Reinsurance Market Reinsurance Market MicrostructureMicrostructureDon MangoDon MangoGuy CarpenterGuy Carpenter

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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

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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

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Continuous Double Auction

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 BID to BUY

L

OW

ER

PR

ICE

HIG

HE

R PR

ICE

Smooth Curve =

Continuity

Order Size = Depth

Mid-Price

Best Bid

Best Ask

Realistic Range

Figure 1Theoretical Order Book

PRICE AXIS

OR

DE

R S

IZE

AX

IS

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Focus on Realistic Range

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 BID to BUY

L

OW

ER

PR

ICE

HIG

HE

R PR

ICE

Transaction

Excess Demand

Excess Supply

Figure 2Realistic Order Book

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Liquidity Crisis = Sell Off

Not enough Buyers anywhere near the Mid-Price

Sellers have two choices:

1. Be patient = hold their Asking price constant, wait for market to stabilize and liquidity to return (temporary market failure)

2. 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 BID to BUY

L

OW

ER

PR

ICE

HIG

HE

R PR

ICE

Mid-Price

Excess Supply

Demand Dried Up

Large Gap in Order Book

Figure 3Liquidity Crisis Sell Off

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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

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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

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Demonstration of Price Movement

Figure 4Liquidity and Price Movement Example

Filling a Market Sell Order for 600 SharesUnder Low Liquidity and High Liquidity

Low Liquidity Order BookPre-Transaction Post-Transaction

Shares to FillBid # Bid Price Bid Shares Market Order Bid # Bid Price

1 35 100 1002 34 200 2003 33 300 3004 32 400 4 325 31 500 5 31

Best Bid Price 35 Best Bid Price 32

High Liquidity Order BookPre-Transaction Post-Transaction

Shares to FillBid # Bid Price Bid Shares Market Order Bid # Bid Price

1 35 600 6002 34 600 2 343 33 600 3 334 32 600 4 325 31 600 5 31

Best Bid Price 35 Best Bid Price 34

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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)

Three phases:

(I) Price Exploration and Quote Development,

(II) Asking Price Development, and

(III) Firm Order Terms

Reinsurance Market Auction (RMA) Structure

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RMA Phase I Price Exploration and Quote Development

BROKERCEDANT

Reinsurer 1

Reinsurer 2

Reinsurer 3

Submission

Quotes (Asks)Proprietary Portfolio Info

…

Figure 5RMA Phase I

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RMA Phase II Asking Price Development

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RMA Phase III Firm Order Terms

BROKER

CEDANT

Reinsurer 1

Reinsurer 2

Reinsurer 3

Firm Order Terms

…

Figure 6RMA Phase III

Reinsurer n

Desired Share

Price and Strategy

Evaluation

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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 price due 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.

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Price Movement in Reinsurance Auction

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

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

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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

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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.

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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

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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.

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Results

1. PMLs increased

2. Required purchasing increased

3. Layer loss cost estimates increased

4. Available supply decreased –increased rating agency stringency and the loss of retrocessional capacity

5. 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.

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Reinsurance Market Reinsurance Market MicrostructureMicrostructureDon MangoDon MangoGuy CarpenterGuy Carpenter