Tag Archives: cat model

No, Insurance Will Not Be Disrupted

I recently had the pleasure of attending the Insurance Disrupted conference in Palo Alto (put on by the Silicon Valley Innovation Center in partnership with Insurance Thought Leadership). This was the single best insurance conference I have ever attended. I was surrounded by hundreds of hopeful, smart, problem-solving professionals from disparate backgrounds and industries all trying to make a difference in insurance without money being the prime motivator.

I was so encouraged by what transpired at the conference, the connections that I made and what I believe would be the promise of a new future that I began to pen this article on my flight home. But something just did not sit right with me as I wrote. Three weeks have gone by, and I am beginning to understand why I felt the way I did; at the end of the day, insurance will NOT be disrupted.

For all the promise of big data, the Internet of Things, autonomous vehicles and peer-to-peer insurance, there was nothing presented at this conference that struck me as disruptive in the way the tech industry is generally thinking of the term today. When technologists think of disruption, they immediately point to Uber and Airbnb, which disrupted the taxi/livery and travel accommodations industries. The taxi industry is literally fighting for its survival. No, that will not be the fate of insurance. Insurance will be a lot more difficult to shake up or disrupt.

Here’s why:

  1. At the core, insurance customers are leasing the potential to access capital. That capital is sitting in predominantly liquid assets. Not real estate, not taxi medallions. How do you make a big pile of money irrelevant?
  2. The modern form of the industry is 300 years old, and the math is pretty solid (that’s why they call it actuarial science). We sell a product whose costs are unknown at the time of purchase. That means scale and immense capital is required to cover worst-case scenarios, which rules out any new business model not having that potential. Peer-to-peer providers just won’t be able to get sufficient scale to efficiently use capital to cover risk. And if they aggressively get scale, then they just become another insurance company, so what’s the point?
  3. Getting a better glimpse into those unknown expenses can create massive competitive advantages. This is where big data and the IoT creators are looking to disrupt, as big data and IoT will generate incredibly large data sets to be used to accurately predict, avoid and mitigate future losses. I have no doubt that these new technologies will make an impact on the industry, but I am less convinced of their disruptive nature. Insurers have already established non-actuarial, big data departments where fraud detections and credit scoring are just a couple of many predictive models being created. IoT devices will slowly be adopted by most insurers as they look to get competitive edges, but the follow-the-leader paradigm of the industry will mean that any edge will disappear quickly, and we will all be running hard just to stay in place. These technologies are impressive. I would classify them as a solid innovations to the industry, but not disruptive. (Disclaimer: I bought a smart battery from Roost.)
  4. Autonomous vehicles represent the one area where some chaos can occur. But notice I use the word “chaos” and not “disruption.” If autonomous vehicles can live up to expectations, then they will be a great service to society, reducing deaths and increasing efficiency. Risk will transfer from a personal lines business to commercial lines, and that could be chaotic for heavy personal lines auto writers such as State Farm and Progressive. But will this be disruptive? Will State Farm or Progressive be fighting for their survival the way that medallion owners in the New York City taxi system are? Again, I doubt it. State Farm is sitting on about $70 billion in surplus capital, and it generally writes at a 100 combined ratio, working the float and cash flow model. I think State Farm and large auto insurers like them will be just fine, and technologies such as autonomous vehicles will be more of an annoyance than an existential threat. And like others, I don’t think autonomous cars are nearly as ready to take over our roads as many seem to think.
  5. For better or worse, state-by-state regulation of insurance is intense and nebulous. Ask Zenefits. The battlefield is already uncertain, and scrutiny by a regulator with political ambitions can kill your disruptive product quickly. Any technology that you think you can create that could potentially benefit the majority of buyers while subsequently raising the price for some other group, alone, would be grounds for a regulator to squash you, as that vocal minority raises their collective voices. In Florida, the state may even create a company to compete against you, writing business at a loss. Insurance regulation might be the ultimate disruption killer.
  6. There was not one presentation on natural catastrophes, which happen to be my area of expertise. How we underwrite, manage and think about natural catastrophe risk has changed quite a bit over the past 20 years. In fact, CAT models have been and may continue to be the most disruptive force in insurance, and yet there is little technology can do to disrupt that area of the industry. I would have been very excited if we had discussions about new business models to help customers with the problems the industry is currently facing with getting adequate flood or earthquake cover to homeowners. If someone had proposed a new product that removed the exclusions of flood and earthquake from the homeowners policy, now, THAT would be disruptive! Alas, nothing on NatCat, and so we will continue to have thousands of homeless families following big storms and earthquakes.

