America, We Need To Have a Serious Talk: There's Something Wrong With Reinsurance

For those of you unfamiliar, "reinsurance" is defined by Marriam-Webster as "insurance by another insurer of all or a part of a risk previously assumed by an insurance company."¹. We have all heard about the big Insurance "Companies" today, or insurers, such as Nationwide Insurance, Farmers Insurance, AAA, Liberty Mutual; the list goes on. Do the names "Reinsurance Group of America", "Swiss Re", "Munich Re", or "Everest Reinsurance" sound familiar to you? Unless you work in the insurance market, my guess is "probably not". I am going to give you a breakdown of what a reinsurer is, the conundrum of capital requirements and risk management, how the system is challenged by the increase in natural disasters, the broader issues at play, as well as some solutions and trends we are seeing in the market today.

Fair warning: This post is very dry, educational, and strongly opinionated in nature. These opinions are my own and influenced by industry exposure.

What is a Reinsurance Carrier, or Reinsurer?

We named some popular insurance companies above. When you purchase an insurance policy from a carrier, this policy is merely an agreement to transfer your personal risk(s) onto the carrier. What many consumers do not realize is that an insurance carrier does not need to have sufficient capital on hand to cover your risk, in case you need to make a claim. This is where reinsurance becomes relevant. Reinsurance is insurance for insurance companies. When a carrier issues policies, they also transfer a portion of their risk (that they have already, contractually agreed to cover) to another entity: a Reinsurance Carrier. This assists the primary insurer (Nationwide Insurance, Farmers, AAA, etc.) to meet and manage their financial obligations and to stay solvent, even in the heat of a surge of claims due to unforeseen circumstances, such as a natural disaster or other large-scale accidents.

Reinsurers are supposed to be a safety net for our insurers. Our insurers partner with these reinsurers to ensure they can meet their obligations and to ensure they can honor their commitments to all policyholders, no matter how significant or numerous the claims become.

The unfortunate side of this system, which has come to fruition in modern years, that consumers fail to realize, is that this system allows our primary insurers to take on more policyholders, more policies, and larger risks, without any obligation to have any excess cash on hand to fulfill these obligations in case disaster strikes.

What is gut-wrenching for me, as someone who has worked in this industry for so long, is seeing so many people who are so unaware of this process. We all assume that when we sign a contract, in good faith, that the countersigning party will fulfill their obligations at their end of the contract; consumers rightfully assume that these primary carriers they purchase their policies from are the party that holds all the risk. The truth is, reinsurance is a critical part of how the entire system works. It provides stability for carriers but also for the financial system on a broader level. When a consumer needs a claim paid, they may really be at the mercy of the reinsurer, not the carrier.

Capital Requirements & Risk Management

How much capital does an insurance carrier or an insurance reinsurer have to have on hand? This will not surprise you, but the answer is: "it depends."

Capital requirements and risk management is primarily regulated at the state level by the National Association of Insurance Commissioners (NAIC). The NAIC has developed Risk-Based Capital (RBC) standards to ensure insurers and reinsurers maintain enough capital relative to their risk exposure. The RBC is designed to prevent insolvency during large-scale disasters by maintaining adequate reserves. Financial data is collected from insurers and reinsurers so the NAIC can verify that every company in the market has enough capital reserves. "Capital reserves," in this context, includes Admitted Assets, Liabilities, Surplus, and Capital.

I think it is important to understand that insurers and reinsurers both use investments as capital reserves. These are highly liquid assets that are readily convertible to cash, usually helping to ensure that a company can meet short-term obligations without disrupting operations. In the event that a claim payout exceeds admitted asset reserves, an insurer or reinsurer could face regulatory scrutiny, corrective action, or sometimes, even liquidation.

❓ A question that I have, personally, that I have not been able to find a sufficient answer for, is what impact Admitted Assets have on claims during a natural disaster or clustered event, where an insurer is forced to pay out on many claims at once. Are the insureds left in wait, forced to liquify their personal assets?

