Reinsurance Market Microstructure

1. Don MangoGuy Carpenter Reinsurance Market Microstructure

3. Capital Market MicrostructureMajor Components* • Price formation and discovery: how latent investor demands are translated into realized prices and volumes • Market structure and design: relation between price formation and trading protocols • Information and disclosure: transparency, ability of market participants to observe information about the trading process *”Market Microstructure: A Survey,” Ananth Madhavan, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=218180

4. Continuous Double Auction • Standard mechanism for price formation in most modern financial markets • Two types of orders: • Market orders – requests to buy or sell a given number of shares immediately at best available price (impatient traders) • Limit orders – worst allowable price to transact with a time limit; not always immediately transacted, so stored in a queue known as an order book • Buy limit orders are BIDS • Sell limit orders are ASKS or OFFERS • At any given time, there exists • BEST (lowest) ASK price and • BEST (highest) BID price • The difference is called the BID-ASK SPREAD • Each Bid or Ask has the following properties: a price, volume, and time limit • Midprice = (BID + ASK)/2

5. Continuous Double Auction Figure 1Theoretical Order Book BID to BUY  • Theoretical Order Book • Continuous = no price gaps • Deep = ability to satisfy any market order without price impact • One such order book exists for each security • Changes over time as quotes expire or are removed, or orders are filled • Maximum depth = all available shares (stock) or notional outstanding (bonds) • Quoting costs, herding effects limit the realistic range to be within certain bounds of Mid-Price • I.e., not feasible to produce infinite quotes for all possible prices ASK to SELL Realistic Range HIGHER PRICE  Smooth Curve = Continuity Best Bid ORDER SIZE AXIS Mid-Price Best Ask  LOWER PRICE Order Size = Depth PRICE AXIS

6. Focus on Realistic Range Figure 2Realistic Order Book BID to BUY  • Actual Order Book • Discrete not continuous = composed of individual quotes • Each quote represents the willingness of an individual market participant (agent) to buy or sell • Minimum Price increments = ticks • Order book can be sparse (have gaps) • Market makers are supposed to fill out gaps in order book, but this can be costly if they have to keep position net • Transaction occurs when a Sell Order can be matched to a Buy Order ASK to SELL HIGHER PRICE  Excess Supply Transaction Excess Demand  LOWER PRICE

7. Liquidity Crisis = Sell Off Figure 3Liquidity Crisis Sell Off BID to BUY  • Not enough Buyers anywhere near the Mid-Price • Sellers have two choices: • Be patient = hold their Asking price constant, wait for market to stabilize and liquidity to return (temporary market failure) • Lower their Asking price to the level necessary to find a Buyer • Each lowering demonstrates impatience, creates incentives for Buyers to put new Orders even lower • This is the mechanics of a price drop!! ASK to SELL Demand Dried Up HIGHER PRICE  Excess Supply Mid-Price Large Gap in Order Book  LOWER PRICE

8. Price Movement in a Continuous Double Auction • “What really causes large price changes?” Farmer et al*, 2004 • High density of limit orders per price (“full order book”) results in high liquidity for market orders  implies small movement in the best price when a market order is placed • Price movement is not uniquely defined, but midprice is often used • Midprice can move due to arrival of: • Market order bigger (in volume) than the opposite best quote widens the spread by increasing Best Ask if it is a buy order, or decreasing Best Bid if it is a sell order • Limit order inside the spread • Cancellation of a limit order * www.santafe.edu/~baes/jdf/papers/fluctFinal.pdf

9. Price Movement in a Continuous Double Auction (cont’d) • Liquidity = measure of market depth and continuity • Depth = amount of shares available • Continuity = orders close together, not spaced far apart • Low liquidity can lead to large price movements when filling orders • Depth of order book is a representation of individual investor appetite for positions

10. Demonstration of Price Movement

11. Reinsurance Market Auction (RMA) Structure • Three phases: • (I) Price Exploration and Quote Development, • (II) Asking Price Development, and • (III) Firm Order Terms • Not continuous but timed (effective date, renewal cycle) • Synchronized blind auction (no way to see other Asks or Bid) • There is an order book of Asks maintained by the Broker • Two types of orders: • Bid = what a cedant thinks they should pay for the reinsurance • Quotes (Asks) = what a reinsurer offers to sell the reinsurance • Each Bid or Ask has the following properties: a price, volume, and time limit • Type of agent determines type of order: • E.g., Reinsurer does not Bid, only one Bid (from cedant itself)

