It is increasingly apparent from the second-quarter results season that the largest reinsurance companies in the world will, at some stage, see their risk management practices tested, as they continue to take on increasing amounts of risk at lower pricing and with expanded terms.
With rates across the reinsurance market down significantly over the last two or three years, while terms and conditions have expanded, significantly in some cases, and aggregate coverage has become increasingly available, reinsurers are naturally taking on more exposure.
However they are taking on this expanded exposure at ever lower rates of return and in an environment when they have not been tested by major catastrophe losses. Suggesting that should the market return to more normal levels of major loss, while smaller losses are already being seen to raise the combined ratio, there is a chance that results could be significantly tested in quarters to come.
This looks set to test the enterprise risk management, portfolio management, loss accumulation and aggregation risk controls of the world's largest reinsurance companies, meaning these sometimes less-celebrated departments of reinsurers will see an increasing focus on their ability to ensure that no undue exposure is being assumed.
Many of the major reinsurers have gone for growth in the last quarter, with three of the big four reinsurance companies all reporting solid increases in premiums underwritten in the second-quarter, while the fourth reported steadier increases.
In recent weeks the reports that pricing is nearing a floor, particularly in U.S. property catastrophe risks, have increased in volume, but of course that means that the underwriting completed in the last few months has all been at very low levels of absolute return.
Underwriting at lower returns, while effectively assuming a larger amount of exposure per unit of risk underwritten, due to expanded terms and conditions, could place these reinsurers at risk of unexpected or outsized losses in the future, especially when catastrophe losses return to more normal levels, as they are sure to do.
There have already been a number of reports from re/insurers that their combined ratios have crept up and that they have seen an increased frequency of smaller losses. That could be as a result of taking on greater levels of exposure, leaving themselves more exposed to smaller loss events and perhaps to accumulation or aggregation risks.
Hence the enterprise risk management departments have their work cut out at the moment, ensuring that the underwriters aren't being over ambitious and taking on more risk than is advisable.
The changes in reinsurance cedents buying habits in recent years can also factor into the exposure that reinsurers are assuming, with the shift towards aggregate coverage one development that could, potentially, come back to bite.
Providing more and more aggregate protection, while also expanding terms such as the hours clause and catastrophe event definitions, could result in unexpected or outsized losses to reinsurance programs which previously would not have touched the per-occurrence layers that were provided.
An increasing use of aggregate reinsurance coverage requires greater risk management controls, another test for the reinsurance community over the coming years.
Similarly multi-year coverage, which means that a reinsurer could suffer losses from a contract but be unable to recoup them through higher prices at the next renewal, is also an issue that requires careful management to ensure that accumulation risk isn't growing within the portfolio.
Under the current market conditions, some reinsurers may have their work cut out to manage risk accumulations and aggregations, if we see a sudden return to more normal levels of large catastrophe loss around the globe.
Similarly, some reinsurers may find themselves increasingly tested by more frequent smaller catastrophe and weather losses, which now stand more chance of triggering the aggregate protections they provide and accumulating losses through the expansion of the hours clause, causing more hits on reinsurance layers as a result.
Taking on more risk at ever lower pricing could be a threat to the solvency of the reinsurance industry, under certain extreme scenarios, and is certainly likely to test risk management practices, at some point over the next few years, and show up any reinsurers that have not been managing the challenging environment so well.
And it's not just property catastrophe loss events which stand to show up any reinsurers that have been less disciplined.
With reinsurers reporting fierce competition in casualty lines, the energy market softening, commercial property insurance lines where big reinsurers also like to play now in their third-quarter of decline and competition over-spilling into almost every area of the reinsurance market, the chances of someone being severely tested are perhaps growing.
Add in the relaxation of terms and conditions, such as the hours clause lengthening, expanded event definitions, bundling of risks into package covers, inclusion of perils such as cyber and terror and the growing inclusion of non-modelled, or less well-modelled, risks and it's easy to see that results could, under the wrong circumstances, go south very quickly.
The world's largest reinsurance firms are known for their risk controls and management, so it is to be hoped that the expansive underwriting of new premiums seen at the recent renewals, leading most to discuss growing portfolios in their results, has been undertaken in a disciplined manner.
Everyone's been talking about the discipline that has been evident in the insurance-linked securities (ILS) fund manager community at the mid-year renewals, with evidence of pulling back seen at some ILS players.
It's interesting that the first to apply the brakes and say no to the underwriting of any risk at any price seem to have been the ILS fund managers, who had been so lambasted for chasing pricing down in the first place.
It's also interesting that at a renewal where the ILS market has remained steady in size, with little in new inflows seen, it is some of the biggest reinsurance firms who have been expansively writing new business and growing their books.
If risk management practices and controls are followed closely and reinsurers remain lucky about the levels of catastrophe losses suffered, they could all look like heroes as a result of this premium growth over the last quarter.
If things don't quite go to plan and losses suddenly escalate, reinsurers could very quickly seem much less heroic to their shareholders as returns tumble.
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