Reactions magazine opens its firewall to give us a peek at the history of the New York Insurance Exchange. NY Gov. Paterson has proposed reviving the exchange and the idea has a certain amount of momentum, despite Paterson’s waning popularity.
Basically, the exchange would be modeled on Lloyd’s (without the bell). Brokers bring hard-to-write risks to the market – think of the Empire State Building’s terrorist risk or D&O on Citigroup or Goldman Sachs. The exchange would have syndicates – basically underwriting teams – to evaluate the risks. If the price was right, one or more syndicates would take on the risk.
The syndicates would have capital backing from, well, wherever. It could be insurance companies, of course. But money could also come from hedge funds, which like insurance risks because they are uncorrelated with market risks. Hedge funds have made insurance-style plays before by buying cat bonds or investing in Bermuda sidecars.
Why did the old exchange fail? Here’s what the magazine says, accompanied by my kibbutzing.
First, it started at the softest part of the softest market ever, in 1980. That market was much, much worse than today’s soft market or even the late ’90s soft market. Don Kramer, now heading up Ariel Re, put it this way:
I had what I called a 5, 4, 3, 2, 1 ratio. I said if you wrote business in 1980, then you are going to have a 500% loss ratio – or you were lying – 400% in 1981, 300% in 1982 and so on.
Second, the syndicates were backed by insurance companies, who really didn’t need the exchange. And since prices were so low, the syndicates would undercut the standard market. A broker would get a quote from AIG, say, then head down the street and get a lower price from AIG’s syndicate on the exchange. After all, a new venture that doesn’t write business doesn’t stay in business – and underwriters’ kids gotta eat, too.
So the exchange grew quickly, becoming the country’s eighth-largest reinsurer, writing $345 million in 1984. A lot of it was crap.
Brokers knew the exchange was hot to write business, so they brought it the worst business. When you’re new to the market, brokers test you, and under the circumstances, the exchange syndicates just couldn’t say no.
This happens a lot, and it’s tied into the “naive capital” problem. For example, Australian reinsurers tried to make Sydney “the next Lloyd’s” in the late 1990s. They made the same mistakes, and over 18 months in 1999-2000, three of them – New Cap Re, REac and GIO Re – failed.
That same dynamic would play out in New York today, and it would be interesting to see whether underwriters today would behave differently. My old boss – around for the nasty, nasty ’80s soft market – says underwriters wouldn’t be suckered as easily, because there is actuarial support today. The actuaries would let them know how underpriced a piece of business is. In 1980, reinsurers had about as many actuaries as they had windmills.
Third, sez Reactions, Americans didn’t understand how to be a following market. The article is vague on this point, but it sounds like underwriters tried to compete with (read: underprice) the lead company on a deal, setting off a race to the bottom.
I have a little trouble with this reasoning. Much of the U.S. reinsurance market was a following market then. Lots of tiny reinsurers were “two-point Tonys,” dependent on a friendly broker to let them in on a sliver of a treaty.
Some of those underwriters were as sophisticated as the best pricing actuary. A few couldn’t price penny candy. If anything, the U.S. reinsurance market is less of a following market today, as no one gets on anything without pricing it first.
Anyhoo, the exchange got off to a miserable start and curtailed writings in 1985, just as rates started to skyrocket. But by then the exchange was saddled with adverse development on horrible business and didn’t have the capacity to write more. By 1986, five syndicates were insolvent. There would be five more. The syndicate closed in 1987. A fascinating (no kidding!) account of the runoff is here.
Could the exchange succeed today? On the plus side, pricing is more sophisticated. The syndicates would be more diverse – with hedge funds and Bermuda companies complementing the risk appetite of U.S. (re)insurers. ERM and capital modeling, tied with more sophisticated capital standards – remember, in 1980, regulators didn’t even have RBC standards – would encourage healthy restraint.
On the other hand, an exchange starting today would be jumping into another soft market and might have to burn through capital to establish itself. And I’m skeptical how willing hedge funds would be to underwrite casualty risks. From my brief experience, non-insurance investors really struggle with the casualty insurer’s need to tie up capital for years – even decades – to support loss reserves. The exchange, for example, was addressing runoff issues in the mid-aughts, more than 15 years after closing.
If it does get off the ground, I wish the new exchange luck, though. As The New York Times notes, the exchange could bring 3,000 jobs to New York.