Abstract

Reinsurance is a mechanism for life and non-life insurance companies (Ceders) to transfer risk to reinsurers who provide back-to-back wholesale insurance to these client-facing insurance companies. On the plus side, this helps to reduce solvency capital requirements but reduces profits while providing stability. Reinsurance treaties can be either on a specific policy basis or for a package of policies. In addition, the claim can be on a percentage of the claims due or over the threshold limit.

Currently, the reinsurance market is primarily an OTC market, with brokers undertaking the placement for a commission. There are automated broking solutions in some markets with a systems support backbone and workflow, which allow stakeholders to come together globally and negotiate point to point. However, like any OTC market, price discovery is not public, and neither is the level of due diligence done on a specific reinsurance partner. Also, there is no easy way for transferring the liability from one reinsurer to another at marketplaces effectively and efficiently. Hence, though regulation can solve one of these issues, i.e., enhanced transparency and public disclosure, it cannot decrypt the fundamental problems associated with sub-optimal price discovery and ease of off-loading or taking on a contingent liability.

Generation 1 – Existing OTC automation

The reinsurance business worldwide focuses on the life and non-life with the non-life segment comprising motor, marine, fire, engineering, micro (health, travel, and Medicare), civil war, nuclear, etc. Studies indicate that reinsurance premiums are almost 25-30% of the overall insurance premiums collected. Nearly 70% of the reinsurance is placed through the broking community.

Some innovative solutions in the global markets allow stakeholders (insurers, reinsurers & investors) to come together through a network and trade point to point receiving quotes, negotiating, and closing contracts/treaties. These are subscription-based systems for the trading partners who receive browser and workflow access to the trading community on the system. Still, there is no online price discovery regarding efficient markets and transparent supply and demand. Additionally, there is no regulatory mandate for the trading partners on this network to be registered with the insurance regulatory authority of any specific country in which the broking automation solution is hosted.

This generation of systems does not solve the problem of making reinsurance placement transparent to the community.

Generation 2 - The framework

This section articulates the framework under which the exchange traded reinsurance security can work in terms of its various aspects. Advanced mathematics around distributions and stochastic variables is not explicitly examined at this stage. Instead, the key elements of the process are how the security is structured and offered, how it is priced, and the risk management at various levels.

Structuring

The structuring process would clearly identify the units of the security and the terms of the security in terms of face value. To keep things simple and evaluate the uptake of the concept, I-Banks (under regulatory guidelines) could initially offer the standard packaged reinsurance security with life-specific and non-life-specific standard tenures and treaty terms. The premiums would obviously be determined by the client-facing insurer (Ceder), while the "spread" (percentage of face value) at which the contract or security would trade would be market determined and based on a view of buyers and sellers.

At this stage, it is worth pointing out the remarkable similarity in the pricing and structure of reinsurance traded security (hence RTS) and the credit derivative family. Keeping matters simple for the scope of this paper, a strong similarity to the CDS is assumed. Tranche building and correlation-based pricing are not discussed at this point. The market (I-Banks) could design and roll such a product out after due consideration of Phase 1, which is the vanilla RTS.

The placement of RTS would be with a segment considering reinsurers, pension funds, and possibly HNI's. These would typically be structured and offered by I-Banks and then formally launched on the exchange through an IPO. Depository and other clearing and payment services would be similar to existing products.

Once launched and traded on an exchange, RTS trades can be made between counter-parties using registered brokers representing the reinsurance community. By regulation, these reinsurance communities will need to have proper registrations of depository portfolios and bank accounts that allow for tracking. This would allow an insurance regulator (working with a banking and capital markets regulator) to validate and track the reinsurers involved in their ecosystem and their standing and stability. Foreign reinsurers are advised to participate in the exchange only through JVs with a local reinsurance player.

SLAs will need to be maintained for the clearing and payment turn-around times. Other important decisions would be around the notification process for an insurance event and the de-registering of security from exchange once the event happens, assuming that the sum insured is completely drawn-down. Also, as RTS's get traded, there will be a need to account for the policy premium to be exchanged between buyer and seller (dirty prices). Finally, there will need to be rules around when windows kick in for prohibiting trading around specific insurers and segments. This is to ensure that there are no opportunistic behaviors around the selling of RTS contracts in a down economy or high correlation event.

Pricing

In Phase-1 (Generation – 1) of the RTS, a simple CDS approach is recommended. While the I-Bank can start off by recommending a basic spread using their insights on their insurers, buyers will trade based on their view. The idea is that the spread follows the simple principle as mentioned below and then gets as advanced as needed by a buyer/seller (correlations, claim probability modeling around probability distributions, etc.):

Spread x face value of RTS = discounted total premiums from insurer – loss probability x loss amount The view of the buyer and seller on how the loss probabilities and loss amounts will move (this approach will usually be actuarial/stochastic for the reinsurers) will decide the actual trading prices, and these will be closer to fair prices than that offered through OTC mechanisms.

Another significant side effect is that spreads (like in a Basel III world of CVA) will give an advance indication of the trends and perceptions of the industry as well as of a specific insurer and his portfolio. Regulators in a Solvency II world could use this spread to decide what SCR and MCR adjustments need to be made for an insurer – in a nutshell, a leading indicator.

Risk management

The process for risk management is at two levels, the first being the risk management associated with RTS brokers and exchanges. Here the risk is more about eliminating settlement risk and keeping margins to ensure that trades are completed in an orderly fashion. These would need an extension to the current incumbent VAR-type systems to project potential losses and provision margin and collaterals for the same. Since reinsurance claim settlements are large ticket items, the VAR equivalent for margining settlement of losses is done on a shorter horizon, like a day or a week.

The second aspect of risk management is for the reinsurers and insurers as well as for the end customer. In all these cases, current systems based on solvency I/II will continue. It is expected that systemic risk should be lower using RTS since there is a more transparent and efficient market though the benefit of this cannot be quantified in "premium" discount terms. Do note that there are also alternate schools of thought which propose that using MTM techniques for these RTS securities can lead to an increase of systemic risk since the MTM accounting can make companies insolvent though they actually have cash in the bank.

RTS based derivatives

As the market evolves, it is inevitable that a stable of options and forwards/futures would develop around the RTS. These are expected to be primarily OTC, with the potential for futures to be traded on popular futures exchanges worldwide.