I don’t think insurance will be disrupted, not in the way folks from Silicon Valley are used to doing it. But the future of insurance will look very different than today. Very digital. Streamlined. Less clunky, more efficient. If “disruption” comes to insurance, it is likely going to require the replacement of the current set of leaders with new ones cultured in this digital age and influenced by the successes of technology to make change happen to their business models.

Paul Vandermarck from RMS (a CAT modeling vendor) perhaps summed it up best when he said that no matter how all of this change to the industry plays out, we know of one sure winner: the customer. And that’s how it should be.

Hurricane Joaquin: Why the Model Matters

It has been fascinating watching the progression of the forecasted path for Hurricane Joaquin — what a perfect example this is of the importance of a modern data and analytics platform!

The big news is that the hurricane is not expected to make landfall on the East Coast of the U.S., but the new forecast depends as much on analytics and big data as it does on actual changes in the storm’s path. The spotlight is now on the European Center for Medium-Range Weather Forecasts (the European model) vs. the Global Forecast System (GFS) run by the National Weather Service. The New York Times has a great article discussing the reasons for the changing forecast and, crucially, the differences between the two models.

This is an excellent lesson for insurers to see the power of modern data and analytics in action and what happens to models when they are not using the advanced capabilities available today. Fortunately, investment in analytics continues to rise, as detailed in SMA’s recent report, Maturing Technologies in Insurance. Almost three in four insurers are increasing their investment in analytics over the next three years. 48% of P&C insurers, in fact, are planning to increase their analytics investments by more than 10% annually during that time.

In recent conversation with key CAT modelers, we have learned that they are working to use their weather data and insights at a more granular level than ever before in coming releases. The advance of these CAT model tools creates opportunities for insurers in search of better predictive capabilities on weather events. An upgrade to the GFS model has been planned by the end of the year, taking advantage of soon-to-be-available computing capacity. Once it is up and running, it will be interesting to see how the upgraded GFS model compares with the current European model, especially when applied to future CAT events.

Insurers can take the continuing story of Hurricane Joaquin as a wake-up call — not only is analytics a critical area for investment, but the quality of the information and the computing capacity available have a major impact on how useful predictive modeling can be.

Updating Your Models for Hurricane Season

June 1 opened the North Atlantic hurricane season, with this year marking the 10th anniversary of one of the costliest storms to make landfall in the U.S. — Hurricane Katrina. Each year, hurricane season puts catastrophe (CAT) models to the test, with potentially millions of dollars riding on their accuracy. The loss estimates calculated by CAT models can play an important role in protecting your organization from financial loss.

The models have changed a lot over the past several years. For example, Hurricane Andrew in 1992 exposed the shortcomings of traditional actuarial methods that insurers use to model risks. And the billions of dollars in insured losses from Hurricane Katrina in 2005 helped lead to today’s CAT modeling rigor and its universal acceptance and use by the industry.

New Storms Change CAT Models
CAT models use algorithms to estimate potential losses stemming from a catastrophic event. Over the 10 years since Katrina, CAT modeling has become more complex because of technology improvements and the greater availability of data. After a significant storm, the models are updated based on the new data and a larger body of knowledge. These changes could considerably affect your property insurance and risk management strategies.

Here are some CAT modeling factors — which for U.S. hurricane exposures have changed several times in the last few years. You should consider the items below as you prepare for this year’s hurricane season:

  • Check your policy, including deductibles, coverage limits and sublimits, to ensure they’re adequate and realistic; check that exclusions are acceptable.
  • Ensure the quality of your CAT modeling data. Incomplete data causes more uncertainty for insurers; improving the data enables more accurate loss estimates and reduces the uncertainty for the underwriters.
  • Take a big picture view of your CAT exposures. By modeling your worldwide portfolio, you can identify regional drivers, which can help put U.S. hurricane risks in perspective. Also, using actuarial resources after a CAT or non-CAT claim can help evaluate your organization’s total cost of risk (TCOR), which can better inform how you use your risk management resources.

