Reinsurers - The Rational Outsiders
In an ideal world of risk theory, randomness can be both tamed and transformed into near certainty by exploiting the fact that fluctuation around the mean diminishes as the number of (independent) risks increases. It is the old “coin toss” model that turns on the paradigm of “rationality meets randomness.”
The financial crisis and the ensuing economic meltdown demonstrated, however, that the predictive powers of financial risk models that operate on this basis are unreliable - largely because humans do not think and act rationally. In practice, market players find themselves entangled in a complex web of interactions and competitive forces that shape their expectations.
As a result, risk positions are sometimes grotesquely inflated and are contrary to initial intentions. That happened a lot in the capital markets.
But what’s this got to do with our industry? As I explain in the new edition of Risk Insights, it could be important in the context of solvency regulation and Solvency II in particular.
Evolving solvency rules should aim to contain the disproportionate inflation of insurers’ balance sheets (rather than provide capital rules that are based on static stress scenarios). Yet, the explicit inclusion of diversification effects that is central to Solvency II will not help deflate insurers’ risk positions in times of excessive premium appetite. Compared to Solvency I, it might even suggest lower increments of required solvency capital as insurance risk builds up.
So if the rules won’t mitigate risk exposure among cedants in the future, then who will? The onus will increasingly be on reinsurers to promote a rational assessment of available information whenever cedants seem threatened to be swept along by market euphoria. At the risk of sounding superior, reinsurers do act more rationally than cedants - but only because they are outsiders to a sometimes irrational market game.
Read our latest Risk Insights publication for my article “Black Sheep or Black Swan - Herding Behaviour in the Face of Risk.”