Reinsurance Innovation Committing to the Leading Edge

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by Chris McKeown

The threats to which reinsurers’ capital is exposed seem to multiply with alarming regularity. Today, the industry is contending with risks that were barely imaginable 20 years ago at best. In an age when carriers must respond to casualty catastrophes, the possible effects of climate change, and financial market calamity – often all on the same earnings call – it is natural to wonder if the right tools and techniques for the job are available. Risk and capital management have only grown in complexity, a trajectory that is likely to continue and probably accelerate.

Many reinsurers instinctually look for ways to cope with these developments using practices and technology already at their disposal. This may work as a stopgap measure, but the emergent risk eventually outpaces the capabilities of those tools. Risk managers, in the process, are forced to assess considerable amounts of risk often with resources insufficient to the task. To call this a crisis of capital management, however, would be to willingly conceal the underlying cause: a lag in innovation.

Catastrophe models, economic capital models, and enterprise risk management (ERM) are but a few of the advances made by the reinsurance industry in addressing an ever-evolving risk environment. Innovation is ongoing, perpetually inspired as the intellectual capacity of the industry adapts existing premises, methods, and technology to create new applications that more accurately address increasingly complex risks. Innovation shows in the development of fresh solutions to old problems and the refinement of existing mechanisms.

The existence of innovation and its potential to build and serve a thriving reinsurance marketplace depends on the industry’s willingness to understand its nature, the necessary investment, and the inherent risks – as well as rewards. This is the double-edged sword of innovation.

Innovation can be a source of competitive advantage. A reinsurer – or service provider (e.g., a reinsurance intermediary) – devises a solution to a particular challenge that the industry faces. It results in improved risk or capital management, for example, leading to enhanced margins, the optimization of capital deployment, or expense management. Since the innovator – or early adopter of a service provider’s new idea – has access first, it realizes the benefit ahead of competitors that wait for the trend to crystallize.

We saw this dynamic at work with property catastrophe models in the 1990s. At first, adoption was slow, with cedents earlier in the cycle gaining an edge. Hesitation naturally arose as the industry considered a shift from traditional rule-of-thumb risk assessment to the complex calculations of probability and severity served up by a computer. Wide acceptance of modeling only began to grow after major natural catastrophe losses in the early part of the decade, when the existing mode of doing business revealed itself to be painfully insufficient.

Of course, catastrophe models are now ubiquitous, a consequence of good ideas being absorbed and becoming more common over time. When this happens, the advantage dissipates, and adoption starts to become the price of admission to the marketplace. With each subsequent adopter of an innovative solution, the solution itself becomes less “new” until, eventually, it is a de facto operating standard.

The evolution of catastrophe models follows this dynamic. Once leading edge, the concept is now de rigueur. Yet, within the catastrophe model segment, innovation continues – from improvements to the models by their developers to the creation of extended capabilities, such as Guy Carpenter’s i-aXs platform. Those among the first to embrace the innovation are still at the leading edge of that technology today through their continued endeavors.

The innovation cycle is continuous. As techniques and solutions are introduced and absorbed, the next generation is already being planned and developed. Thus, it is incumbent upon reinsurers to decide what positions they will take regarding the leading edge. To be an early adopter entails a continual commitment to spotting, developing, and implementing new ideas. It’s not something that can be done once and forgotten.

Alternatives to staying at the front of the industry do exist: there are several points at which a company can enter the innovation cycle. Some may opt to watch the experiences of competitors on the “bleeding edge,” only adopting the innovations that are most likely to gain traction, while others may wait for commoditization or get on board when market conditions leave them no choice. The costs – financially and in terms of other company resources – may be higher at the tip of the spear, but the returns tend to be far greater. Ultimately, a company needs to make a deliberate decision on where in the lifecycle to adopt emerging solutions; an ad hoc approach can be disruptive, expensive, and unproductive.

