Insurance is protection. When the reinsurance market fails, risk isn’t transferred and, in the worst case, people are left exposed – market failures undermine the very reason that insurance exists. 2022 was such a market failure. We discuss the underlying economics and the lessons the industry must learn – that a modern market mechanic with robust price discovery is critical – so it doesn’t happen again.
2022 was one of the most challenging reinsurance markets in decades. It was so hard that many in the industry drew comparisons to the market in 1993 following hurricane Andrew. While 1993 and 2022 were very different, both were market failures due to systemic problems. The hard market in 1993 taught the industry hard lessons about the way risk is modeled, but reinsurers learned and the industry is much stronger today because of it. So what about 2022? The hard market in 2022 was a deadlock driven by external factors – inflation and bond movements. While the root cause is completely different (and seemingly external), we must still introspect and learn from 2022 so that we do not repeat our failures – insurance is about protection, and an insurance market that deadlocks when it is needed most is the opposite of protection.
So what, exactly, caused the market to deadlock in 2022 and how can we learn from it? In short, as we will see, the industry deadlocked because its market mechanism failed to provide robust price discovery.
1993: Lessons learned
The market failure in 1993 was the predictable consequence of one of the industry’s dirty little secrets: in 1992, market pricing ignored hurricanes of Andrew’s size. For decades, the market priced hurricane risk as if storms the size of Andrew didn’t happen. Unsurprisingly, when Andrew hit, the losses dug deep into re/insurers’ capital and rendered more than a dozen entirely insolvent. Following Andrew, re/insurers needed to rethink the way they modeled and priced natural catastrophe risk.
Andrew precipitated a revolution in modeling and pricing catastrophe reinsurance. Most significantly, reinsurers began adopting probabilistic hurricane models that included large events like Andrew. As reinsurers retooled their underwriting approach and rebuilt their capital bases, the market roared to life again.
This brings us to something that our industry should be proud of – hurricane Andrew caused $15B ($30B today) in insured losses and upended the industry, while hurricane Ian in 2022 caused $60B (est.) in insured losses largely without touching reinsurers’ capital reserves. In 2022, despite a major hurricane, catastrophe losses were more than manageable and Gallagher Re observing some of the best underlying ROE in a decade. Reinsurers have learned quite a bit from Andrew and other catastrophes over the past three decades, and the industry is that much stronger for it.
2022: Lessons to be learned
The market failure in 2022 was the natural consequence of an entirely different dirty little secret – the market today does not de-novo price risk; instead, it makes incremental adjustments based on market conditions. Standard process in the industry is to price based on comparables – a reinsurance underwriter might ask Where did the market price [this treaty] last year?” Were there losses last year? How has pricing changed for risk with [certain properties] year-over-year? How does [this treaty] relate to typical risk with [certain properties]? The price of reinsurance is determined based on the answers to these questions – oftentimes a simple adjustment to the price last year based on general pricing trends. The danger of this incremental approach is self-evident: the market will not be able to price risk when a large shock invalidates precedent. These kinds of shocks are rare but inevitable – just like Andrew was rare but inevitable – and are precisely what drove the market failure in 2022.
Concretely, the market failed during the fall 2022 renewal cycle because systemic shocks invalidated precedent and reinsurers froze. Two cascading effects drove the meltdown:
Movement in the bond market caused a supply shock – Quickly-rising interest rates precipitated one of the worst years on record for bonds, forcing reinsurers to write down the value of their capital by 15% on average. With 15% less capital to write coverage against, alongside a spike in inflation and even more uncertainty about where the market would go next, there was no precedent to inform pricing.
Without transparent price discovery, pricing tension had been building for years – In a market based on comparables, pricing levels can persist year-over-year regardless of whether or not they make sense. Parties ask for pricing to move one way or the other, but inevitably capitulate to precedent. Tension inevitably builds as parties believe they are getting an unfair deal, until a shock forces the market to rethink pricing de novo and the tension erupts in large demands for payback.
Bond movement and inflation by themselves would have caused enough of a supply shock to cause a major disruption. Reinsurers who believed that pricing levels had been low for many years added fuel to the fire with pricing demands that went well-beyond the potential impact of that shock. Nobody knew where pricing should land, and reinsurers slammed on the underwriting brakes. Cedents who asked for quotes or put out firm order terms heard little or nothing from reinsurers. Those that tried to move forward anyway often came up far short, e.g. Florida’s Citizens Property Insurance only found half of the coverage it needed in its renewal. The market failed, and clients’ protection was jeopardized.
The lesson we must take away from this is that we need a new market mechanism that implements proper, robust price discovery. It is unacceptable for the reinsurance market to fail when large shocks hit it – these might be the very moments when protection is most important for clients. In the same way that Andrew showed us that we needed to take large hurricanes seriously, the market shocks in 2022 showed us that we need to take market mechanics seriously – our current approach to incremental pricing is unfit for the kind of robust risk transfer that the re/insurance industry needs.
Conclusion: we need a robust, modern reinsurance market
How can the reinsurance industry prevent market failures going forward? The key is a modern, transparent market dynamic:
Reinsurers must come to the market with individual conviction on how much it will cost them to cover a risk, to be aggregated into a true market clearing price. (Individual views will never be perfect, but a healthy market will aggregate them into something more informed than any individual price; if reinsurers simply regurgitate status-quo pricing levels, that cannot happen.) The market must be transparent with true price discovery, so that everyone can see that the market is properly aggregating participants’ views.
2022 would not have happened if the reinsurance market did these things. If reinsurers worked from independent convictions about their price to cover a risk, the movements in the bond market would not have precipitated a market failure – reinsurers would have been able to assess the impact of reduced capital and provide new pricing with conviction. If the market reliably and transparently priced risk at true market clearing prices, there would be no building tension and no need to ask for payback. The lesson of 2022 is that we need a market with these features.
At the end of the day, re/insurance is about protection, and market failures undermine risk transfer and jeopardize the industry. In the same way that the market learned from its failures in the wake of Andrew, it must also learn from its failures in 2022 and move towards a market model that offers true price discovery so it can be more robust to shocks. Moreover, just as climate change is impacting the natural catastrophe landscape, our increasingly interconnected world means that shocks like those seen in 2022 will only become more common. It will not happen overnight, but in the same way that Andrew precipitated a revolution in cat modeling, 2022 should be our wakeup call to move towards a market model that is as robust as the protection that we promise our clients.
Tremor’s Panorama process offers true price discovery. If you want to learn more about modern marketplaces and Tremor’s reinsurance platform, we’d be happy to give you a demo or answer your questions. Reach out to us!