In every discipline in finance, an income producing asset is thought to be worth the net present value of its expected future cash flows. Outside of periods of manias and bubbles where the greater fool theory predominates, this is about as uncontroversial and as canonical as you can get.
The one exception to this seems to be in reinsurance.
In reinsurance, there still seems to be a significant portion of the market which views the correct price for income producing reinsurance treaties to be set by the level of returns achieved recently, maybe the last year or so.
Now, occasionally there may be valid reasons for this way of thinking for specific cedants, perhaps as a loss revealed new information about exposures or claims handling.
But for the market as a whole, the clearing price of risk should only respond if new information alters either the view of expected future cash flows or the range of uncertainty around this estimate, which would manifest in a higher cost of capital.
In fact, in every other discipline of finance, this undue attention to recent losses would be recognised as an explicit cognitive bias that leads to sub-optimal decision making. It is called the recency bias.
Now, there is a market where this type of industry model is valid, where a small group of market participants are able to control pricing and market returns for a commodity product. It is called a cartel.
And hey, don’t knock it if you’ve never tried it. Collecting an economic rent for turning up is good work if you can get it. But once the cartel is busted, it doesn’t really behoove you to continue to act as if it was still in place, or to openly pine for it when negotiating with your counterparties.
As has been well documented, the cat cartel was busted by multiple factors, including the proliferation of vendor models that lessened information assymetries, aggressive intermediation ensuring efficient price discovery and market clearing, and reduction of barriers to entry for new capital formation.
With essentially no barriers to entry for new capital (our commodity product), there is no way for incumbents to prevent new entrants trading on expected future cash flows rather than on their recent experience.
What’s unusual about all this is that on some level this is entirely understood by just about everyone in the market. But as psychologists will tell you, there is a difference between intellectually understanding something and knowing it.
Even today, conversations with market participants inevitably revert to an old paradigm of recent loss experience and trailing returns, even if the speaker personally does not trade that way.
It’s as if in trying to understand the market, we all have individually moved on to a new paradigm, but collectively we have not processed that everyone else has moved on too.
That not only do I know we’re in a new paradigm, but that so does my competitor and counterparties. And that they know I know, and I know that they know I know.
This matters, because whatever the finance theory, the real world is still run by human decisions and thus human psychology.
There are signs this is changing. On the record commentary about the upcoming renewals in Florida from leading cat players in my colleagues' reporting this week appeared totally centered on expectations of pricing in higher social inflation, not loss experience per se. (If you haven’t read it you should).
It’s hard to know exactly if this is the market finding religion, or just tactical messaging.
It certainly seems that at least some of the loss “creep” seen in Florida in recent years has not been a failure of models to anticipate market-wide social inflation, but more due to some cedants failing to accurately estimate and disclose their share of market losses in real time.
It remains something of an open question as to whether this has been due to innocent modelling errors or because of deliberate and tactically timed loss disclosures around financial reporting and renewals. The recent allegations at Catco provide an example that this type of tactical disclosure is not alien to our industry,
But perhaps it is more becoming to talk in terms of modelled expectations than finger-pointing on losses.
All else being equal, the stock market doesn’t pay you more this year because your portfolio went down last year. And neither should your cedants.