You Know the Market is Hot When Reinsurance Markets Collapse

Reinsurance premiums have collapsed, according to reports from the annual meetings of reinsurers and brokers in Monte Carlo over the weekend. Bloomberg reports that this is due to “…the absence of costly disasters and increasing competition from new entrants…”, but both these reasons strike me as suspect…

For one thing, no self-respecting risk manager would reduce their expectation of a catastrophic hurricane occuring next year just because one didn’t occur this year. For another thing, new entrants into the reinsurance industry are facing the same stochastic world that existing insurers face, so discounting to buy business is potentially fatal. If new entrants are buying business below actuarily fair value then they do so at their peril. Put simply, the risks facing all insurers (new and old) are pretty much unchanged so this cannot be the reason for reinsurance cost falling.

The real reason for insurance premia declining is lack of demand, and this is related to risk aversion. People buy insurance when risk aversion is high – they are prepared to pay away return in order to protect their downside. But as investors become more risk tolerant, their demand for insurance declines. Provided insurers can cover their risk expectations, insurance rates will decline in turn.

The decline in reinsurance premia is just another indication that investors are becoming more risk tolerant. The increasing appetite for risk has driven implied volatilities in option markets lower, stock market valuations higher and led to some flattening of yield curves. Investors are bidding up risk assets, which means that risk premia on offer are declining in tandem. It would seem timely to lighten up on risky assets.

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