There is a "triple theme" we've seen this month in industry news articles.  First, modelers must be enjoying their days in the sunlight as once again it seems that everywhere you look more and more people are talking about modeling more and more risks.  What began as a means to estimate exposure to rare, devastating hurricanes is now becoming the bread you make the sandwich with --indispensable.

Next we were struck by continuing concerns about premium rate decreases. That's not new news but what was new to us, is that of all people, the ILS markets seem to be the ones slowing up in their underwriting because they can't get the premium they need.  You may remember the "hot money" moniker applied to them a few years ago.  Not so fast it seems. There have been documented instances of pull backs (translation: underwriting discipline) and the aggregate numbers lend support to this view.

It's undeniable that there are more stories about modeling these days. The general thrust of the stories is that improvements in modeling technology mean that prospective users who rarely had direct access to models in the past now use them regularly.  This is music to the ears of the likes of OASIS and to the modelers themselves. You can imagine, though, some consternation within underwriting departments as long insured policies may now be accompanied by cold, hard, predicted loss numbers.  Arguments ensue, we are sure, when underwriters are asked to drastically increase a rate, or decline a risk, based on a newly run model, or on a coverage that may not have sustained a claim.

This discussion apparently occurs on a macro scale in very large insurers who make a decision to write business from a client at the less than required rate (as called for by the model results) in order to obtain business from the same client in a more profitable line of business. It all comes down to the numbers.  

If a company is big enough, and determines that the profit it could earn from obtaining the higher priced line is worth taking the technical loss on the lower priced line, it will underwrite certain LOB's at a loss. It works out pretty well as the big four reinsurers have been doing well.

A company needs to have scale, both geographically and in coverage types, to be able to succeed at this. For companies without scale they are required to choose between insuring the business at a near or certain loss, or simply passing on it and letting a rival insure it.  Often, this can be a wrenching decision. Client acquisition is a long, costly and arduous process and no carrier wants to lose a client. When this wrenching decision is precipitated by a model result alone you can be certain there are arguments.

Models aren't perfect --even the modelers deny that they are.  And when no major hurricane has made landfall in the US in nearly ten years (despite predictions) you can be sure that underwriters are mindful of that "fact" if they question why a long term piece of business is being passed on because of the model analysis.  On balance, though, that line of argument simply can't win when an insurer adds up the aggregate exposure to its entire book and factors in the prospective modeled loss. Insurers take risks but they don't take unnecessary risks.

This leads to an interesting trend. You may recall some of the traditional market reaction several years ago when the spigot of alternative capital coming into the market began to fully open.  It was thought that this new money was "dumb capital" or "hot money" and would underwrite any risk put in front of it simply to generate a premium.  As it turns out, and it's impossible to generalize this, there are cases when alternative capital has refrained from writing risks as the premium prices continue to plummet.

The clearest example is the reduction in the rate of alternative capital coming into the market.  Although the amount grew to $72 billion in 2015, S&P says that the rate of increase has slowed from prior years and that this slowdown "is a sign of a pricing tipping point having been reached in certain peril regions."  Translation: if the return isn't good enough, in this case the premium, the capital will go elsewhere.  

This macro evidence is one thing but when you look closer you see other signs too. Barbican's managed third party ILS capital Special Purpose Syndicate 6120 was hard hit by losses from the Tianjin port explosion and the Pemex oil rig explosion. The SPS in fact incurred a full year loss for 2015.  The SPS paid its obligated claims but has not renewed for 2016.  Translation: the ILS investors decided that after paying the 2015 claims their appetite for 2016 had waned.

What seems troubling though is that traditional reinsurance capacity actually did decline in 2015 and it wasn't just a slowing of the increase as with alternative capital.  Traditional reinsurance capital declined by 4% down to $493 million.  Some of this decrease was due to the stronger US dollar but no one is suggesting that the amount of traditional capital increased.  

