Seldom known to mince words or eschew controversy, Cass Business School’s professor Paula Jarzabkowski has co-authored with Rebecca Bednarek and Paul Spee a new book, called Making a Market for Acts of God, which suggests exactly this.
In an industry which exists to cushion the worst out of Armageddon-like catastrophe events, there has been a transition, Jarzabkowski argues, from thinking of reinsurance as protection for unknowable ‘Acts of God’, to packaging it as a commodity.
“That comes with a lot of dangers because the underlying risks still carry the characteristics of Acts of God, and therefore you shouldn’t just commoditise them and trade them off as something easy to define, bundle and sell at the best possible price,” says Jarzabkowski.
Conventional hallmarks, she argues, such as pricing cycles, padding out catastrophe risk with less volatile lines of business and underwriting expertise, are diminishing features in the evolving market landscape. “In other industries, such as property, you get boom and bust, but in re/insurance that is how the industry self-regulates,” says Jarzabkowski. “For a re/insurer with skin in the game, it is about paying back afterwards. That’s a norm, and it has allowed the market to survive.
“That’s how the industry has worked, but there has been rapid and unprecedented change. A lot of that has been driven by buyers, as they consolidate globally and become too big to fail. They’ve changed the way they're buying to bundle risk across lines. What they do buy is a bundle to cover a portfolio of risk. They’re make much more efficient purchases and…optimising their capital. It’s become the norm and now everybody now does that,” she continues.
Jarzabkowski suggests this erodes market patterns, while encouraging larger placements and reducing the number of reinsurers involved in this top tier. Whereas previously cycles roughly determined the right price, buying has become multi-year and multi-risk, partially driven by buyer demand and partly driven by multi-year catastrophe bonds.
“The cycle is eroding; collective wisdom is eroding; and there is a depression of price. At the same time, ART
“Expertise in quoting for those is almost obsolete. For worldwide cat XL, what can a little Lloyd’s reinsurer do to help to understand the pricing of that? So instead of spreading it around the market, it’s being concentrated within just a few players. What used to be a well-diversified community of people taking risk is now a very small group deciding what the risk is. They are shrinking the pool of reinsurers, and you can see that size matters because the reinsurers can’t wait to consolidate, to be big enough to be part of the game,” Jarzabkowski says.
“The incentives at play have changed with the products and packaging, she stresses. “If it’s collateralised in a special purpose vehicle and if something happens and it triggers – great,” she says.
“The problem is that these are Acts of God, although these bonds have very specific and narrowly defined criteria about what triggers them. If you’re able to define what the event is – fantastic, you’ll get your payment. But reinsurance is supposed to be for the thing that they can’t quite define or specify.”
This erodes conventional norms, both contractual and implied, she notes. “Cedants want reinsurers to pay rapidly in a claim, and the reinsurer typically pays when the big event hits, because they tend to get the contract next year. That’s why they form those relationships, they’re in the business together, and afterwards the reinsurer can obtain those cyclical increases in price,” says Jarzabkowski.
These incentives do not exist in the ART space, whatever the collateral, claims Jarzabkowski. “They may still be good products, but they aren’t working on the same basis,” she says. “There is no incentive for the ART provider, because it’s a very small percentage of their portfolio. They aren’t in the same game; there’s no interest in keeping the insurer alive and vice versa.”
Incentives have also changed on the cedant side, she suggests. “The comparison with subprime mortgages is to do with the bundling of risks, and who is responsible within the organisation. We haven’t said cat bonds are similar to subprime mortgage products, but that the bundled risks create a different focus,” says Jarzabkowski.
The culprit, she suggests, are the centralised reinsurance buyers within the big international insurance groups buying these bundled reinsurance covers across risks and geographies they cannot comprehend, incentivised by capital optimisation metrics and increasingly complex and sophisticated risk models, which – the banking crisis parallel suggests – may not be fit for purpose.
“It used to work very well, because people didn’t used to think that they could out-model Armageddon. The person buying the risk cover is no longer the person who understands the local risks being taken,” she says.
“That’s exactly the same thing which happened to create the financial crisis. We know these things are hard to measure and that ART is too reliant on models. Buying protection for these risks has become more about scientific models and more about capital optimisation, and there is no evidence that it is necessarily going to work. It might, but it’s going to be very expensive if it doesn’t.”