How do reinsurers make their money? [MENA FOCUS]

Introduction

One often hears within the region that the game is really in the hands of reinsurers and not retail insurers. This is probably true of all or most insurance markets; it is certainly true within the GCC region because of the higher exposure to top heavy accounts.

A criticism that is often levied at retail insurance companies within the region is that they live off reinsurance commission. It is evident from the published report and accounts of retail insurers within the region that their profitability relies significantly on the ‘risk free’ reinsurance commissions; earning them the dubious, although not always justified, title of reinsurance commission agents.

The following is a snapshot of some annual report and account figures from three leading UAE insurance companies:

AED’000

Oman Insurance Co

ADNIC

Orient Insurance Co

2009

2010

2009

2010

2009

2010

Gross Written Premium

2,337,733

2,443,641

1,551,541

1,770,197

1,001,920

1,128,165

Reinsurance Ceded

1,061,551

1,211,640

940,046

1,042,599

731,046

830,144

Percentage

45%

50%

61%

59%

73%

74%

Net Technical Income

317,893

232,465

234,065

221,736

110,560

123,562

Reinsurance Commission

173,722

138,569

75,044

109,543

100,830

114,322

Percentage

55%

60%

32%

49%

91%

93%

 

The reinsurance figures above are ‘broad brush’ figures but serve to illustrate, for example the proportional reliance of each of the above market leaders on reinsurance. They also illustrate that, post-crisis reliance on reinsurance increased and the reinsurance commission income as a percentage of net technical results for all three companies increased. These three companies collectively command more than 25% of the UAE insurance market and, in most cases, as one climbs down the insurance league tables reliance on reinsurance actually increases in the aggregate.

Therefore, one can easily deduce from the above that insurers are largely living off reinsurance commissions. The proportion of risk taking and the return on net risk premium for most market players is relatively negligible. This is also largely the case because of the relative heavy reliance on proportional forms of reinsurance.

Reinsurers vs. Insurers

If the above is true, then the argument that reinsurers (and not retail insurers) are vicariously competitive in the GCC retail insurance market holds water.

But how do reinsurers make money? How does their business model differ from that of insurance companies?

The following snapshot of two European reinsurance conglomerates would help answer this question:

Munich Re (€ ‘m)

Hannover Re (€’m)

2009

2010

2008

2009

Gross Written Premium

18,322

20,410

8,121

10,275

Reinsurance Ceded

1,165

1,532

887

756

Percentage

6%

8%

11%

7%

Net Technical Income

505

-9

70

-100

 

When crunching financial results of reinsurers the following interesting points can be elicited:

  • The level of premium ceded to retrocession as a percentage of premium written is a 10th of the percentage of premium ceded to reinsurance by retail insurance companies in the region;

 

  • Their combined ratios from one year to the next hover within the 100% mark, suggesting that reinsurers are price takers and not price makers. They operate strictly in the price elastic segment of the demand curve. This is not necessarily the case with some of the retail insurers in the region who still enjoy varying degrees of protectionism and can, in some segments or markets exert influence on price;

 

  • Despite running at a technical loss and/or at what in economics is termed normal profit, reinsurers generally register relatively healthy net profits. The years when some of the larger reinsurers registered losses this was more finance and investment markets related. For example, Munich Re’s RoE for 2010 was just over 10% despite a technical insurance loss (a combined ratio marginally in excess of 100%) due to the catastrophes incurred that year. Munich Re enjoyed improved investment returns in 2010. Similarly Hannover Re registered over € 700 million in profits in 2009 despite a net technical loss. Conversely, despite a net technical profit in 2008, they registered a net loss due to the financial crisis and its impact on investments.

 

The technical strength of international reinsurers is derived from accepting business from a wide market. For example, Munich Re reinsures over 4,000 companies in over 160 markets. The wider spread of business helps soften shocks or volatility from localised events. Retail insurers mitigate this by relying more heavily on reinsurance. Reinsurers mitigate this by having a wider spread.

Reinsurers also rely more on non proportional reinsurance. Reinsurance or retrocession capacity is tantamount to capital; but made available in the event of a loss. Like capital, reinsurance capacity comes at a cost. Insurers under-estimate this because their financials suggest that reinsurance for them is generally means of earning ‘risk free’ income in the form of reinsurance commission. Although reinsurers may earn retrocession commissions, they are less reliant on it and, hence, retrocession is more of a pure cost to reinsurers than reinsurance is to retail insurance companies. Capacity is viewed to be so much of a cost that, for example, Munich Re simply define added value from their profit centres as risk adjusted earnings less cost of capital / capacity.

Conclusion: Implications on the retail market

There are a number of implications on the retail market that can be derived from the above. However, since we are in the business of risk I will conclude on just two implications which, however, are important from a risk-return perspective.

  • Insurer Perspective: Reliance on reinsurance results in reinsurers being the largest component of debtors in the insurers’ books. This presents a substantial credit risk for reinsurers. A default of a reinsurer that is participating across the treaties of a particular insurer can result in a serious credit risk for that insurer. The only insurer to fail in this region (about a decade ago) did so because of inadequacy of reinsurance protections.

 

  • Reinsurers’ Perspective: A market for a reinsurer represents an area were capital (which has been acquired at a cost) is being deployed. Whilst reinsurers tend to take a long term view of markets or relationships, they can also pull the plug on classes or markets that are not providing the added value when taking into account risk adjusted earnings less the cost of capital. For example, with increasingly deteriorating returns on surplus reinsurance one would expect an emphasis by reinsurers to cut down on this form of proportional cover when discussing 2012 renewals.

These two perspectives point towards one conclusion, i.e. reinsurance is effective only when it is backed by creditworthy security and creditworthy security comes at a cost since reinsurers also need to make money. This will probably be the simple raison d’être that will influence changes in reinsurance buying within the region in years to come.

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About insuranceguild

Sharing Knowledge for the Common Good: Many associate guilds with British pre-industrial era. However, predecessors of guilds are found as far back as the 3rd century BC in the Roman Empire. They were also present in various civilizations including Ptolemaic Egypt, India, Iran, China, African dynasties as well as various European countries such as medieval Germany and Italy. A guild is typically an association of practitioners from the same trade. In addition to protecting and developing crafts, trades and business, guilds also helped foster a learning environment among members. Through this platform I wish to share articles of an insurance / risk management nature and hopefully generate comments from readers that would help to enrich my knowledge as well as the knowledge of other insurance and/or risk management practitioners. About the Author: A Chartered Insurance Practitioner by profession, James Portelli is also a Fellow of the UK Chartered Insurance Institute and of the UK Institute of Risk Management and holds an MSc in Risk Management from Glasgow Caledonian University, U.K. James has been active in insurance and risk management since 1990 and in training since 1987. He started his insurance career in general insurance underwriting and agency/broker management with Middlesea Insurance plc (also forming part of the company's Risk Management Implementation Committee and assisting in captive insurance development). He first moved to the Middle East in 1998 occupying senior training, technical, consulting, business development, risk management and strategic development roles. James is also a 2008 CII (UK) Morgan Owen Prize Winner and the 2011 IRM (UK) Steve Butterworth Award Holder.
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2 Responses to How do reinsurers make their money? [MENA FOCUS]

  1. Abdallah Tamimi says:

    I tend to agree that “The wider spread of business helps soften shocks or volatility from localised events. Retail insurers mitigate this by relying more heavily on reinsurance. Reinsurers mitigate this by having a wider spread”

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