The Basel III Endgame regulation was supposed to take effect on July 1, 2025. This has been postponed, and it appears as though it will continue to be postponed. You can download the white paper here, but the gist of this regulation is that insurers and reinsurers will face about a 16 to 25% increase in capital requirements. This white paper also covers the potential impacts on consumers, such as higher borrowing costs, reduced credit availability, and increased costs for financial services. Although from a regulatory perspective, it looks to prevent financial crisis for consumers, it appears that there may be unintended consequences, which are likely to have disproportionate effects on low-and-moderate-income borrowers: because of the higher capital requirements and reduced credit access that experts see happening with Basel III, this may shift financial activities to less-regulated non-bank sectors, potentially introducing new risks to our financial system.

Challenges During Natural Disasters

Like so many other natural disasters, in recent years, we have seen the cohesion of policyholders, insurers, and reinsurers, melt before our eyes. Once a well-oiled machine, the vulnerabilities of this system have been exposed through claims denials, reinsurer exclusions and aggregate limits, and insufficient capital held by insurers.

Claims Denials, Exclusions, & Aggregate Limits

We see this so often during natural disasters, where claims are immediately, and outright, denied. This often happens rightfully and legally, and with a wipe of sweat off the forehead of the Denial Specialist from the Claims Department. These claims are often denied "rightfully and legally," based on very technical policy language, exclusions, and technicalities. Sometimes, these Denial Specialists are on the hunt for that one line of language to deny the claim, because wouldn't you know: the insurer does not have the capital to pay the claim, and they are waiting on reinsurance funds. Delays in reinsurance payments can further exacerbate this process for smaller or less solvent insurers.

Another important note here is about aggregate limits. Especially after a grouping event, where many policyholders are affected in one area at the same time, reinsurers will implement aggregate limits (be sure to watch out for aggregate limits on your personal policies from your own insurers, too!). An aggregate limit is the maximum amount, in total, that a company will pay out for all covered claims during that policy period. Even if a reinsurer pays their fair share of claims to an insurer during a natural disaster, if that event is impactful enough to their policyholders, that insurer may very well face a liquidity issue. This is pure conjecture, but I think this may have something to do with the amount of policy denials that we see during natural disasters.

Broader Issues At Play:

Underestimation of Risk

Although the NAIC has guidelines, it is very clear that the world around us is moving more quickly than risk models. With the increased rate of climate change, it is becoming increasingly difficult to use past data to predict future events. This leads to higher-than-expected claims payouts for insurers and reinsurers, which affects profitability. When profitability is effected at this level, pressure and premiums rise for policyholders. We are also facing new, emerging risks that are proving difficult to navigate: pandemics, epidemics, cyber attacks, infrastructure attacks, and supply chain disruptions are serious concerns that all lack adequate coverage and risk mitigation strategies.

Moral Hazard

Merriam-Webster defines "moral hazard" as "a situation in which a party is incentivized to risk causing harm because another party is obligated to remedy the consequences of the harm caused." Insurers that rely heavily on reinsurers may take more risk than they really should (moral hazard), which creates even more pressure on insurers and policyholders.

👀 Where I find this concept quite fascinating is looking back to the Silicon Valley Bank (SVB) crisis of 2023.

If you recall, SVB was FDIC insured, which should mean that anyone with an account was insured for up to $250,000 in funds. What really happened in 2023, was that everyone, including those who had accounts in excess of $250,000, got all their money back from the government. In banking, this is the "Too Big to Fail" concept: SVB was simply far too critical to the economy, and the failure of SVB bank would have resonated loudly. In the insurance industry, this concept is often referred to as "systemic risk." The last known "SVB-like" situation in the financial market involving an insurer can be traced back to American International Group Inc., or AIG, during the 2008 financial crises, where they received a $150B+ government bailout due to massive overexposure to credit default swaps tied to the subprime mortgage market. Thankfully, AIG is alive and well as one of the top 15 insurers in the U.S. today.

In 2022, the State of Mississippi sued State Farm for minimizing policyholder payouts for Hurricane Katrina. This was done very quietly and out of the public's eye, only brought to light by a public records request by the Sun Herald.