If you have locations in CAT-prone areas, you can fine-tune their CAT loss estimates with an understanding of how they’ve changed with each model update. Aligning your risk data with CAT modeling changes can yield better outputs for insurers to underwrite your risks.

To register for a webinar on June 17, 2015, on the lessons from Hurricane Katrina, click here.

Catastrophe Models Allow Breakthroughs

“In business there are two ways to make money; you can bundle or you can unbundle.” –Jim Barksdale

We have spent a series of articles introducing catastrophe models and describing the remarkable benefits they have provided the P&C industry since their introduction (article 1, article 2, article 3, article 4). CAT models have enabled the industry to pull the shroud off of quantifying catastrophic risk and finally given (re)insurers the ability to price and manage their exposure to the violent and unpredictable effects of large-scale natural and man-made events. In addition, while not a panacea, the models have leveled the playing field between insurers and reinsurers. Via the use of the models, insurers have more insight than even before into their exposures and the pricing mechanics behind catastrophic risk. As a result, they can now negotiate terms with confidence, whereas prior to the advent of the models and other similar tools, reinsurers had the upper hand with information and research.

We also contend that CAT models are the predominant cause of the reinsurance soft market via the entry of alternative capital from the capital markets. And yet, with all the value that CAT models have unleashed, we still have a collective sour taste in our mouths as to how these invaluable tools have benefited consumers, the ones who ultimately make the purchasing decisions and, thus, justify the industry’s very existence.

There are, in fact, now ways to benefit customers by, for instance, bundling earthquake coverage with homeowners insurance in California and helping companies deal with hidden volatility in their supply chains.

First, some background:

Bundling Risks

Any definition of insurance usually addresses the concept of risk transfer: the mechanism that ensures full or partial financial compensation for the loss or damage caused by event(s) beyond the control of the insured. In addition, the law of large numbers applies: the principle that the average of a large number of independent identically distributed random variables tends to fall close to the expected value. This result can be used to show that the entry of additional risks to an insured pool tends to reduce the variation of the average loss per policyholder around the expected value. When each policyholder’s contribution to the pool’s resources exceeds the expected loss payment, the entry of additional policyholders reduces the probability that the pool’s resources will be insufficient to pay all claims. Thus, an increase in the number of policyholders strengthens the insurance by reducing the probability that the pool will fail.

Our collective experiences in this world are risky, and we humans have consistently desired the ability to shed the financial consequences of risk to third parties. Insurance companies exist by using their large capital base, relying on the law of large numbers, but, perhaps most importantly, leveraging the concept of spread of risk, the selling of insurance in multiple areas to multiple policyholders to minimize the danger that all policyholders will experience losses simultaneously.

Take the peril of earthquake. In California, 85% to 90% of all homeowners do NOT maintain earthquake coverage even though earthquake is the predominant peril in that state. (Traditional homeowners policies exclude earth movement as a covered peril). News articles point to the price of the coverage as the limiting factor, and that makes sense because of that peril’s natural volatility. Or does it make sense?

Is the cost of losses from earthquakes in California considerably different than, say, losses from hurricanes in Florida, in which the wind peril is typically included in most homeowners insurance forms? Earthquakes are a lot more localized than hurricanes, but the loss severity can also be more pronounced in those localized regions. Hurricanes that strike Florida can be expected with higher frequency than large damage-causing earthquakes that shake California. In the final analysis, the average projected loss costs are similar between the two perils, but one has nearly a 100% take-up rate vs. the other at roughly 10%. But why is that so? The answer lies in the law of large numbers, or in this case the lack thereof.

Rewind the clock to the 1940s. If you were a homeowner then, the property insurance world looked very different than it does today. As a homeowner back then, you would need to virtually purchase separate policies for each peril sought: a fire, theft and liability policy and then a windstorm policy to adequately cover your home. The thought of packaging those perils into one convenient, comprehensive policy was thought to be cost-prohibitive. History has proven otherwise.

