Concurrency is central to the “firmness” of a traditional firm order terms (FOT) process, yet it leaves cedents and reinsurers alike thinking they see opportunities left on the table. In reality, these opportunities are a mirage – without concurrency they disappear, leaving in their place an expensive process that struggles to match the performance of concurrent terms.
So why do cedents see opportunities, and why do those opportunities disappear? We will see that the answer, witnessed in analogous markets across a wide variety of industries, lies in game theory – for a reinsurer, to be paid far below the rest of the market is leaves money on the table risks undermining their own portfolio; when cedents relax concurrency, reinsurers who would otherwise have been competitive typically protect themselves by offering less-favorable terms than they would be willing to accept as concurrent FOT.
Traffic and game theory
Before we unpack what happens with non-concurrent terms, we will start with an analogy to traffic. The photo below shows traffic on a Toronto highway:
Traffic on this Toronto highway is disciplined and moving slowly. Cars are staying in their lanes and even leaving the shoulders open on either side of the road. As a driver, it is tempting to look at the space between lanes and the shoulders as an opportunity to get where you are going faster; as a city planner, it is tempting to see wasted space that could be used to increase throughput and reduce congestion. Despite the fact that traffic is moving, it is easy to feel regret as if something could be better.
Now contrast the traffic in Toronto with traffic in Delhi:
Here, we see a traffic jam. There are no obvious behavioral norms about lanes or shoulders. If drivers don’t immediately fill the space in front of them, someone else will and they’ll never get anywhere; the road is fully utilized to the point that even bikes cannot fit between the cars. We have relaxed the rules that gave us regret in Toronto, but instead of increased throughput we see traffic has ground to a halt.
So how does this all relate to game theory? Game theory tells us that when we change behavioral norms, we need to consider the equilibrium when everyone adopts the new norms. When we look at traffic in Toronto, we see an opportunity for a few cars to deviate from the norm with a positive impact on those cars and throughput overall. However, if we let this deviating behavior become the norm, cars and other vehicles end up filling space in an equilibrium where traffic is at a stand-still. In effect, even though it seems like the empty space in Toronto leaves opportunities on the table, any traffic engineer knows that this is a mirage because attempts to utilize the empty space in a significant way will actually slow traffic down.
Non-concurrency and traffic
How does non-concurrency relate to traffic? The punchline is that concurrent terms are like traffic lanes – the structure that they give to the placement process is key to the results that cedents have come to expect. Invariably, cedents and reinsurers alike will see opportunities to deviate norms, but the equilibrium if we abandon concurrent terms is completely different and will commonly be worse than where we started.
To be concrete we’ll set up an example. Consider a cedent buying coverage for a $50M xs. $50M layer. Suppose that most of the market requires FOT at 10% rate on line (ROL) to provide coverage, but a few reinsurers – totaling $20M of authorized capacity – would be willing to provide coverage at FOT of 9.5% ROL.
A traditional FOT placement runs smoothly but appears to leave money on the table. In order to get a full fill, the cedent sets its price at 10% ROL for everyone. With inside knowledge that $20M of capacity was available at 9.5%, the cedent’s natural desire is to try to price the $20M at 9.5% ROL while paying everyone else 10% ROL. With this possibility in front of the cedent, it looks like non-concurrent terms would save money over an FOT approach.
If we replay this example through a non-concurrent process, we will see that the cedent will struggle to achieve the results it wants. There are many ways to place coverage with non-concurrent terms, but one thing they all have in common is that they put an added burden on the reinsurer to read the market. Outside of one-time deals, reinsurers are not happy to be paid substantially less than others on the same program – in a typical case, this means they left money in the table (they could have gotten the same line at a higher price if they had demanded it), and in the worst case it means they misunderstood the risk. Concurrency automatically protects reinsurers against these effects, while non-concurrency requires the reinsurer to protect itself. When reinsurers protect themselves they offer less-favorable terms, thus with non-concurrent terms, reinsurers typically act as if their price is higher than it actually is. This is not unique to reinsurance – non-concurrency has parallels with similar consequences across all of market design.
In our example, non-concurrency will elicit higher pricing from many reinsurers than it did in an FOT world. Exceptions aside, the 9.5% reinsurers price somewhere above 9.5%, and the 10% reinsurers price somewhere above 10% because they do not know where the rest of the market will be. The cedent had hoped to bind $20M at 9.5% and $30M at 10%, but this will not happen. Instead, the cedent will bind almost everyone strictly above those minimum prices, with the total cost easily exceeding the uniform 10% ROL that it would have in a concurrent approach.
Thus, we see that the benefits of non-concurrency are an illusion for the cedent – when reinsurers all know that they are being priced non-concurrently, they guess what the market will do and offer less-favorable terms than what they would be willing to accept in an FOT world. The benefits the cedent thought it saw was a mirage, and the ultimate results may be substantially worse than what would have achieved with concurrent terms.
Place concurrently with Tremor
Treor uses concurrent terms – often called uniform pricing in economics – because the process is simpler and the results are better. Asking reinsurers to guess where the final market price will land adds work for reinsurers and leads to a poor placement when the guesses are wrong. In fact, for these reasons uniform pricing is a best-practice in modern market design. Are you interested in learning more about why Tremor uses concurrent terms? Reach out to us!