Richard Rodriguez says there is now a more disciplined and risk-based approach to underwriting.

Reinsurance buyers may be enjoying the benefits of lower rates, but the days of the really soft market are over. Underwriters are more disciplined than they used to be, and this time it’s for real

The London market is full of stories of senior reinsurance executives talking up rates even while their underwriters were chasing down prices to suicidal levels. Many of the offending companies and syndicates are no longer with us, but the cycle remains firmly entrenched in the psychology of the reinsurance industry.

As rates head south once again, some old hands are harking back to the last soft market of the late 90s when underwriters haemorrhaged red ink. The market, to quote a recent report from Willis Re, is “showing signs of reverting to its historic pattern of feast or famine”.

Yes, but only up to a point, because the world has changed for ever. Although we still have a reinsurance cycle, and always will, underwriters are better equipped technically than ever before. They are working within underwriting guidelines that accurately reflect the exposures they are accepting and, unlike in the past, are rigorously applied. As a result, the days of the roller coaster should now be behind us.

Of course, people have said this before and been wrong, but the evidence of this new discipline is with us already. Whereas in previous soft markets prices might have fallen by 25% in a year, recently we have seen drops of around 5%-15%. Reinsurers may not all be meeting their return on equity targets, but most of them are still making profits.

I believe that any further softening will be limited in scope. Rate reductions will be well targeted; the days of indiscriminate across-the-board cuts are history. In fact, reinsurers are in many ways behaving in a more disciplined manner than the primary market.

One reason is that reinsurance underwriters at the leading companies, those that set the rates, understand better than ever the value of the risks they are seeing. They are writing within clearly defined frameworks and have a massive infrastructure to support them – for example, capital modelling, data gathering and retrieval systems, actuarial expertise and software.

Human nature being what it is, underwriters who lack any firm idea of what a risk is worth and do not have a handle on their exposures will be more likely to compete for business, regardless of whether the price is adequate. That is why soft markets, up to now, have had such devastating consequences.

“Underwriters who lack any firm idea of what a risk is worth and do not have a handle on their exposures will compete for business, regardless of whether the price is adequate.

Richard Rodriguez

Those underwriters who have the necessary understanding, by contrast, will act with restraint. They may still be willing to undercut the technical rate, but they will do so within guidelines laid down by senior management. The most influential reinsurers in the market have now achieved these underwriting standards, or are getting there, even if some of the followers are still some way behind.

To understand this sea change, we need to go back to 2001 when 9/11 rounded off a terrible year for the reinsurance industry. Senior management, under pressure from shareholders, made a more technical and reliable approach to underwriting a top corporate priority. The old argument that reinsurance underwriters lacked the necessary data and had to rely on gut feel instead would simply no longer wash.

The mood change coincided with a quietening down of the previously frenetic merger and acquisition activity within the reinsurance industry, leaving management with more time to put their houses in order. Meanwhile, developments in pricing, reserving and modelling techniques and associated software facilitated the better storage, retrieval and analysis of data, so vital to accurate underwriting.

At about the same time, we saw the rapid emergence of techniques to develop risk-based corporate frameworks that can be used to impose organisation-wide disciplines. Concepts like dynamic financial analysis and enterprise risk management may have seemed mind-bogglingly complex at the time (that is still the case for some insurance executives), but they have since become mainstream. Indeed, they are embodied in the FSA’s capital adequacy regime and will become enshrined in Solvency II.

Shareholders, regulators and (increasingly) the ratings agencies are demanding a more disciplined, risk-based approach to reinsurance underwriting. The techniques now exist to make it feasible, and any reinsurer that fails to apply them will soon find their competitive position seriously damaged.

This may all seem like bad news for those cedants who have been rubbing their hands at the prospect of ridiculously cheap reinsurance contracts. I would argue, however, that it brings welcome stability to the market. How much time have insurers spent trying to make good reinsurance recoveries? How much money have they wasted in legal fees and write-offs?

At least your reinsurers are likely to be there when you need them.