The bundling of perils creates a margin of safety from a P&C insurer’s perspective. Take two property insurers who offer fire coverage. Company A offers monoline fire, whereas Company B packages fire as part of a comprehensive homeowners policy. If both companies use identical pricing models, then Company B can actually charge less for fire protection than Company A simply because the additional premium from Company B affords peril diversification. Company B has the luxury of using premiums from other perils to help offset losses, whereas Company A is stuck with only its single-source fire premium and, thus, must make allowances in its pricing that it could be wrong. At the same time, Company B must also make allowances in the event its pricing is wrong, but can apply smaller allowances because of the built-in safety margin.

This brings us back to the models. It is easy to see why earthquake and other perils, such as flood, was excluded from homeowners policies in the past. Without models, it was nearly impossible to estimate future losses with any sort of reliable precision, leaving insurers the inability to collect enough premium to compensate for the inevitable catastrophic event. Enter the National Flood Insurance Program (NFIP), which stepped in to offer flood coverage but never fundamentally approached it from a sound underwriting perspective. Instead, in an effort to make the coverage affordable to the masses, the NFIP severely underpriced its only product and is now tens of billions of dollars in the red. Other insurers bravely offered the earthquake peril via endorsement and were devastated after the Northridge earthquake in 1994. In both cases, various market circumstances, including the lack of adequate modeling capabilities, contributed to underpricing and adverse risk selection as the most risk-prone homeowners gobbled up the cheap coverage.

Old legacies die hard, but models stand ready to help responsibly underwrite and manage catastrophic risk, even when the availability of windstorm, earthquake and flood insurance has been traditionally limited and expensive.

The next wave of P&C industry innovation will come from imaginative and enterprising companies that use CAT models to economically bundle risks designed to lower the costs to consumers. We view a future where more CAT risk will be bundled into traditional products. As they continue to improve, CAT models will afford the industry the confidence needed to include earthquake and flood cover for all property lines at full limits and with flexible, lower deductibles. In the future, earthquake and flood hazards will be standard covered perils in traditional property forms, and the industry will one day look back from a product standpoint and wonder why it had not evolved sooner.

Unbundling Risks

Insurance policies as contracts can be clumsy in handling complicated exposures. For example, insurers have the hardest time handling supply chain and contingent business interruption exposures, and rightly so. Because of globalization and extreme competition, multinational companies are continuously seeking value in the inputs for their products. A widget in a product can be produced in China one year, the Philippines the next, Thailand the following year and so on. It is time-consuming and resource intensive to keep track of not only how much of a company’s widgets are manufactured, but also what risks exist surrounding the manufacturing plant that could interrupt production or delivery. We would be hard-pressed to blame underwriters for wanting to exclude or significantly sublimit exposures related to supply chain or business interruption; after all, underwriters have enough difficulty just to manage the actual property exposures inherent in these types of risks.

It is precisely this type of opportunity that makes sense for the industry to create specialized programs. Unbundle the exposure from the remainder of the policy and treat it as a separate exposure with dedicated resources to analyze, price and manage the risk.

Take a U.S. semiconductor manufacturer with supply exposure in Southeast Asia. As was the case with the 2011 Thailand floods or the 2011 Tohoku earthquake and tsunami, this hypothetical manufacturer is likely exposed to supply chain risks of which it is unaware. It is also likely that the property insurance policy meant to indemnify the manufacturer for covered losses in its supply chain will fall short of expectations. An enterprising underwriter could carve out this exposure and transfer it to a new form. In that form, the underwriter can work with the manufacturer to clarify policy wording, liberalize coverage, simplify claims adjusting and provide needed additional capacity. As a result, the manufacturer gets a risk transfer mechanism that more precisely aligns with the balance sheet affecting risks it is exposed to. The insurer gets a new line of business that can provide a significant source of new revenue using tools such as CAT models and other analytics to price and manage those specific risks. By applying some ingenuity, the situation can be a win/win all around.

What if you are a manufacturer or importer and rely on the Port of Los Angeles or Miami International Airport (or any other major international port) to transport your goods in and out of markets? This is another area where commercial policies handle business exposure poorly, or not even at all. CAT models stand ready to provide the analytics required to transfer the risks of these choke points from business balance sheets to insurers. All that is required is vision to recognize the opportunity and the sense to use the toolsets now available to invent solutions rather than relying on legacy group think.

