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
 Sell limit orders are ASKS or OFFERS
markets
 At any given time, there exists
 Two types of orders:
– 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
 The difference is called the BID-ASK
price (impatient traders)
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
 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
BID to BUY 
Realistic Range
Smooth
Curve =
Continuity
Best Bid
Mid-Price
Best Ask
ORDER SIZE
AXIS
 Changes over time as quotes expire or
are removed, or orders are filled
HIGHER PRICE 
 One such order book exists for each
security
 LOWER PRICE
 Theoretical Order Book
– Continuous = no price gaps
– Deep = ability to satisfy any market
order without price impact
 ASK to SELL
Order Size
= Depth
PRICE AXIS
5
Focus on Realistic Range
Figure 2
Realistic Order Book
 Transaction occurs when a Sell Order
can be matched to a Buy Order
BID to BUY 
Excess
Supply
Transaction
 LOWER PRICE
 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
HIGHER PRICE

 ASK to SELL
Excess
Demand
6
Liquidity Crisis = Sell Off
Figure 3
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!!
BID to BUY 
Demand
Dried Up
Excess
Supply
Mid-Price
 LOWER PRICE

HIGHER PRICE

 ASK to SELL
Large Gap in
Order Book
7
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
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
Bid #
1
2
3
4
5
Best Bid Price
Low Liquidity Order Book
Pre-Transaction
Shares to Fill
Bid Price
Bid Shares Market Order
35
100
100
34
200
200
33
300
300
32
400
31
500
35
Bid #
1
2
3
4
5
Best Bid Price
High Liquidity Order Book
Pre-Transaction
Shares to Fill
Bid Price
Bid Shares Market Order
35
600
600
34
600
33
600
32
600
31
600
35
Post-Transaction
Bid #
Bid Price
4
5
Best Bid Price
32
31
32
Post-Transaction
Bid #
Bid Price
2
3
4
5
Best Bid Price
34
33
32
31
34
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Reinsurance Market Auction (RMA) Structure
 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
 Three phases:
 (I) Price Exploration and Quote
Development,
 (II) Asking Price Development, and
 (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)
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RMA Phase I
Price Exploration and Quote Development
Figure 5
RMA Phase I
Reinsurer 1
Submission
Reinsurer 2
BROKER
CEDANT
Proprietary
Portfolio Info
Quotes (Asks)
Reinsurer 3
…
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
Reinsurer 3
Price and
Strategy
Evaluation
CEDANT
…
Reinsurer n
Desired
Share
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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
 Price moves due to changes in
 More difficult to define price
Asking Prices:
movement than in capital markets
– Technical Price changes:
 Far fewer sequential data points
innovations in loss cost estimates;
(annual)
increased profit margins (e.g.,
post Sept 11)
 Dissimilar products crosssectionally and over time
– Strategic differentials
– Product lines
 Blind auction, signals or
anticipation of other actions
– Cedants
– Liquidity = market depth
– Opaque differences in features
 Enough signed lines at a given
– Different underlying portfolios
price to fill out the program
– Brokers estimate comparable
pricing
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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
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.
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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
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.
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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
Microstructure
Don Mango
Guy Carpenter