Oversubscription happens in a reinsurance program when the capacity needs of the buyer – the cedent – are exceeded by the capacity offered by the sellers – the reinsurers.
It is a basic economic phenomenon that if a product sold-out while there were still more parties willing to buy it, then alternatively the product’s price could have been raised to the point where it sold-out at the exact moment when all buyers had purchased their fill. This is in some sense the “right” price – the price where demand meets supply.
In the case of reinsurance, the tables are turned – If more reinsurers express interest in selling risk at a given price than the amount of risk offered, then the price could have been lowered to a point where only those reinsurers willing to sell at the new price point remain. Oversubscription happens in the traditional placement process because this lower price is never found.
It has long been intuitively understood by those in the industry that oversubscription is a signal that the price is too high. However, until now it has been impossible to precisely quantify the resulting cost. In this post, we will use Tremor’s unique market data to quantify the inefficiency consequent to an oversubscribed reinsurance program.
Oversubscription is common in a traditional reinsurance placement. To see why, lets briefly describe how traditional placement occurs. In a standard placement process, the cedent and its broker use indicative pricing from a small subset of the market to set a price for coverage. This price is presented to the market at-large as Firm Order Terms, or FOT, and each reinsurer authorizes the amount of coverage it would like to provide at the FOT. Of course, since FOT are set based limited and sometimes misleading information from a subset of the market, the total amount of coverage authorized by reinsurers will never precisely equal the size of the buyers reinsurance needs, or program. It will always be more – an oversubscription – or less – an undersubscription. In the case of oversubscription, economics 101 says that the price was above the fair market clearing price, inflating cedent costs and necessitating sign-downs that reduce predictability for reinsurers.
One Tremor Advantage: Aggregate Supply
Because of the way that bidding happens on the Tremor platform, Tremor captures information about the market structure of placement events that has never before been possible. We can then process and summarize this data to provide answers to heretofore unanswerable high level questions, such as quantifying the cost oversubscription.
One important piece of summary information that Tremor can produce is a characterization of the Aggregate Supply curve. The aggregate supply curve captures the total amount of coverage that reinsurers have authorized at each price point. In the context of a standard process, this would be equivalent to knowing the total amount of coverage that reinsurers would authorize at each possible setting of the FOT. Since quotes on Tremor specify capacity authorizations at each possible price point, we can use this information to construct aggregate supply.
Measuring The Cost of Oversubscription
It turns out that having access to the aggregate supply curve is the key to measuring the impact of oversubscription. More specifically, the aggregate supply curve allows us to determine the extra cost of reinsurance based on the rate of oversubscription. For an individual program, we look at the price that would lead to a 10% oversubscription, a 20% oversubscription, and so on, and then we compare those to the price at which the program would precisely fill, known as the market clearing price. This tells us, for this program, the extra cost the cedent was overpaying due to the oversubscription. In other words, for a single program, the aggregate supply curve directly tells you the cost of oversubscription.
Here, though, we are interested in estimating the cost of oversubscription broadly, not just for a single program. We can do this by carefully averaging our aggregate supply curve analysis over many treaty programs that have been placed by Tremor. When we do this, we obtain the figure shown below. It shows the average cedent overpayment as a function of the oversubscription percent:
Looking at the figure, you can see that even a modest oversubscription corresponds to a substantial increase in price. For example, a program that is oversubscribed by 25% is likely priced at least 10% above the fair market value.
The Power of Tremor’s Independent Market
With Tremor, oversubscription is a thing of the past, but the solution to oversubscription is not simply an algorithm, process, or product; instead, the solution is a market structure. In order to set prices in a way that a program fills precisely, Tremor must collect and contemplate information about the capacity reinsurers would authorize at each possible price point. Neither cedents nor brokers can collect this information -- for the same reasons that a football coach cannot double as a referee. The kind of rich information needed to clear the market without oversubscription can only be reported to an independent marketplace that both sides of the market trust to confidentially, reliably, and efficiently clear transactions.
Traditional reinsurance relationships hide the reality that a standard reinsurance transaction is a competitive interaction, pitting the cedent’s wits setting FOT against reinsurers’ resolve to drive higher prices. The crux of oversubscription is not a lack of effort from the cedent or broker, but the simple fact that in this competitive world, pricing information and best offers can only be obtained through rounds of slow, costly negotiation. Tremor breaks this vicious cycle by eliminating the competitive battle, yielding substantial efficiency improvements by eliminating oversubscription, expanding capacity, and disincentivizing quote inflation. These drive significant value for cedents, but also benefit reinsurers as they get more control over their allocation and expanded demand for reinsurance.
Undersubscription is also inevitably common. When an undersubscribed program eventually fills at FOT, aggregate supply data allows us to estimate the price inflation implicit in reinsurers’ initial quotations.