At the end of the day, the next wave of innovation will not come directly from models or analytics. While the models and analytics will continue to improve, real innovation will come from creative individuals who recognize the risks that are causing market discomfort and then use these wonderful tools to build products and programs that effectively transfer those risks more effectively than ever. Those same individuals will understand that the insured comes first, and that rather than retrofitting dated products to suit a modern-day business problem, the advent of new products and services is an absolute necessity to maintain the industry’s relevance. The only limiting factor preventing true innovation in property insurance is imagination and a willingness to no longer cling to the past.

Addressing Objections to a Second Look at a Reinsurance Recovery

Most ceding companies avail themselves of catastrophe reinsurance, a product that pays anywhere from 90 to 100% of aggregated event loss after the ceding company’s retention up to the limits obtained. Generally the retention is determined as some fraction of the company’s surplus and the exposure profile of the company from any one catastrophe. The ceding company wants that retention high enough to not merely be swapping dollars with the reinsurer for frequency events, but low enough that the “shock” of the sudden demand for cash to pay claims does not impair the company.When a broker tells a ceding company what the rate-on-line is for a catastrophe treaty … (the rate for a limit of coverage) or the inverse of a payback period, that number is not assuming any reinstatement of limits occurring. The reinsurers have now worked it that the reinstatement premium will in effect accelerate the payback period and increase the actual rate-on-line by requiring 100% as to time in reinstatement calculations. This was not always the case — at one time the reinsurer only charged for the reinstatement limits at a pro rated factor of the time remaining on the treaty.

Catastrophe reinsurance is somewhat unique in that its limits must be reinstated, but reinstating those limits now generally comes at a price higher than the original limits costs. This is so because the reinstated limits are only good for the remainder of the treaty period, not for the entire annual contract period as were the original limits. For example, suppose a Texas ceding company had a catastrophe treaty for the period from Jan 1, 2012 to December 31, 2012 and a hurricane came through Houston on October 1, 2012, exhausting the cedant’s treaty limit. The cost to reinstate that entire limit is the same dollars as it was to initially secure the original limit, but the second limit is good only from October 1, 2012 to December 31, 2012. Thus, the limits costs are the same for a three-month period reinstatement as they were for a twelve-month original limit of the same amount.

Reinsurers may tell ceding companies at renewal time that they are renewing at the expiring rate, but what the ceding company must be aware of is that a reinsurer’s practice is not unlike the federal government saying it will not raise tax rates, but then taking away some deductions so that the net effect is to increase the tax owed. At renewal, the ceding company may find that because of some change in the treaty definitions initiated by the reinsurer, it will have to pay more for the treaty even thought the “rate” stayed the same. The net effect may be that while the rate did not change, the measurement against that rate did change, making the actual treaty costs increase or coverage decrease.

Consider also that if the ceding company had been carrying its original limits equal to the one in one hundred year storm, and such limits were appropriate, the reinstatement limit is now being carried for a second one in one hundred year event occurring in the same year, but happening again in the next three months, a highly unlikely scenario. The reinsurer is actually making the ceding company reinstate the catastrophe limit at a higher cost for an event that is even less likely to occur … but never fear, the reinsurer will offer to sell the ceding company yet another product that will cover the reinstatement costs … a treaty now for a charge slightly below the reinstatement costs that will pay the reinstatement premiums for the catastrophe treaty so that the ceding company will have reinstatement limits available in the event a second one in one hundred year catastrophe strikes within the next three months. (A pre loss, pre pay option treaty so to speak, where the ceding company can prepay the reinstatements now at a discounted rate!)

One of the primary attributes making for sound-rating analysis is the law of large numbers. That is, enough units are insured providing that sufficient losses are experienced in order to provide predictability to an event. By its very nature, catastrophes are generally unusual events as far as the individual ceding company is concerned. Regional ceding companies may experience an event that exceeds its retention only once every several years. Reinsurers thus, by in large, do not price catastrophe treaties for ceding companies on the individual cedant’s catastrophe experience.

