Wednesday, December 13, 2017

Reinsurers headed for catastrophe, say academics

The way that reinsurers are bundling catastrophe risk has alarming similarities to the way that banks bundled subprime mortgages before the financial crisis, according to research by three business-school academics in the UK.

In their new book Making a Market for Acts of God, Paula Jarzabkowski, Rebecca Bednarek and Paul Spee point out three important similarities to the pre-crisis market for mortgages: the increasing reliance on technical models, the concentration of risk into the hands of a few very large institutions and the distribution of that risk to non-specialists through the capital markets.

Against a backdrop of globalisation and increasingly frequent disasters, the authors argue that the reinsurance industry is becoming a source of potential systemic risk.

“We show how a flood in Thailand can disrupt global supply chains, impacting the operations of businesses as far away as the American chain, Walmart,” says Jarzabkowski. “We don’t know if new insurance-linked securities are the right way or not — but we do know they don’t operate on the same principles as the traditional reinsurance that has paid for major losses in the past.”

In the case of the Thai floods, the authors say that reinsurers were surprised by losses that they had not realised were in their portfolio.

The book draws on a three-year academic study led by Jarzabkowski
and Bednarek, who wrote up the results in a research paper published in late-2012: Beyond borders: Charting the changing global reinsurance landscape.

Bundling risk is efficient, they write in the paper, and adds value to reinsurance buyers, but the increasing complexity that it brings can pose a challenge to the traditional model of underwriter judgment.

“As the technical element of underwriting grows, so there is a stronger technical function and, with it, the tendency to standardise judgment around common pricing and analytic tools and techniques,” they write.

Consolidation and global growth have had a similar effect, they add, pulling attention away from the core underwriting function toward other aspects of business development (not to mention concentrating more risk in fewer hands).

Bundled risks are also much more difficult for investors in products such as catastrophe bonds to understand, the authors fear, drawing comparisons to the slicing and dicing that went on in the pre-crisis mortgage market.

Despite the strongly stated argument, some insurance industry participants are sceptical of the authors’ understanding of the reinsurance industry and catastrophe bonds in particular.

“Catastrophe bonds are a much more open and transparent process than the old derivatives products,” says one reinsurer. “It’s clear what triggers it.”

It is certainly true that managing a diverse, global portfolio of risk is a different proposition to what reinsurers were doing 40 years ago — and it also true that complex products can lead to major market breakdowns, as demonstrated by the London Market for Excess in the 1980s and AIG during the subprime crisis.

With this in mind, it is always worthwhile to examine processes and strategies as businesses evolve, but some critics of the book worry that the authors may themselves have become the victim of complexity.

Or as one reviewer on Amazon put it: “A brave attempt for sure, but it is hard to escape the view that this work will add more confusion than clarity to an already complex subject.”

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