Why Reinsurers View the Industry Differently Than Insurers


From a reader:

Was reading a history of American International Group Inc (NYSE: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?

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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 was a big company, and a plum to have as a client, many imagined.  But American International Group Inc (NYSE: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 American International Group Inc (NYSE: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.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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