Rates for catastrophe insurance are based on “cat models.” Cat models are used against the ceding company’s risk locations and dollars of exposure at those locations. That is, all other things being equal, having 5 billion dollars of insurance exposure along the coast where the models predict a hurricane will strike will cost the ceding company more to reinsure than 5 billion dollars of inland exposure, where the models show the effects of a hurricane are less intense.

During any catastrophe, claims are filed in multiples of what the ceding company may be used to dealing with on a normal basis, and the ceding company may be required to utilize the services of independent adjusters to augment their own claims personnel services. The combination of high volume, tyranny of the urgent, and utilization of temporary staff provides ample opportunity for mistakes in coding, reinsurance reinstatement premium calculations, and event identification.

Event identification is simply the realization that the loss may not be correctly identified to the named event covered. Not all policyholders may immediately turn in a claim, and a claim that is turned in months after the event may be miscoded and missed in reinsurance recovery. Additionally, not all reinsurance recovery is utilized because the cedant did not realize that certain subsequent events are covered.

For example, suppose a claim is paid and closed, and a recovery is made from the reinsurer for the event. Two years later the ceding company receives a suit alleging bad faith and deceptive practices and other allegations that the claim was mishandled. Many insurance companies will put its Errors and Omissions carrier on notice of the allegation being made. However, not all will notify the reinsurer of possible additional development under the treaty for the catastrophe under the ECO/XPL* portion of the cat treaty, which treaty has already been tapped. The ceding company will likely have a per claim retention under its Errors and Omissions policy, plus it is responsible for the stated limits of the policy it issued to the insured before its Errors and Omissions coverage kicks in. Whereas the cat treaty retention has already been met, meaning the ECO/XPL coverage of the cat contract will essentially provide Errors and Omissions coverage sooner to the cedant.

Additionally, depending on the definition of net retained loss under the treaty, it is possible under given circumstances that the ceding company could collect twice for the same Errors and Omissions loss, once under the treaty’s ECO/XPL and if large enough, additionally under its Errors and Omissions policy. An argument by the reinsurer that a collection under the Errors and Omissions policy inures to the treaty should be challenged with a claim that then the premium of the Errors and Omissions policy must similarly reduce the measure (earned premium) against the rate the reinsurer is charging. In other words the reinsurer does not get the inuring benefit of the Errors and Omissions without a corresponding allowance for its costs to the cedant. However, the cedant may be better off arguing the definition of retained loss under the treaty than to argue for the inuring costs.

During the turmoil of a catastrophic event, it is entirely likely that other reinsurance treaties will be overlooked or receive lesser attention. Most per risk treaties have a single occurrence limit, so that the per risk treaty is not used for catastrophic events. However, in many instances the per risk treaty inures to the cat treaty, so that the costs of the per risk treaty reduces the measure against which the cat rate is multiplied. In other words the costs of the per risk treaty reduces the costs of the cat treaty, because technically, the per risk treaty is supposed to be used up to the measure of its occurrence limit before the cat treaty is utilized; the recovery paid by the per risk treaty reduces the catastrophe loss.

As well, premiums may be missed or double paid, inuring contracts overlooked, or checks directed to the wrong reinsurer. I have seen the case during a catastrophe where a premium payment check was directed to the wrong Lloyds Syndicate, and such Syndicate was either so disorganized or so unethical, that it did not return the misdirected funds until after a formal request was made by the ceding company for the return over a year later. You can’t tell me the Syndicate thought that it was entitled to the money or did not realize it was not in the ceding company’s program.

The reinsurers are not your “friends.” They are not in the business to watch out for the interests of the ceding company — reinsurers are in business to make money, just as ceding companies are in business to make money. In 2010, just the top five reinsurers wrote over 98 billion dollars in premiums.

In a brokered market, the intermediaries do not only work for the interests of the ceding companies — they are in many cases dual agents. The word “intermediary” means go between, and for purposes of finances, intermediaries are the agent of the reinsurer, as provided in a standard intermediary clause ever since the federal case of 673 F.2d 1301; The Matter of Pritchard & Baird, Inc., which held that for purposes of money transfer, the broker is the agent of the reinsurer. Money received by the intermediary from the ceding company is considered money to the reinsurer, but money received by the intermediary from the reinsurer is not considered money to the ceding company.

