On Reinsurance

 |  Includes: AIG
by: David Merkel, CFA

From a reader:

Was reading a history of AIG and it was discussing the early years. There was a line to the tune of 'anything Hank reinsured paid off'.

You've written many times usually in the context of LTC, that insurers should not insure anything where the customers have a better idea of future claims than the company does. How is this rule not violated by reinsurance? Are reinsurance actuaries better, or are most deals in agreement about the risk and more about regulatory arbitrage/capital relief?

My response:

Which history are you talking about?

His response:

Fatal Risk – "They pretty much hit it perfectly. Whatever they laid off risk-wise seemed to result in claims and it was during a period where reinsurance was fairly cheap. They got the best part of the deal, by far."

Okay, now I get it. I've reviewed Fatal Risk, and have the most helpful 5-star review at Amazon. I also have a special discussion with Roddy Boyd here. I regard him as a friend of mine. If insurers are supposed to be conservative, their reinsurers should be doubly so. But AIG (NYSE:AIG) was a big company, and a plum to have as a client, many imagined. But AIG would hand off underpriced risks to reinsurers, and there was a saying current when I worked at AIG 1989-92 "Never give a reinsurer an even break." This varies from the clubby reinsurance world pre-1980, where reinsurers and insurers would adjust terms of agreements in order to be fair, whatever that means.

AIG broke from that, and stressed the strict letter of the contract, and did not compromise. An example from my time at AIG: a reinsurer of annuity business was caught short when Congress implemented the "DAC tax," which was really a tax on new insurance premiums. The reinsurer lost and asked us to compensate them. We refused; there will always be more reinsurers.

Much reinsurance on the life side does cover regulatory arbitrage and capital relief. With P&C, that's not a big factor; rather it is risk reduction.

Reinsurers see more of the industry than a single insurer, that partially compensates for the reinsurer not having as much detail as the ceding insurer. Reinsurers underwrite insurance companies and their management teams, in addition to the exposures at hand. If an insurer gets a reputation for being too slick, reinsurers back off.

AIG may have been different because they were so big. But even AIG had rough times with reinsurers: rescission of annuity treaties with Lincoln National in the mid-90s (costing hundreds of millions), and earnings management with General Re, on a reinsurance deal that did not pass risk, which led to the downfall of Hank Greenberg.

P&C reinsurers have other ways of mitigating risk as well, for example, requiring the company to take the first $XX million of losses, and limiting total losses covered. So, no, reinsurers aren't brighter than insurers, but they have to be selective, and not write business just to deploy capital. If they are disciplined, they will turn down business when they can't make money on underwriting, and send shareholders the excess capital.

Disclosure: No positions