Structured Reinsurance: A Renaissance?

Corporate insurance buying strategies are changing. Maybe it has taken the challenges being encountered in the continued hard market to finally shake things up. Buyers are getting frustrated, hemmed in by the need to demonstrate value whilst having to operate to tight budgets with lean resources, yet confronted by an insurance market in retreat and a frustratingly inefficient annual renewal process.

In desperation many companies are having to choose between paying more, buying less or running a broker tender to put a squeeze on costs. None of these are really smart plays. But there is a fourth option.

Captives’ principal function as an aggregator, transformer and seller of insurable risk is often overlooked. How many captives participate in all their key insurance programmes, setting retentions intelligently in light of their modelled risk profile and market pricing? How many buyers fully leverage their risk diversification and corporate risk appetite, and enhance that leverage by reinsuring the unwanted portfolio volatility on a long-term, fixed cost basis?

Captive-centricity and structured reinsurance, when deployed collectively to their fullest potential, can unlock huge economic and operational benefits, and can transform corporate insurance buying. So why do so few companies adopt this approach?

Maybe the business models of the larger brokers – commission driven and consulting projects sold separately – are at odds with developing long-term, sophisticated risk financing strategies for their corporate clients that would mean less dependence on the cyclical, monoline insurance market.

Bridging the gap

The most efficient model is to set retentions at that point at which market pricing starts to look good value, where insurers’ high expense cost is more than absorbed by the efficiency of large-but-remote losses being subsumed into a very large global portfolio of similar risks.

But these levels of retention might well be beyond the corporation’s appetite, and very likely well beyond that of individual subsidiaries. Captives can certainly be used to bridge the gap between business unit and corporate risk appetite; but structured reinsurance makes this much easier by ‘stretching’ the captive’s bridging potential.

If you could bring together all the insurable risk of a global business, and exchange the aggregate unwanted financial volatility from that risk portfolio with a reliable, creditworthy counterparty for a known, fixed cost then it is possible to move from being a buyer of insurance towards becoming a seller of risk.

What is Structured Reinsurance?

When used to support this strategy structured reinsurance consists of a multi-year, multi-line programme negotiated on pre-agreed terms, providing each loss and potentially annual aggregate protection. There is a significant element of risk-sharing which rewards good claims experience.

The core value proposition of structured reinsurance is that it will, in pretty much any circumstance and for pretty much any large client, reduce the cost of insurance over the medium-term, and ideally in the short-term too, without exposing the company (or its captive) to unwanted levels of risk. How? By recapturing three elements of the cost of traditional insurance.

Firstly, the external insurance system is very expensive to run compared to captives. Typically, primary or first excess layers are best suited for a captive – high premiums, low volatility. This is how most captives are used and captures the first cost element, but often only in respect of two or three lines of business. Structured reinsurance facilitates greater captive participation – higher retentions and a broader range of risks.

Secondly, there is hidden value in a diversified portfolio of uncorrelated risks. Ordinarily this value is given away to the market through buying several separate classes of insurance (their ‘products’) from a wide variety of insurers every 365 days. What is at stake here is the difference between the aggregate volatility of individual risk types and the volatility of the portfolio.

Thirdly, structured reinsurance has an aggregate limit across the whole contract, which should be sufficient except in the most unlikely scenario of a huge shift in frequency of medium-to-large losses occurs. You are effectively buying much less overall insurance limit than in the siloed model. And if the limit runs out there is always the opportunity to extend the programme.

A Lost Art Rediscovered?

Beyond the significant economic win, structured reinsurance provides a vast array of other advantages – additional capacity; expandable and extendible; speedy claims payments; inclusion of difficult-to-insure risks; absorption of significant acquisitions cost-effectively. Their flexibility is almost unlimited.

It might seem like a hard market option, but those companies that incepted programmes during the soft market still enjoyed huge economic and other benefits, which of course are being magnified now in terms of cost savings, coverage preservation and budgetary stability.

Although structured reinsurance has been around for decades, broker expertise and reinsurance underwriting capability largely disappeared during the recent prolonged soft market. Given current interest levels, is it any surprise that brokers and reinsurers are now trying to rebuild these skills? Perhaps we are about to see a resurgence of this lost art.