Today's reinsurance firms should not forget mistakes of the past, says expert

Compared to the banks, the global insurance industry fared surprisingly well during the 2008 financial crisis. Indeed, there have not really been any major market disputes since the Unicover workers' compensation spiral in the US in the mid-1990s, in which a complicated series of poor value reinsurance contracts left some insurers exposed to huge potential future claims in return for low premiums. One of the reasons often given for this is that the industry learned its lessons from the old London Market of Excess Loss (LMX) spiral of the 1980s, and the near-collapse of Lloyd's of London.

In their new book Making a Market for Acts of God, academics Paula Jarzabkowski, Rebecca Bednarek and Paul Spee argue that now, with new players and new ways of providing cover for risks coming into the catastrophe reinsurance markets, the industry risks forgetting the mistakes of the past – and the potential for another crisis in the event of a costly catastrophe. The authors liken the current trend towards bundling together policies into 'catastrophe bonds' to the packaging and resale of sub-prime mortgage-backed securities that triggered the banking crisis.

There are always potential problems when risks are underwritten that are so remote from the primary insurance risk that is being covered that there is no linkage between them. In this sense, there is a good degree of similarity between with the insurance market did in the 1980s which led to the LMX spiral with the sub-prime crisis and the packaging of mortgage-backed securities. In both cases, an excess of capital and the failure to appreciate accumulation and aggregation risks led to collapse. It is interesting that the authors of this book think that history is repeating itself again.

Reinsurance refers to the practice by insurance companies of insuring the policies that they hold with another insurer or specialist reinsurance firm. A reinsurance agreement between the 'ceding' company and its reinsurer sets out the circumstances in which the reinsurer would then pay a share of the claims incurred by the ceding company. By spreading the risks and the costs of insurance claims, reinsurance helps to ensure that insurers remain financially viable - particularly after a major disaster such as a hurricane, a terrorist event or the recent devastating earthquake in Nepal.

The authors of the new book claim that insurers have been increasingly reinsuring their risks through complex bundled arrangements, sold on to pension funds and other institutional investors in the form of catastrophe bonds and other insurance-linked securities. The ultimate result of this is the potential spread of mainstream insurance risks to parties that do not necessarily understand them.

These new ILS structures have not really been properly tested yet, but the numbers are large enough that at some point they will be subject to a major challenge. These contracts currently account for around 10% of reinsurance business underwritten globally, so it is unlikely that their failure at the moment would lead to the wholesale collapse of the reinsurance market – but there could be one or two big failures, and some significant fallout.

As the book notes, there is a flood of available capital in the market - bringing with it a heightened danger that those deploying that capital will expose it to investments that are not fully understood. It would be wonderful if the insurance industry was able to find a way to deploy this excess capital in such a way that we saw new, innovative products made available to fill the massive void in the global market that is left due to underinsurance, especially in emerging markets where economies - as Nepal has so dramatically illustrated - would benefit from better access to insurance solutions.

Unfortunately, the excess capital is being blamed by the markets for simply driving down rates, which are particularly soft in the reinsurance sector at the moment. With soft rates at one end, and new products that are disconnected from the underlying risk insured at the other, the structure could be vulnerable.

Nicholas Bradley is an insurance and reinsurance industry expert at Pinsent Masons, the law firm behind Out-Law.com.