Even all these years after Pritchard and Baird, I have recently witnessed where an unscrupulous reinsurer told the ceding company that it must collect from the intermediary the refund funds portion representing the intermediary brokerage fees. I have also witnessed where this same ceding company signed and agreed to placement slip terms but some 9 months later when the contract wording was finally provided, change the minimum premiums to equal the deposit premiums within the contract, successfully slipping this change by the cancer chemo patient general manager of the small ceding company and then arguing that it had no record of any change. Such behavior is inexcusable and would never have been caught without an independent reinsurance recovery review.

If reinsurers did things right, then the National Association of Insurance Commissioners would not have needed to adopt a rule requiring that final contract wordings must be signed within 9 months of the contract’s effective date to allow for accounting treatment as prospective, as opposed to retroactive, reinsurance.

It’s absurd to think that this type of rule should be necessary in the first place. The 9-month rule, which really comes out of Part 23 of SSAP 62, requires that the reinsurance contract be finalized — reduced to written form and signed within 9 months after commencement of the policy period. In effect the reinsurers being remiss in generating a timely reinsurance contract punishes the ceding company. The National Association of Insurance Commissioners also found it necessary to adopt the so-called 90-day rule. This rule requires the US ceding companies to take a penalty to surplus in an amount equal to 20% of reinsurance recoverables on paid losses 90 days past due. The rule also requires a 20% penalty to surplus for all recoverables due from so-called “slow payers.”

In effect reinsurers have been so remiss in generating timely contracts and paying bills in a timely manner that the National Association of Insurance Commissioners had to create rules to prod them into doing the right thing by punishing the ceding company if they don’t.

It also never ceases to amaze me the attitude of ceding companies in their thrill of receiving a 25% ceding commission from the reinsurer in a proportional treaty for business that costs the ceding company 33% to generate. Or how the reinsurer now “did them a favor” by allowing a 27% ceding commission in the renewal. Or how that so called quota share treaty that the reinsurer is supposedly a “partner” in has a catastrophe cap included for the benefit of the reinsurer. If this represents what it is like to partner and be the “friend” of ceding companies, then the plaintiff’s bar should certainly also be considered a friend of ceding companies.

Reinsurance intermediaries are required to be licensed in most states. Penalties are imposed on unlicensed intermediaries. In some states, led by New York through its Rule & Regulation 98, reinsurance intermediaries must have written authorization from a reinsured before procuring reinsurance for the reinsured. The reinsurance intermediary must provide the reinsured with written proof that a reinsurer has agreed to assume the risk. The reinsurance intermediary also must inquire into the financial condition of the reinsurer and disclose its findings to the reinsured and disclose every material fact that is known regarding the reinsured to the reinsurer.

Record keeping requirements also exist, mandating that the reinsurance intermediary keep a complete record of the reinsurance transaction for at least 10 years after the expiration of the reinsurance contract. Reinsurance intermediaries under these regulations are now responsible as fiduciaries for funds received as reinsurance intermediaries. Funds on reinsurance contracts must be kept in separate, identifiable accounts and may not be comingled with the reinsurance intermediaries’ own funds.

Most of the time the intermediary’s sales pitch to the ceding company emphasizes how it has a great relationship with the reinsurers, the inference being that such a relationship will ultimately provide for a better price for the ceding company in the negotiation process, as if the reinsurer will do a “favor” for the intermediary which will directly benefit the ceding company. Such fairy tale thinking is best left to children’s books and not in the board rooms of ceding companies. The truth is the intermediary is more dependent for its success on the relationship it has with the reinsurer than it is on the ceding company, and the intermediary is not about to alienate the reinsurer for the sake of a ceding company.

In the brokered market, the ceding company typically has no say in the treaty terms. What most small to medium ceding companies fail to realize is that just as an insurance policy that it issues is subject to being a contract of adhesion by virtue of the legal maxim of contra proferentem, so too is the reinsurance treaty to the reinsurer.

