The Pros and Cons of (De)Centralization When Placing Facultative
January 28, 2015| By Chris Crowder | P/C General Industry | English
The following question was posed recently by a client:
"Is it better to place Facultative from a centralized purchase point (i.e., Home Office), or on a decentralized basis (i.e., the Field)?"
In considering the question, a colleague shared a letter written by one of our former CEOs. The letter was his response to another client asking the same question. Over the years, we have seen insurance companies flip flop between the two approaches, usually in conjunction with a change in management. There are pros and cons to both approaches and, like most people, I have a bias so I'll recap what he said in the letter and let you judge for yourself.
In favor of Centralization:
- Efficiency - This sometimes means "buying the cheapest." Never mind whether buying the cheapest anything usually works out with complex financial products [note author's irony]. I'm still trying to figure out how it could be considered "more efficient" to have folks in the field call someone in their home office and ask that person to turn around and place reinsurance for them.
- Control - Sometimes this means "buying less" and other times it means making sure that what they are buying aligns with their treaty and net appetite. It also means making sure they are tracking what they buy so they can match that up when a claim comes in on the original policy. This was a real issue "back in the day" but with technology and data advances in recent years, matching Fac purchases to Primary claims shouldn't be a deciding factor.
- Economic factors - I have lost count of how many times someone in Finance has been surprised and said, "We paid more in (re)insurance costs than we got back in claim collectibles?" No kidding. And what do you say when your insureds tell you that? I'm pretty sure that’s the underlying principle of (re)insurance. If it were the other way around, how long would your (re)insurers remain in business? We all take plenty of risk and generally get paid appropriately for it. And there is certainly no lack of competition to keep us honest.
In favor of DeCentralization, these are the obvious factors:
- Communication, as in clarity of communication - Ever played the "telephone" game where you whisper something into a person’s ear, then that person turns and does the same to someone else, and so forth? It’s funny to hear what comes out the other end when it’s done for fun. Not so funny when you are trying to protect yourself against a catastrophic exposure. "Many hands make light work," is one rule that definitely does not apply in this situation.
- Subsidiarity and Information = "Ownership" - The closer that ownership/responsibility for the end result is to the front line assumer of risk (i.e., the underwriter), the better it usually turns out. Who better knows the territory, producer and insured risk than the front line underwriter? In our experience, the further away from the front line underwriter that the decision to purchase Fac is made, the less it reflects or lines up with the underlying exposure.
- Two heads/Four eyes - No, we're not talking “Return of the Alien.” Accessing a topnotch Fac market means your underwriters are dealing with people who handle the volatile end of the risk spectrum every day. When your underwriter sees a tough risk only a handful of times a year, it has to help your bottom line to have someone who deals with such risks every day casting their eyes over the risk, and sharing his or her market experience as respects coverage, structure, terms and conditions, and pricing.
- Locals talking to Locals - Again, there’s nothing wrong with calling in "the experts" from out of town to help out with a Fac placement. But usually local knowledge goes a very long way. Reinsurance is no different. When your centralized placer of Fac has to figure out the nuances of the local placement, and then explain it to someone who also doesn't understand those nuances, well...you can see how that is going to end up.
Less obviously, there are hidden costs ("opportunity costs") to Centralized placements:
- The risk you never should have taken at the offered market terms. Without diving into the math, trust me when I say that you have a much higher chance of writing your “mistakes” than not. Centralized placements tend to focus on one thing in their conversation with the Fac market. That is, getting the Fac placed rather than talking about whether you should do the risk at all in the first place. Fac will never make a “bad” risk into a good one, although it certainly can lessen the sting on a volatile risk.
- The risk you should have written, but didn't. This is the toughest one to quantify because no one measures it. You didn't write the deal because it was too much of a hassle to run it up the flagpole (for Fac), for a variety of reasons. In the end, with limited time and resources, it can be easier to offer less capacity, place restrictive terms on it, or simply decline it outright (a.k.a. “the path of least resistance”), which leads to unhappy producers (agents/brokers).
To me, the bottom line is what I would do if I were running a primary insurance operation. I would opt for the decentralized model in a minute. Granted, I would want to do so with the right controls in place, including strong financial credentials, acceptable contract wordings, and appropriate monitoring of Facultative activity and results.
I will close with a quote from that long-retired reinsurance veteran who penned that letter many years ago,
"Net-net, I believe the decentralized system would contribute more to shareholder value than the centralized system."
In my 30-plus years of experience in this business, companies that behave in the former way seem to have better net results in the long-term. And that is pretty much “the bottom line.”