reinsurance market microstructure don mango guy carpenter
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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