For innovators and early adopters, the challenge is to identify the likely game-changers and integrate them into their operations smoothly and quickly. Doing so can lead to new business opportunities, improved margins, and growth in shareholder value. It takes dedication, though. A company has to accept a higher resource commitment and a bit of uncertainty. The rewards, meanwhile, tend to justify the internal angst.

Those who invest in and prioritize research and development – and introduce new tools and ideas – benefit from more than just the prestige of being first. Early movers define the standard to which others will have to adapt later. They shape the development of innovation, and thus its evolution, as it moves from a radically new idea to an accepted marketplace practice. In possessing this control, they hold the upper hand over their competitors, which become weighted with the burdens of the catch-up clamor.

To see this dynamic in action, look to the proliferation of ERM. As this holistic approach to managing risk and capital became an-oft repeated mantra, the companies early to accept it became first to develop practical solutions that advanced the concept further. The experts of Guy Carpenter were able to use their experience and understanding of other models and early casualty versions – fraught with limitations and insufficient historical data – to create better solutions. This also contributed to Guy Carpenter’s development and subsequent advancement of MetaRisk, the company’s proprietary capital modeling platform. The maturation of ERM frameworks called for increasingly robust tools, with MetaRisk providing the resources necessary to understand the implications of different capital management decisions.

The push forward continues with the next evolution in modeling, for casualty risk. Over the last several years, a globally intertwined business community and the inextricable tangle of carriers’ insurance supply chains induced a call for new solutions. In response, Guy Carpenter, along with Arium, Ltd., is creating a Casualty Cat model that tracks primary and derived risks throughout a portfolio and identifies accumulated exposures.

Innovation must be continual, because of the lifecycle that governs it. If you’re not innovating (or adopting) now, you’re falling behind. The advantages of one innovative solution are quickly outpaced when another is developed or that same solution is adapted to new situations; and if the originator is not doing the work to make those leaps, the reputation of innovation can be quickly lost.

Constant attention must be paid to emerging ideas and developments within the industry. Internally, vigilance detects where current solutions may be lacking and what risks on the horizon may call for new tools. Priorities must be placed on encouraging innovation and insight throughout the organization; no matter what the intellectual store of a company, without the means to both express and act on insight and creativity, it will not keep pace.

Guy Carpenter has positioned itself at the cutting edge of model development, with industry-first models, including CASUS, LEAD, European flood models and REVEAL, and platform initiatives like i-aXs and MetaRisk. Riding the leading wave of innovation earns companies a reputation that proves not only a company’s ability to serve its clients the most advanced risk management solutions, but also assures those organizations seeking commonplace tools that the service provider they have chosen is at the top of its field. Keeping that edge of innovation sharp preserves these advantages.

Innovation requires a dedication to research, creativity, resources, and foresight. Above all, it takes courage to accept the risks. In fact, the best companies learn from occasional mistakes. Of course, a position on the “bleeding edge” of innovation presents a set of risks with which all companies may not be comfortable. It requires careful gauging of the advantages of being first against the risks of unproven innovation. This stance is taken before the marketplace has decided which way it will lean towards a solution, which has either not yet been openly discussed or is the subject of conflicted debate. As with all risks, however, there are ways to mitigate through consistent and thorough investment in research and testing.

The advantages of innovation leadership are as dramatic as the risks may appear. A leadership position enables a company to wield the double-edged sword of innovation, as opposed to being a victim of responding to its strike. It distinguishes an organization, forging a reputation that carries throughout the enterprise. Innovation moves a company ahead of its competitors while nourishing the marketplace. A company’s innovative ideas further enrich its industry, both enhancing its relevance and improving its returns.

Chris McKeown is CEO of Guy Carpenter & Company’s Global Analytical and Specialty Practices. Based in Boston, he oversees the firm’s Instrat® unit, its line of business specialties, and the Rating Agency Advisory, ERM Advisory, and Business Intelligence units. Mr. McKeown can be reached at .