"The fact that we are retaining more of the risks we underwrite demonstrates to quality reinsurers that it is in our best interests to control losses and make profits."
New model creates balance between
ceding and retaining risks
By Phil Zinkewicz
"The fact that we are retaining more of the risks we underwrite demonstrates to quality reinsurers that it is in our best interests to control losses and make profits."
--Detlef Steiner, CEO, Clarendon Insurance Group, New York, New York
In 1999, when Germany-based reinsurer Hanover Re decided to purchase the U.S. specialty insurance group Clarendon, everything seemed to be "coming up roses," as the song goes. Clarendon was writing program business with considerable success, having posted net income of $13 million the year before Hanover Re entered the scene. At the time Hanover completed its acquisition, the company had net income of $59 million. But a year after the acquisition, Clarendon Insurance Group posted a $1.8 million net loss and in 2001 the net loss posted was $38 million.
What happened? Several things, really. First, like many other insurers, Clarendon was paying the price for overextending itself during the soft market years of the 1990s. Also like many other insurers, Clarendon needed to increase its loss reserves to compensate for business it had underpriced.
But Clarendon was facing another, more serious problem: The reinsurance market was undergoing a metamorphosis. In the past, reinsurers' dealings with primary insurers were relationship-driven. If a reinsurer had a long-term relationship with a primary insurer and wanted that relationship to continue, often that reinsurer would look the other way and pay questionable claims. But, by the turn of this century, things had already begun to change. Stung by large losses from previous years, reinsurers began to seriously question claims from primary insurance companies, long-term relationships notwithstanding. September 11 only exacerbated the situation, so today reinsurers are quicker to deny claims even at the risk of protracted court battles. For primary carriers, reinsurance collectibles have become a major problem.
At the time of the Hanover Re acquisition, Clarendon operated exclusively as a fronting company--writing program business through managing general agents (MGAs), then ceding most of that business to reinsurers. Clarendon's success up to the point of the Hanover Re acquisition resulted from making money from ceding commissions. But when reinsurers started refusing to pay claims, Clarendon's problems really began to surface.
In order to turn Clarendon around, Hanover Re turned to Detlef Steiner, a former Hanover Re executive board member and now Clarendon's chief executive. When Steiner took the helm of Clarendon in 2001, the first thing he did was throw out the insurer's fronting model. At one time, Clarendon had been reinsuring 80% to 100% of the risks it took on. Steiner eventually reduced that proportion to approximately 30% to 40%.
"When the market was soft," says Steiner, "Clarendon was making money on its comfortable fee level. But management did not monitor the programs it was writing for overall profitability. Consequently, reinsurers were hit with the losses. Some of them exited the program market and did not pay."
That left Clarendon with hundreds of millions in reinsurance recoverables that were in dispute. Today, says Steiner, Clarendon is very close to clearing up the recoverables problem, but the insurer is now operating under a new model. By retaining more of the risks it writes, Clarendon now makes its profits from a combination of ceding commissions and the underwriting profit from the business it keeps.
Of course, "underwriting profit" is the operative phrase here. In order to achieve an underwriting profit, Clarendon has had to exercise much tighter underwriting controls than when it was ceding all of its business.
"The fact that we are retaining more of the risks we underwrite demonstrates to quality reinsurers that it is in our best interests to control losses and make profits," says Steiner. "And, because of the hard market with its increased prices, we have done well on the underwriting side. Because of the bad experience that some people have had in program business, many have deserted the concept as unworkable, but this is not true."
Steiner maintains that program business still has great profit potential, but only if insurers recognize that it was the "fronting" element that caused program business to fall into disrepute. "When people talk about program business, they all agree that programs involve homogeneous lines of business," says Steiner. "But they forget that writing program business depends to a great extent on the outsourcing of the functions closer to the policyholder."
Here Steiner is talking about the managing general agent concept, which he believes is program business's greatest strength. "Because of outsourcing, program business is an incredibly efficient model. Rather than maintaining extensive back-office facilities to produce and process the business, in program business the personnel needs are reduced and processing expenses are capped based on the arrangement with the general agent," he says.
Therefore, according to Steiner, homogeneous lines of business and outsourcing functions that are closer to the policyholder are the two critical elements of program business. The question, however, is how to make it work. After all, primary insurers have been using the services of managing general agents to write program business for years, and the marriages have not always been successful. It must also be pointed out that when Clarendon experienced its difficulties, part of the problem was that it was using MGAs that were producing bad business which Clarendon was passing on to reinsurers.
"Sound underwriting standards that both insurers and general agents adhere to are key to making program business work," Steiner says. "Underwriting was not really a concern when program business was primarily fronted. In our new model of program business, profit is made on the program itself, not the fee, so underwriting cannot be ignored. Program insurers are retaining an increased amount of risk and must enact strict underwriting due diligence on all programs to be successful. Today's professional managing general agents must understand that following strict underwriting standards is the only way to ensure profitable programs and meet their own needs, as well as the needs of insurers and reinsurers. When underwriting controls are matched with the efficiency of the outsourced program business model, the industry will not be able to ignore the results. When conducted the right way, program business has built-in advantages that allow it to outperform the traditional business model by a substantial margin."
Therefore, Steiner says, Clarendon is interested in building strong relationships with MGAs who are diligent in following underwriting standards and who work only with retail agents who have the same conviction. "We're not looking for program business on a line basis. We are looking for MGAs that exercise control over their business whatever line the program involves."
The Clarendon chief also says he is intent on accepting only business that shows profitability, especially now that the company is retaining more risk. When Steiner first took charge of Clarendon, he began by not renewing fully 50% of existing program business. What's more, Clarendon audits each program it takes on. "If we don't find that it is being managed properly by the general agent, we don't take the business," he says.
Will Clarendon's new approach to program business remain in place if and when the market turns soft once more? Steiner laughs at the question, saying he has been asked that many times. "We will not give up our profitability check of program business on a gross basis," he says. "Nor will we ever go back to being exclusively a fronting company. If we see that we can make more money in a soft market by ceding more business, we might change the percentage of our ceded business versus retained business, but we will always seek to retain as much risk as possible." *
For more information:
Clarendon Insurance Group
Web site: www.clarendon-ins.com