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					Reinsurance Market
Microstructure
Don Mango
Guy Carpenter
2
Capital Market Microstructure
Major 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

                                                                   3
Continuous Double Auction



   Standard mechanism for price            Buy limit orders are BIDS
    formation in most modern financial
    markets                                 Sell limit orders are ASKS or OFFERS

   Two types of orders:                    At any given time, there exists
     – Market orders – requests to buy – BEST (lowest) ASK price and
       or sell a given number of shares – BEST (highest) BID price
       immediately at best available
       price (impatient traders)            The difference is called the BID-ASK
                                             SPREAD
     – Limit orders – worst allowable
       price to transact with a time limit; Each Bid or Ask has the following
       not always immediately                properties: a price, volume, and time
       transacted, so stored in a queue limit
       known as an order book
                                            Midprice = (BID + ASK)/2




                                                                                     4
 Continuous Double Auction
                                                                             Figure 1
                                                                      Theoretical Order Book
                                                                 ASK to SELL           BID to BUY 
 Theoretical Order Book




                                              HIGHER PRICE 
   – Continuous = no price gaps
   – Deep = ability to satisfy any market
     order without price impact                                                          Realistic Range

 One such order book exists for each
  security                                                      Smooth
                                                                Curve =
 Changes over time as quotes expire or                        Continuity                Best Bid




                                                                                                               ORDER SIZE
  are removed, or orders are filled




                                                                                                                  AXIS
 Maximum depth = all available shares
  (stock) or notional outstanding (bonds)


                                               LOWER PRICE
 Quoting costs, herding effects limit the                           Best Ask                Mid-Price
  realistic range to be within certain
  bounds of Mid-Price
   – I.e., not feasible to produce infinite
     quotes for all possible prices                                                               Order Size
                                                                                                   = Depth



                                                                                PRICE AXIS
                                                                                                                 5
 Focus on Realistic Range
                                                                           Figure 2
                                                                     Realistic Order Book
                                                              ASK to SELL         BID to BUY 
 Actual Order Book
   – Discrete not continuous = composed




                                              HIGHER PRICE
     of individual quotes
   – Each quote represents the




                                                   
                                                                                    Excess
     willingness of an individual market                                            Supply
     participant (agent) to buy or sell
   – Minimum Price increments = ticks
   – Order book can be sparse (have
     gaps)                                                   Transaction

   – Market makers are supposed to fill


                                             LOWER PRICE
     out gaps in order book, but this can
     be costly if they have to keep                              Excess
     position net                                                Demand

 Transaction occurs when a Sell Order
  can be matched to a Buy Order




                                                                                                  6
    Liquidity Crisis = Sell Off
                                                                           Figure 3
                                                                   Liquidity Crisis Sell Off
                                                              ASK to SELL          BID to BUY 
     Not enough Buyers anywhere near
      the Mid-Price




                                              HIGHER PRICE
     Sellers have two choices:
                                                                                      Demand




                                                   
    1. Be patient = hold their Asking                                                 Dried Up
       price constant, wait for market to
       stabilize and liquidity to return
       (temporary market failure)                                  Excess
    2. Lower their Asking price to the                             Supply
       level necessary to find a Buyer                                                   Mid-Price

     Each lowering demonstrates                                Large Gap in


                                             LOWER PRICE
      impatience, creates incentives for                         Order Book
      Buyers to put new Orders even
      lower
     This is the mechanics of a price
      drop!!




                                                                                                     7
Price Movement in a Continuous Double Auction

 “What really causes large price
  changes?” Farmer et al*, 2004
                                            Midprice can move due to arrival of:
 High density of limit orders per price      – Market order bigger (in volume)
  (“full order book”) results in high           than the opposite best quote widens
  liquidity for market orders  implies         the spread by increasing Best Ask if
  small movement in the best price              it is a buy order, or decreasing Best
  when a market order is placed                 Bid if it is a sell order
 Price movement is not uniquely              – Limit order inside the spread
  defined, but midprice is often used         – Cancellation of a limit order




     * www.santafe.edu/~baes/jdf/papers/fluctFinal.pdf

                                                                                    8
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




                                                                   9
Demonstration of Price Movement
                                         Figure 4
                             Liquidity and Price Movement Example

                           Filling a Market Sell Order for 600 Shares
                             Under Low Liquidity and High Liquidity

                                  Low Liquidity Order Book
                         Pre-Transaction                                 Post-Transaction
                                                       Shares to Fill
                Bid #         Bid Price   Bid Shares Market Order                  Bid #    Bid Price
                     1               35           100           100
                     2               34           200           200
                     3               33           300           300
                     4               32           400                                  4          32
                     5               31           500                                  5          31
        Best Bid Price               35                                   Best Bid Price          32


                                  High Liquidity Order Book
                         Pre-Transaction                                 Post-Transaction
                                                        Shares to Fill
                Bid #         Bid Price    Bid Shares Market Order                 Bid #    Bid Price
                     1               35           600            600
                     2               34           600                                  2          34
                     3               33           600                                  3          33
                     4               32           600                                  4          32
                     5               31           600                                  5          31
        Best Bid Price               35                                   Best Bid Price          34

                                                                                                        10
Reinsurance Market Auction (RMA) Structure

 Not continuous but timed (effective        Three phases:
  date, renewal cycle)
                                             (I) Price Exploration and Quote
 Synchronized blind auction (no way to       Development,
  see other Asks or Bid)
 There is an order book of Asks
                                             (II) Asking Price Development, and
  maintained by the Broker                   (III) Firm Order Terms
 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)




                                                                                   11
RMA Phase I
Price Exploration and Quote Development



                                Figure 5
                               RMA Phase I

                                                        Reinsurer 1

                                         Submission
                                                        Reinsurer 2
    CEDANT                     BROKER

               Proprietary
                                        Quotes (Asks)   Reinsurer 3
              Portfolio Info

                                                             …




                                                                      12
RMA Phase II
Asking Price Development




                           13
RMA Phase III
Firm Order Terms

                         Figure 6
                       RMA Phase III
          Firm Order
             Terms


                                 Reinsurer 1

         BROKER
                                 Reinsurer 2
                                               Price and
                                                Strategy
                                 Reinsurer 3   Evaluation
         CEDANT

                                      …

                                 Reinsurer n
                       Desired
                        Share

                                                            14
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.


                                                                          15
Price Movement in Reinsurance Auction

 More difficult to define price      Price moves due to changes in
  movement than in capital markets     Asking Prices:
                                        – Technical Price changes:
 Far fewer sequential data points        innovations in loss cost estimates;
  (annual)                                increased profit margins (e.g.,
 Dissimilar products cross-              post Sept 11)
  sectionally and over time             – Strategic differentials
   – Product lines                          Blind auction, signals or
   – Cedants                                 anticipation of other actions
   – Opaque differences in features     – Liquidity = market depth
   – Different underlying portfolios        Enough signed lines at a given
   – Brokers estimate comparable             price to fill out the program
     pricing




                                                                            16
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




                                                                              17
Reinsurance Market Liquidity Crisis
2006 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.




                                                                       18
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


                                                                          19
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.




                                                                         20
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.


                                                                                21
22
Reinsurance Market
Microstructure
Don Mango
Guy Carpenter

				
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