Presumably this means that traditional carriers have determined that prices really are too low and they just simply will pass on insuring certain coverages if they can't get their price. Obviously this is what one hopes it means but there is much evidence to the contrary.  You have to wonder about underwriter discipline, and whether it's real or not, when you see a comment such as the one made by Evan Greenberg at Chubb. Greenberg said that "Many markets participants are simply gambling that if they don't have a normal level of expected CATS or large losses they will make money--a pretty dumb plan."

In the same vein, and even more critical, were comments from David Shipley of Managing Agency Partners (MAP) a Lloyd's syndicate who criticized rivals that are currently underwriting for volume saying that the strategy was "bordering on suicidal". The MAP active underwriter Richard Trubshaw said that in addition to prices being battered, terms and conditions in many classes were so far adrift of any reasonable view of a long term profit margin that "the day of reckoning cannot be too far away".

The dilemma facing markets is understandable. Premium prices have dropped so much that reinsurance demand has actually increased. When premiums were high some cedents decided to increase retentions and or centralize group reinsurance purchases based on enterprise-wide exposure. The net result was that the amount of reinsurance coverage they purchased declined and they retained the money that would have been paid in ceded premium.

Now, after a prolonged period of rate decreases, as well as the more generous terms and conditions alluded to by MAP, cedents are interested in reinsurance again. Not only is it more cost effective to offload the exposure elsewhere but recent claim events such as the Tianjin loss has left more than a few cedents wondering how they would have fared had they reinsured healthy portions of their exposure.

The demand seems to be creeping back but it's been prompted by prices so low that some in the reinsurance industry say would be "suicidal" to continue charging them. After a period of dwindling demand in certain lines, reinsurers are seeing renewed interest, but at prices they are reluctant to extend. You can see why at this stage any demand is hard to pass up but some markets are willing to do just that. It's ironic that certain ILS funds are amongst those who seem to be passing up business too.

In a down market everyone suffers but logically it would seem that brokers stand the most to lose. If less coverage is being sold, and the coverage that is being sold is at a lower price, then it stands to reason that broker commission-based revenue will decrease.  How can it not?  Only by three ways that we can think of.

First a broker could try to identify new clients and bring new buyers to the market. New clients who might be interested in either existing product lines or new product lines would be the clearest way to increase broker revenue. After all, how many stories can we read about "coverage gaps" and lack of insurance in "emerging markets" before someone actually gets on a plane to visit prospects who might not even have been aware that there are coverage opportunities available that could lessen their exposure and allow them to write more business.  

This is the essence of what a broker does. Several years ago Eric Andersen at Aon Benfield identified this process of  pure "organic growth" as precisely the path the broker intended to follow. 

Another path to increased revenue for brokers is a half-sibling of pure organic growth. By generating new products and services to make available to existing clients brokers can and do generate new revenue. These new services run the gamut from impressive new modeling capabilities to London market broker facilities.

Services pertaining to better understanding risks would seem to be work that no one can object to. Who is going to deny that should a broker develop a more accurate model, or a better analysis of an insurer's aggregate exposure, that these are positive developments? Besides, the client has the option of deciding whether it will buy the service or product and can decline if it wishes.

Where the broker revenue increase effort begins to encounter market pushback is when increased commissions and fees are added to services that the market has trouble justifying paying. For example Willis has recently tried to add an iincreased commission on Slip Market Brokerage on a range of London specialty placements. The reported rationale was to help defray the additional cost of transacting business in Lloyd's.

Most cedents are well aware of the commission differential already in place between business placed into Lloyd's and London compared to the US, Bermuda or Europe. Apparently though, for some, the current differential (estimated to be at least 5 percentage points) is not enough.  

A more well known example of when the market reacts to broker efforts to increase remuneration is of course the argument over the follow form facilities set up by brokers at Lloyd's. Markets that decide to join the panel are typically required to pay an upfront fee to the broker to be able to participate in the facility and the broker receives an increased commission fee as the facility manager.

