Combine Katrina and Spitzer and reinsurance managers are under attack on all fronts

Hurricane Katrina versus Hurricane Spitzer – which will be the agent of the most enduring change? Duncan Gemmel of the Donald Macdonald Partnership examines the pressures on today’s insurance brokers.

Hurricane Katrina is the global insurance industry’s biggest loss to date with an estimated total payout of more than $80 billion. Katrina has left myriad legacies: it exposed the inadequacies of catastrophe modelling, has threatened the solvency of several reinsurers, has exhausted the capacity of some entire markets, came early in the season, has reignited the global warming debate in the United States and has re-emphasised the dependency of the US on imported fuel.

On top of that, Katrina exposed serious inadequacies in insurer and reinsurer accumulation models and as a result some insurers and reinsurers have gone into run-off. Moreover, underwriting teams are relocating and at last renewal some cedants faced uncertainty about renewal capacity and price. And some policy exclusions and limitations are being challenged by the state and by individuals.

But while it’s yet to be seen as a silver lining, the flip-side is that new capital came into the market and opportunistic startups appeared, especially in Bermuda.

All in all, post-Katrina insurance remains a very uncertain world with some insurers now facing major shortfalls on the covers and others, particularly in the energy markets, very major price increases

Not too long before Katrina, another storm battered the US insurance community. Eliott Spitzer, the New York State attorney general exposed bid rigging between US brokers and US insurers to the detriment of clients. He publicised previously concealed sources of broker revenue from insurers and imposed very large fines on both brokers and reinsurers. Consequently the US regulator, the Securities and Exchange Commission, has investigated the effect of financial reinsurance on 2005 and earlier results, leading to the restatement of accounts and the replacement of key figures at the top of the US insurance industry.

Spitzer’s impact has been devastating. There has been serious damage to the reputation of the insurance industry, albeit with a theoretical reduction in future insurance costs and added impetus to the captive movement. Some brokers have seen their earnings halved, causing further damage to the industry’s reputation and in some cases the sale of some of their non-core businesses. Such a depression in earnings, stock prices and bonuses has created a climate for the wholesale movement of people and while financial reinsurance might have bought some time for some threatened insurers and allowed them to trade through, the removal of that reinsurance could ultimately only serve to accelerate their demise.

Combine Katrina and Spitzer and reinsurance managers are under attack on all fronts. Katrina’s effects include price increases, the pressure to increase retention levels, downgrades in security, increased competition for best capacity among other buyers, capacity pressure caused by new relationships and the corresponding security risk and the price for uncertainty associated with CAT models.

Spitzer meantime has provoked an increase in regulation, a need for capital models (required by regulators and investors) and more demand for traditional cover.

Reinsurance buyers have already begun to respond – and in some cases the effect has been almost revolutionary. Where traditionally reinsurance was an input to the risk management plan, it is now an output of the plan. The shift in focus might best be illustrated in Table One.

The net effect of the Katrina Spitzer storm will be a seachange in behaviour for reinsurance managers, moving from cost-based to value-based reinsurance buying.

The broking community has had to respond to this shift, in a corresponding revision of their own approach. That’s to say, reinsurers’ needs have evolved and by default, brokers (and underwriters) have had to adapt to reflect those needs.

Underlying this evolution however, has been transparency. A new breed of brokers is in the offing as transparency becomes the watchword for the market. Independence is no longer a strong enough moniker to convince reinsurers of the impartiality of advice and brokers are having to go to greater lengths to convince their clients not only of the quality of their advice, but of the heritage of that advice as well.

Katrina/Spitzer is also prompting a shift in regulation – not only in terms of transparency but also as European and North American regulators follow the banking community with Solvency II, the so-called three-tier regulation. Likewise rating agencies are raising the stakes; Standard & Poors has introduced Enterprise Risk Management (ERM) as an additional assessment category.

This means that in the future, companies will be judged on the way in which they control risk across the whole of the business and not just the individual risk types – liquidity, strategy, capital etc. And it is distinctly possible that other agencies – notably A. M. Best – will follow suit.

And investors are caught up as well. The number of large and unexpected losses in recent years and the evident difficulty insurers have in assessing frequency and severity mean that investors will require much higher levels of assurance that this aspect of the company is under control.

What will be the most enduring change? Katrina can lay claim to some significant short-term effects – price, capacity and security. But Mr Spitzer wins. His legacy is to see long-term changes in modelling, broker services, regulation, non-executive pressures and programme structures.

But short term or long term, the best defence for buyers is a rational reinsurance strategy closely tied to group financial objectives: output, not input.

This Special item appeared in issue 106 of JTW News - June 2006

Author: Duncan Gemmel - Donald Macdonald Partnership