closely with InsurTech startups and others have followed suit. Reinsurers have also started to explore blockchain applications, notably the B3i consortium including Aegon, Allianz, Munich Re, Swiss Re, and Zurich, among 15 participants in total.⁵ But in engaging in this open interoperability, with insurers and brokers able to talk to one another through open platforms (demonstrating a strong resemblance to the changes occurring in the banking sector), reinsurers could be planting the seeds of their own demise. To borrow a phrase from Bill Gates, the market may need reinsurance but not reinsurers going forward.⁶

The Impact of InsurTechs on Reinsurers

The InsurTech shift is encouraging shorter value chains between innovative distributors, shifting risk directly to reinsurers and cutting out friction and cost from middlemen, including insurers.

Reinsurers bring not only capital but also intellectual property through their underwriting and product knowledge. In theory, the breadth and depth of knowledge can provide distributors with more support than a single insurer.

Reinsurers can also be a drag on innovation, if they and their shareholders cannot adapt quickly enough to enter new markets and support new risk types.

In Making a Market for Acts of God⁷ the authors describe a distinct “reinsurance-underwriting” market culture, comprising underwriters acting within “densely-nested relationalities” that extend across geographic regions and across firms. The culture is made by practices and it exists despite having no common IT (e.g. there is no common trading platform), no universal common risk-calculation algorithm (though catastrophe risks, also called CAT models, are held in common), and no overarching regulatory regime.

The sector is not only opening up to alternative sources of capital to take on new risks, but also new players are emerging and engaging with unusual and unfamiliar risk types. This makes the reinsurers’ data and practices become less relevant, while other actors are prepared to adopt more powerful and accurate data analytics capabilities.

There is no shortage of capital trying to find the shortest route to the best risk receivers. Reinsurers are alert to the threat that they may appear to gain access to market opportunities faster by bypassing traditional ceding agents. However, a changing distribution strategy may fail to highlight and prevent reinsurers being substituted by alternatives such as ILS and capital markets, or even big tech companies that have access to more sophisticated data models, able to price risk at least as well as them.

This is actually a present issue, not a speculation.

Emergence of New Risk Trading Platforms

According to data from Willis Re,⁸ insurance-linked securities and alternative reinsurance capital continued to grow in 2016, rising by over 7% from $70 billion to $75 billion, or nearly 17% of the total reinsurance capital, while at the same time the underlying return-on-equity (RoE) of the reinsurance sector continued to shrink.

The data also showed that reinsurers seem unable to control their expense ratios, “despite the pressure they face and the fact the industry has been aware of the need to increase the efficiency of its underwriting capacity for a number of years now”.⁹

Pressure on margins has been increasing, as capacity has increased. Reinsurers are now operating business units close to break even, with Willis Re's tracked group running at an RoE of just 8%. In the new normal, rates are less likely to harden following major risk events as the industry recapitalizes more quickly than previous historic cycles of underwriting results.

In a military analogy, this is like attempting a radical change in formation while under fire and running out of ammunition. Cost increases due to investment in new technology, speculation on emerging ventures, and the design of products that cover new risks run against the need for immediate operational efficiency and effectiveness. But one way forward, to the benefit of InsurTechs and capital markets, has been the development of new risk trading platforms – these are intermediaries that can “auction” blended risk packages. These include ILS and traditional reinsurance models and act as a portal for risk trading.

When Aon Benfield launched its ABConnect platform in 2016 it commented:

Collaborating with our reinsurer partners through this next generation platform will result in more real time information to share with clients and enable them to make more informed placement decisions.¹⁰

Other new platform players are emerging. These would include the likes of Extraordinary Re, which is planning a $1bn launch¹¹ in 2018. It is aimed at new and underserved classes of risks, such as “contingent business interruption and cyber”. New risks mean new solutions.

As fast moving FinTech and InsurTech players develop new sources of data leveraging the Internet of Things to drones and biometrics, the input of data to underwriting models will inform new risk profiles and the ability to price new and emerging risk types more accurately. This backward innovation from distributors to reinsurers and capital markets, or alternative risk takers, will see specific market segments become more commoditized at one extreme, and others run their business on dynamic real-time risk pricing models.

Platforms will better facilitate competition and provide hubs for risk trading and knowledge sharing. This will break away from traditional consensus-based profiling and inefficient relationship-led supply chains. These could, however, provide a new infrastructure that is suited to engage in new business relationships in our dynamic twenty-first century.