On one hand it's indisputable that sophisticated markets have made decisions in their best interests to join broker follow-form facilities and pay the required fees. Presumably, they are capable of acting in their own best interests. To be fair most of the negative publicity surrounding the follow-forms come from markets which decided not to participate or were not invited to participate. Such markets may feel that their underwriting independence has been thwarted. The facility is called a "follow-form" facility for a reason.

Follow-form revenue and slip revenue may indeed be new revenue sources and can probably be categorized as organically new revenue. But these streams are distinct from pure organic revenue growth that comes from identifying new coverage needs and bringing new clients to the market.  

In any other market when demand slackens prices are usually adjusted downwards. The goal usually is to make your product more attractive to buyers. In the case of insurance, and reinsurance especially, the premium prices have declined so much brokers can quite rightly say that they have already adjusted their price. Their commission rate has remained the same but the lower premium means that they're receiving less than they normally would have and are still providing the same services.

This requires a bit of parsing but we think it's the way the brokers see it. The brokers of course are not capacity providers. Just because it is a slack market, and the cost of the product they are selling has decreased, they still have to perform the same services --placement, contracts, claims, etc. -- that they would if the cost of the product had stayed the same or increased.  

An analogy could compare this process to owning a global oil pipeline network. The owner needs to keep it operational and deliver oil to distant locations regardless of the price of the oil running through the pipeline. Those pipes still have to function the exact same way whether or not the price is $20 per barrel or $80 per barrel.

If we follow this pipeline analogy a bit more, aside from imposing new fees, such as pipeline inspection fees, pipe maintenance fees, etc., the only way a pipeline network owner can increase revenue is by pushing more oil through the pipes. He doesn't control the price of the oil. One way to do that might be to lower the price for the service in the hopes that more oil producers will flock to his pipeline network to save distribution costs.

There. We said it and the sky hasn't fallen in (yet). We can't help but observe this is one aspect of any market, which all of us who make a product comparison in a grocery aisle, encounters every day that is never mentioned in any article. 

We detect rumbles of thunder in the distance. Lord Voldemort? Let's hurry on to some other developments.

Hank Watkins is the President of Lloyd's North America.  In remarks made at California State University last month he made some interesting observations.  He was speaking at a "Career Day" for university graduates about insurance.

Watkins described the Excess & Surplus (E&S) lines business as the "best kept secret" in the insurance industry.  E&S business is coverage that can't be obtained from an insurer admitted in a particular jurisdiction but is available from a non-admitted carrier. The buyer usually needs to certify that he cannot obtain the coverage from an admitted carrier.  In the US, states have long institutionalized protections for in-state insurers, but if the admitted carriers don't offer a coverage the state has an interest in having the risk insured if only for economic purposes.

Everyone knows what E&S coverage is. We've all heard the famous examples of coverages obtained in the E&S market not available in the admitted markets that have provided insurance for risks such as Betty Grable's legs and Bruce Springsteen's voice. We may have encountered the E&S market ourselves if we are members of a homeowners association that requires hard to obtain liability insurance or if we have a high value home in a flood zone.

It's been tough lately to make money in the E&S market (we're told) as premiums have dropped over the past two years. But risks continue to be written and more participants have come into the market. Whether the continued activity is due to the attraction of the E&S market or the lack of attraction in other markets we can't say. 

Maybe it had been our own lack of curiosity but it was a revelation when Watkins explained that the "E&S business insures risks that other insurers won't; and then when the E&S sector proves those risks are insurable, or a good business to be in, the rest of the industry moves in to offer products for those risks".

He cited autonomous vehicles, drones and ridesharing as emerging risks that the E&S sector took on first.  Other examples, such as satellite coverage, are more well known and well institutionalized by now. Lloyd's is the largest surplus lines insurer in the US. No wonder Watkins was waxing eloquently about E&S business as it represents over 60% of Lloyd's US premium. 