12. RMA Phase I Price Exploration and Quote Development

13. RMA Phase II Asking Price Development

14. RMA Phase III Firm Order Terms

15. Arbitrage Opportunities in the RMA? • Identification of a possible arbitrage? • Involves private contract between cedant and the reinsurers • Final value of this contract is private, so traded derivatives are unavailable. • No short-selling • Can the RMA punish a reinsurer whose asking price is wildly divergent from the consensus range of quotes? • Over-Priced Re might be asking more than other markets because: • Higher technical pricedue to a higher indicated layer loss cost, higher internal expense requirements, or a higher profit load; • Higer strategic differential due to a desire to nudge the final price upward or indicate weak interest. • The RMA results for Over-Priced Re: a low (or no) share being offered. That’s the extent of the market punishment.

16. Price Movement in Reinsurance Auction • Price moves due to changes in Asking Prices: • Technical Price changes: innovations in loss cost estimates; increased profit margins (e.g., post Sept 11) • Strategic differentials • Blind auction, signals or anticipation of other actions • Liquidity = market depth • Enough signed lines at a given price to fill out the program • More difficult to define price movement than in capital markets • Far fewer sequential data points (annual) • Dissimilar products cross-sectionally and over time • Product lines • Cedants • Opaque differences in features • Different underlying portfolios • Brokers estimate comparable pricing

17. Price Movement in Reinsurance Auction (cont’d) • Could have some degree of consistency on approach to Technical Price derivation • But there are many valid reasons why that would and perhaps should differ among competitors • If Strategy differentials were zero everywhere, market quotes would at least reflect legitimate cost differences (where cost includes desired profit margin) and could be called “high information content” • Informational Reductions: • Modification of technical price (esp. loss cost) to make market price appear more appealing • Strategy differentials: invisible changes in price that may or may not represent any “information,” merely positioning or other incentives

18. Reinsurance Market Liquidity Crisis2006 U.S. Property Catastrophe Reinsurance • “Perfect storm” of influences led the U.S. catastrophe reinsurance market to what can only be called a liquidity crisis • U.S. insurers were unable to purchase reinsurance in the desired quantity at anything resembling the expiring prices • Systemic crisis, striking across the board • The RMA mechanics that led to this crisis were: • Catastrophe model changes, • Changes to rating agency capital formulas, and • Loss of retrocessional capacity.

19. Catastrophe Model Changes • Reinsurers and brokers use catastrophe models for layer loss cost, program pricing and structuring. • Insurers base their catastrophe reinsurance purchases on: • Key PMLs like 1-in-100 year and 1-in-250 year occurrence loss; • Prior year reinsurance purchasing, often defined in terms of program attachment and exhaustion return periods; and • Peer purchasing decisions, again in terms of return periods. • Discipline around cat modeling is so ingrained in this market that variations in that variations in quotes (asking prices) among reinsurers is low • Variations in quotes are due to internal expense loads, profit loads, and strategy differentials. • 2006 RMS introduced version 6.0 of US Hurricane, leading to dramatic increases in PMLs and layer loss costs

20. Rating Agency Changes • Fall 2005, A.M. Best changes BCAR formula. • Previous BCAR subtracted after-tax impact of one net catastrophe PML (one-in-100 wind event or one-in-250 earthquake event). • In mid-2005, A.M. Best introduced a stress test to monitor the impact of a second catastrophe event on the BCAR for all insurers. • Reinsurers responded by reducing limits in high catastrophe zones, as well as attempting to move exposures to retrocessionaires, sidecars or catastrophe bonds. • Similarly, on March 21, 2006, Standard & Poor’s revised its criteria to include an exposure-based catastrophe capital charge for insurers, similar to the capital charges for reinsurers.

21. Results • PMLs increased • Required purchasing increased • Layer loss cost estimates increased • Available supply decreased –increased rating agency stringency and the loss of retrocessional capacity • Price for that reduced supply increased – due to the substantial deficits from 2004 and 2005, the owners of reinsurers targeted higher returns, which translated to higher profit margins underlying the quotes. Liquidity Crisis • Many large U.S. insurers, with exposure across the country, were unable to place their desired programs. • Could not buy the desired amount of limit even if they raised their bids. • Liquidity breakdown was not a price issue, but a capacity issue. • The supply of additional reinsurance capacity (cat bonds, sidecars) could not grow quickly enough.

23. Don MangoGuy Carpenter Reinsurance Market Microstructure