Making a Market for Acts of God – Paula Jarzabkowski, Rebecca Bednarek & Paul Spee
As the authors themselves acknowledge at 7.2, this book is ambitious, setting out, as it attempts, the workings of the international reinsurance industry in just 231 pages, including the index, a glossary and references. It also makes a difficult task unnecessarily complex by the awkward use of words and expressions which the authors may think makes the work more scholarly-sounding but which only serve to create confusion. Consider the following at 3.5.3: ‘As we have seen, the [reinsurance] deal as a tradable object is generated at the nexus of two practical understandings: technicalizing (sic) and contextualizing.’ What this appears to mean is that the original reinsurance requirement is put into a contractual form, recognisable in the market in the context of similar arrangements, so as to facilitate the provision of a quotation. What it does not mean is that such arrangements, when concluded, can then be traded like commodities. Some such trading of written risks did once happen, with disastrous results, in the case of LMX business (see below) but this is not mentioned in the book. Moreover, despite the title, the context is by no means restricted to catastrophe reinsurance.
The authors appear to have three major points to discuss. The attempts to replace accumulated underwriting knowledge with statistical models; the growing dominance of a small number of mega reinsurance players; the increasing involvement of the capital markets in this business. These features, they argue, risk undermining a tried and tested method of working, with potentially disastrous results such as the banks suffered with the great meltdown of 2008.
Amazingly then, they make absolutely no mention of the London Market Excess (LMX) debacle of the 1990s that almost put an end to Lloyd’s and has been highlighted by financial commentators, such as John Kay of the Financial Times, as a sort of precursor to what happened later to the banking fraternity. Nor is anything said about AIG’s disastrous foray into the sub-prime loans market.
While much is made of the importance of achieving consensus pricing in a diverse market and the danger of this discipline being lost if programmes are going to be written in their entirety by one or two reinsurers worldwide, the clear danger of such risk concentration (systemic risk if ever it existed) is glossed over. Nor is anything said about the similar demise of the subscription market in direct insurance. Many risks which forty years ago would have required the participation of a number of insurers to provide the required capacity and thus could not have been completed had the leader’s (referred to in the book as the ‘market maker’) price been considered too low, can now, as the result of mergers and acquisitions, be written 100% by a single insurer. Indeed the subscription market mindset now exists mainly at Lloyd’s and, as syndicates develop greater capacity, may not continue there for much longer
The authors are on firmer ground when they get onto the use of statistical models and the blind faith that some have in the maths. The experience of bankers with their once much-vaunted Value at Risk (VaR) models should serve as a warning to us all. The authors are right to point out that putting too much faith in models at the cost of exercising underwriting judgement could lead to the gross under-evaluation of a potential disaster. They do not add that the availability of a lot of data also leads to a false confidence that encourages excessive competition and squeezes any profit out of the business (just look at UK Motor Insurance). They are correct, however, in their description of the work of actuaries and do not fall into the trap of treating them as omniscient, as is too often the case in the insurance business.
The involvement of the capital markets is a different matter. Since these deals tend to be fully collateralised, they should, on the face of it, offer better security than conventional reinsurance. The problems with them are twofold: firstly there is the lack of a clear correlation between the losses actually sustained by the reinsurer as the result of a catastrophe and what they might recover from a bond; and secondly the effect that catastrophe bonds can have in driving down prices for conventionally written business. What capital markets actually represent here is what the insurance business refers to as ‘innocent capacity’. Sooner or later some of these investors are going to face huge losses and will then wish that they had stuck to treasury bonds, however low the yields.
The book is, in essence, an attempt to educate and in this respect suffers from the problem of all education: how to explain something while at the same time making clear that what has been stated does not hold good in all circumstances. The concern with Alternative Risk Transfer (ART), in this case taking the form of capital market catastrophe bonds, probably needs to be put in the context of an earlier form of ART: captive insurance companies. At their advent some believed that captives heralded the end of (direct) insurance as we know it while others regarded them as a flash in the pan. They did not bring insurance to an end; and while some, predicated entirely on tax considerations or the widely-held belief that insurance is too expensive, did crash and burn, most survived and now operate happily alongside the regular market. Perhaps catastrophe bonds will go the same way. This lack of perspective, like the omission of LMX or reference to the old direct subscription market, is a great shortcoming, probably reflecting the authors’ lack of experience in the business.
A brave attempt for sure, but it is hard to escape the view that this work will add more confusion than clarity to an already complex subject.
John Murray
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Top reviews from other countries
John Murray
Catastrophe Reinsurance: A Complex Subject Rendered Confusing
Reviewed in the United Kingdom 🇬🇧 on May 17, 2015Amazon Customer
Kindle version not worth the money
Reviewed in the United Kingdom 🇬🇧 on January 25, 2020