Let's look at the Aliso Canyon leak differently from a cyber risk. The Aliso facility was the second largest methane storage facility in the US and and owned by Southern California Gas Company. Presumably, the dimensions, capacity and content of the facility were known down to the cubic centimeter. The underground facility has been used for gas storage since 1973. The location of the facility was certainly known as was the size and extent of the surrounding residential community. It seems that there was no information or data about this risk that couldn't have been known.

However when SoCal Gas went to look for liability coverage for their Aliso facility they ended up in the E&S market.  Is this a surprise? Probably not. After all it would seem that even a rudimentary model could compute the risk of potential harm from an accidental discharge involving a cache of methane big enough to fill the country's second largest storage facility located in close proximity to residential communities. Maybe the model didn't count on a methane leak that lasted for 111 days, but whatever size and duration leak the declining underwriters did foresee, it was enough to force SoCal Gas to the E&S market because they couldn't get all the coverage they needed from admitted carriers.

Back to our refrain. Someone insured the risk. Despite modeling results, that made the risk unpalatable to the admitted market, the risk was insured in the E&S market. We have no knowledge of the SoCal Gas insurance program. We don't know whether they retain a self-insured layer or not. We are only noting Manzitto's observation about the "gigantic loss" and that "a number of E&S carriers" will be involved. 

The E&S market has been walloped by the overall slump in insurance premiums but rates are generally higher than in the admitted market. Most admitted insurance rates are regulated but in the E&S arena the rules of the market govern. It goes back to what Hank Watkins observed. Part of the E&S carrier experience is determining whether the coverage can be profitable. If it is, then the rest of the industry moves in to offer that coverage. 

There is evidence that admitted carriers are moving into the E&S space. There is simply too much risk capital available to ignore a sector of the market that generates a higher level of premium.  Even Berkshire Hathaway Specialty Insurance has an appetite for it. When you remember the often stated goal of moving down the food chain to get closer to the risk, what could be a better relationship than providing a unique coverage to a buyer that has already tried but failed to buy the cover from an admitted carrier? 

There is one problem that we can think of and that is "E&S risks are considered high hazard, and often little historical loss data is available."  If we combine the lack of historical loss data, and the paucity of available models mentioned by Watkins, we can see why carriers, such as Hamilton, have decided to pass on certain types of coverages.  

Other carriers, exposed to the same gaps in risk quantification, do decide to provide the coverage but at a price they set and within limitations they insist upon. The E&S market offers this flexibility as E&S carriers "have freedom of rate and form, allowing them to write more exclusions, waivers, and riders than a standard policy in order to meet their clients' unique needs."

Lloyd's Watkins had another observation too, about E&S acting as a "surge tank" for the industry. He sees it as a role it plays when insurers pull out of risky markets and the E&S sector moves in. What's clear is that, just as carriers are matching coverage premiums and profits with appropriately priced capital (written on their own book, a sidecar or ILS vehicle, etc), they are also matching their admitted and non-admitted companies with "high hazard" risks if they desire to insure them albeit with a more limited contract and with a premium that's not regulated.

We wonder, given the increasing import of modeling, and the reasoning of the likes of Hamilton for not entering a market like cyber (lack of quantifiable metrics), how it is that E&S carriers could end up on a fairly quantifiable risk like Aliso Canyon. Presumably the rates they charged were formulated with all the model information available and the the nature of the E&S market allowed them to obtain a high enough premium for the "gigantic loss" they may now face. We wonder how much effect competitive pressures might have had on those rates.

Watkins would seem to be right on target. The E&S route may allow carriers to slip the regulatory leash in terms of pricing. By using the "sophisticated pricing models", noted by A.M Best, whatever those models may be, E&S carriers can get the premium prices they need. This is one area where underwriting discipline is key. As PwC observes about the E&S market, "There is potential for significant exposure to shock loss (such as catastrophic events or triggers), large risk concentrations, unique operations, unfavorable management, and emerging risks." 

You can't afford too many mistakes if the risks are that high. You especially can't afford too many mistakes when competition is fierce and when others will write business that you may pass up. Sometimes avoiding a mistake might just mean doing nothing.