The Latin phrase “contra proferentem” is a standard in contract law, which provides that if a clause in a contract appears to be ambiguous, it should be interpreted against the interests of the person who insisted that the clause be included. In other words, if you speak ambiguously in a contract, your words can literally be used against you. This is designed to discourage people from including ambiguous or vague wording in contracts because it would run against their interests. This is a decisive advantage for many ceding companies in what are often ambiguously defined treaties produced by reinsurers.

All too often the ceding company simply falls in line with what the reinsurer says is the proper interpretation of the treaty language. Whether such complicity is reflective of the incorrect notion that the reinsurer is their “friend” and operates in its best interests or just ignorance, the fact is that ceding companies are often not fully utilizing the product for which they have dearly paid.

The services offered by such entities as Boomerang Recoveries, LLC provide for the ceding company a second look at the treaties it purchased and how it structured its recoveries from its various treaties. Every “touch point” along the recovery process provides for possible missed opportunity. An expressed reluctance by a ceding company to have its recoveries reviewed by an independent reinsurance professional represents misplaced loyalties. The loyalty of a ceding company is to its policyholders or its stockholders, not to its reinsurers.

Good faith and fair dealing owed by a ceding company to the reinsurer does not include foregoing rightful reinsurance recoveries or agreeing with every position of the reinsurer. In this day of increased litigation for Errors and Omissions and Directors and Officers issues, ceding companies should be more concerned with demonstrating their due diligence and exhibiting fiduciary responsiveness by trying to recover every dollar that they are entitled to receive under the treaty contracts, than in worrying about what reinsurers may think about an independent review of its reinsurance recovery process.

Think of it this way, if the ceding company obtained some tax advice on a return it had filed which showed that by refiling, it would be refunded $1,000,000 on the taxes it paid to Uncle Sam, will the officers of that company argue that filing an 1120X (Corporate Amended Tax Return) is a bad idea because it might look like an admission that the company had not taken every deduction entitled to it when it was originally filed or that the IRS might think poorly of the company? That would be absurd, but so too are the arguments that recasting and review of past reinsurance recoveries is a bad idea.

As we have seen:

  1. Every touch point in the recovery process is a potential to miss recovery … its just human nature to make more mistakes at the time of crisis than otherwise.
  2. Catastrophe treaties are not priced for individual company experience, but by models, so that additional recoveries will not directly impact the future rate charged the ceding company.
  3. Reinsurers are not in business to be your friend. Ceding companies pay sufficient premiums to collect all that they are entitled to collect under the treaty.
  4. Reinsurers will not tell ceding companies when a mistake is made or that it owes a ceding company more money.
  5. Intermediaries do not make a commission and are not paid to assure that the ceding company appropriately and fully utilizes the treaties that are placed.
  6. Reinsurance treaties are esoteric and a ceding company cannot rely on an intermediary to watch out for its best interests or interpret contracts in its favor.
  7. Increasing Directors and Officers exposures demand that officers and managers demonstrate their due diligence and the full filling of fiduciary duties. Even if no additional funds are shown as recoverable after a review, the effort is demonstrative of duties fulfilled.
  8. Intermediaries are dual agents and primarily “sell” their services to ceding companies by emphasizing the great relationship they have with reinsurers. Ceding companies need to understand that great reinsurer relationships do not mean better terms for ceding companies or that the intermediary is willing to sacrifice that relationship for the sake of the ceding company. Indeed, intermediary relationships with reinsurers are an extension of and built upon their loyalty to those reinsurers, not the ceding companies.
  9. Reinsurance treaties follow the legal maxim that ambiguities are construed against the drafter of the contract. Ceding companies need a truly independent expert that is not tied to the reinsurer, as is the intermediary, to argue for them and review recoveries on their behalf.

Cronyism has no place in today’s economy. Insurance managers are not reinsurance recovery experts, and utilizing the services of independent reinsurance recovery experts should be thought of as no different than utilizing the services of legal or tax experts to maximize the financial position of the ceding company. The deference ordinarily given to a reinsurer by a ceding company is substantially more than it would ever give to say, an insurer that carried its fleet auto coverage or its Directors and Officers coverage. Ceding companies should stop thinking of reinsurance as some sort of friendship pact and start considering it as they would any other insurance protection it purchased for its financial stability.

* Excess of policy limits, extra contractual obligations