I recently read an article written by Guy Ellis, the Marine Reinsurance Underwriter at Hiscox Syndicate in London. It is an article which is not only timely but, I believe, relevant for the non-marine community as well. The principles of Insurance and Reinsurance are common irregardless of the class of business. Of particular interest to me were his comments on "Spreading of Losses" and "Providing Security". I hope you enjoy the article.

"Even the most casually interested observer of the marine reinsurance market must by now be aware that the dynamics of this business have radically altered.

The reinsurance market follows perfectly the basic economic principles dictated by supply and demand, with feast followed by famine. It would be hard to find a more transparent, or reactive, cycle. By definition, in a neutrally balanced market, a year that sees no major catastrophes will produce very good profit. The nature of the business means that this should not be considered as fully earned; rather a portion should be reserved to provide balance for the years which do suffer a catastrophe. Unfortunately, such results are often viewed only in the short term, encouraging the surfeit of capacity which ensures that precisely as capacity peeks the market goes into a state of decline, which can only be halted when enough pain has been administered to the account to drive the excess capacity to back out.

After five years of virtual free-fall in rating and deductible levels, the bottom has been hit with bone-jarring force. For the purchaser of reinsurance, for so long reliant upon the malleability of this market to absorb ever greater tranches of under-priced and increasingly primary business, the party is over. There now needs to be a paradigm shift in attitude to the pricing of direct insurance if the increasing gap between direct rates and reinsurance costs is to be successfully bridged.

It was ever thus. One of the great clichés of the market is that of "the tail wagging the dog". There should not really be any great surprise that this is the case. The ultimate risk carriers of the majority of the largest exposures, the retrocessional market, are naturally the first to be impacted by major claims and therefore the fastest to react to deteriorating results. The price rises/coverage restrictions that they impose quickly force the direct reinsurance market to reassess the exposure that it takes on, and in turn that direct market is left with higher retentions and larger costs, forcing them to put up original rates.

In fact, the defining characteristic of the last soft cycle has been the extent to which the market has lost money for the 1998-2000 years of account without the occurrence of major casualties. Rather, the lack of retentions combined with a woefully depleted premium base, have meant that standard attritional losses have cost the market dearly.

For the latest closed year in Lloyd's, 1998, the risk code analysis of incurred claims at 36 months, expressed as a ratio to gross premium, for the main marine excess of loss accounts paints a depressingly vivid picture:

Hull excess of loss 174% Cargo excess of loss 111% Energy excess of loss 232% Whole account 156%...

Furthermore, it should be noted that the comparable figure for 1999 at the same stage (i.e. 24 months) showed little or no improvement, and, from a pure pricing perspective, 1999/2000 is now widely viewed as being the nadir of the current market cycle. It was against such a backdrop that the market has seen a number of more serious incidents occurring in the first quarter of the 2001 year. Most notably, the loss of Petrobras P36 off the Brazilian coast has resulted in an insured claim of just under $500m, and will be paid very quickly. Other incidents at El Paso, Conoco and Tosco refineries will take longer to quantify as the business interruption cost is assessed, but these add to the poor start to the year.

The greatest difficulty that the direct market will now face may prove to be the time lag built into their ability to react to hardening reinsurance rates. Many insureds have enjoyed the luxury of long term deals, with prices fixed for the duration, with very little opportunity for the market to re-rate in the majority of cases. A lot of this business is tied in for at least a further twelve months, with less than adequate pricing and deductibles.

As direct policies come up for renewal, the most common question coming from these insureds, when presented with large percentage rises, will be "why me?". Many purchasers will feel that they personally have not been responsible for the malaise throughout the market, having not produced large losses, and should therefore not pay increased premiums.

To answer this vexing question it is necessary to review the two basic principles of insurance theory, as defined in the Llyod's introductory textbook.

Spreading of losses

"The financial losses of the insureds are spread amongst all those who insure by compensating the few who suffer loss from the funds built up from the contributions of the many policyholders. The spread of losses is equitable as each policyholder pays an amount commensurate with the risk introduced. Thus the contributions are not random or equal. The function of the underwriter is the management of the fund and the assessment of equitable premiums."

It is, therefore, axiomatic, that many members of this equitable pool can individually be producing satisfactory results at a time when the total premium base is deficient to cover those reasonable and genuine claims that do occur. It is also a truism that even the prudent insured suffers fortuitous losses at some time or another. If this were not the case, the insurance industry would not exist. Furthermore, and to turn the question on its head, how many insurance purchasers complained in the years in which their premiums dropped regardless of exposure or record?

Whilst a rise might appear to be high in percentage terms it should be remembered that, for example, in order to re-coup a fifty per cent reduction in the expiring year, it would take a one hundred per cent increase. Another example would be to take as an assumption that the last time the market was able to charge a reasonable rate on exposure was in 1996, this rate equating to the base of 100. On average, business will have seen a 25% reduction for each of the subsequent four years of account. This means that the comparable premium base, assuming identical exposure, in the year 2000 would be 31.64. The implication therefore, is that the market as a whole needs to see a 316% rate increase to return to the position it was in in 1996. This is before any consideration is given to the effects of inflation, both on increasing exposures and as an impact on reducing the value of deductible levels.

Providing Security

"Insurance does not remove the risk…Insurance reduces worry for the insured by providing security. It gives peace of mind and relieves policyholders from a great deal of potential financial hardship".

Ultimately, it must be recognized that all sectors of the industry have been pricing their respective products at untenable rates and all must now share a mutual determination to build the premium base to such a level that the industry is able to fulfill its prime function of equitable risk transfer to the mutual benefit of both buyer and seller. The position may be a little complicated by the fact that the benefits of both insurance and reinsurance purchasing remain intangible until the point when the unexpected occurs and a claim is made.

For the buyer to enjoy the peace of mind which the risk transfer mechanism is designed to provide, it is vital that the premium base is strong enough to leave the seller financially secure and able to meet any future obligations. The hidden cost of a purchasing strategy based purely upon price has been recently demonstrated to insurance buyers by the demise of the Australian reinsurance market, leaving many with an unplanned element of co-insurance which by far outweighs the original perceived "saving" in premium.

The price rises currently being quoted in the reinsurance market should help the recovery from the internecine rating levels of the recent past and will hopefully assist to ensure future stability and security for all."

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