❓ What is the tipping point today for any one large reinsurer or insurer in the U.S., where they will just become Too Big to Fail?

Vicious Cycle

After these natural disasters occur, reinsurers, facing substantial losses, respond by raising premiums or reducing the number of policies they are willing to insure. This creates what the industry refers to as a "hard market." This puts more pressure on insurers and policyholders: higher reinsurance costs get passed down to primary insurers. Do the insurers absorb this cost? Absolutely not! Consumer policyholder premiums are increased, or coverage is limited, in the new "high-risk" areas. In extreme situations, for consumers, this can lead to financial burden or even displacement from a community. No matter the cause of the event, ultimately, the policyholders always pay the price (quite literally).

Solutions & Trends In Today's Market

Increased Capital Reserves

Although there is no implementation date, Basel III Endgame will increase required capital reserves across the entire market. Although there are said to be consumer drawbacks for this, these more strict regulatory requirements, on the surface, seem like they could potentially lead to fewer outright denials, if insurers and reinsurers have the capital on-hand when a disaster strikes.

Parametric Insurance

With Parametric Insurance, there is no lengthy, drawn-out claims process, dealing with fine print. These policies are issued with a set of clear, pre-defined triggers (parameters). If parameters are met, then the claim criteria are met, and the policyholder is paid by the insurer. These policies are often based on a few parameters, such as a combination of a geographic location (such as where your house is sitting), as well as the environmental factors the policy is protecting against, such as earthquake magnitude or wind speed. For example, if an earthquake happens (Parameter 1) within 50 miles of your home (Parameter 2), this policy would be triggered for a payout. Parametric policies are known for reducing disputes and delays in claims processing, and so far, overall, have had a very positive connotation in the market.

Better Modeling & Climate Adaptation

Although our past data does not serve us in the way we need it to, technological advances have helped modeling companies make large strides in catastrophe modeling. The issue stems from the availability and access to these more advanced models. Smaller insurers with less available capital will continue to rely on old, outdated models, as long as their states allow them to use those models, leaving them with less accurate risk assessments and underinsured policyholders. Due to the slowness in changing technology, even at large insurers and reinsurers, these companies, too, may still be using older models because changing technologies is difficult, costly, time consuming, and it ultimately effects overall profitability.

What is the Solution?

The comprehensive solution to these issues plaguing the insurance and reinsurance industries requires a collaborative approach. Heightened regulations are indeed a crucial part of the equation. While heightened regulations are one solution worth exploring, there are other potential strategies that could be considered:

Regulations and Limits on Insurance Company Profitability: Implementing stricter limits on insurance companies' profitability and executive compensation could help ensure that financial gains are more equitably distributed and reinvested into improving services and maintaining adequate reserves. Additionally, tighter regulations on insurance companies' investments could reduce risk exposure and enhance financial stability.
Regulations on Improved transparency: Insurers and reinsurers should be required to provide clearer information about their risk transfer processes and financial health to policyholders.
Regulations on Risk Models: Mandating the adoption of advanced, climate-aware and other catastrophe risk models across the industry, including for smaller insurers.
Public-private partnerships: Collaboration between government entities and private insurers to address coverage gaps in high-risk areas.
Consumer education: Increasing public awareness about insurance products, risk management, risk mitigation, moral hazard, and including parametric insurance options.
Climate change mitigation: Supporting broader efforts to address climate change, which is a root cause of increasing natural disasters.

Ultimately, solving these issues will require coordinated efforts from regulators, insurers, reinsurers, technology providers, policymakers, and policyholders, alike. It's a complex challenge that demands ongoing attention and adaptation as the risk landscape continues to evolve. Because in the world of reinsurance, where "the house always wins," until it doesn’t, our ability to confront these challenges head-on will determine whether the system can weather the storms to come.

Next Up: Insurance Market Dynamics

For those of you interested in getting a little more technical, check out my blog post entitled, "Insurance Market Dynamics: Math & Models Behind the Scenes," where I break down the current mathematical equations and models that are used to represent the issues in the insurance and reinsurance markets today.

America, We Need to Have a Serious Talk: There's Something Wrong with Reinsurance