Wagging the dog

Reinsurance woes send primary carriers scrambling

Until recently the reinsurance world was a galaxy far, far away. That changed after the 2000 stock market crash, the Sept. 11 attacks and, more recently, the hurricanes that struck Florida, New Orleans, Texas and other parts of the Gulf Coast in 2004-05.

“It’s almost as if the reinsurance tail is wagging the primary dog,” says Paul Walther, chief executive officer and principal consultant of Reinsurance Directions in Heathrow, Fla. He’s had a front row seat for some of those hurricanes–and fortunately very little damage–but his front row view now reveals a shrinking market.

Less capacity
“The [reinsurance] market is currently much less inclined to take on more risk,” he continued. “As a result not only is there less coverage available, but also what you can find costs more.”

A recent study from the Insurance Information Institute reaches the same conclusion. It found that reinsurers are raising prices for natural disasters from 10 percent up to as much as 200 and 300 percent in some storm-vulnerable regions of the country. In addition, the I.I.I. concludes, reinsurers are requiring primary insurer customers to reassess their exposures. The global reinsurance market, which bore about half of the $61.2 billion in hurricane-related damage in 2005, expects another active hurricane season this year.

“Higher reinsurance prices have pushed up the cost of primary insurance coverage and forced primary insurers to cut back on coverage in risky areas,” reports I.I.I.

There are basically two types of reinsurance coverage but “the big bucks” are spent on quota share treaties, according to Walther. This arrangement, also know as proportional reinsurance, is concluded between a primary carrier and a reinsurer, which agrees to take on a certain percentage of risks, as defined by the treaty. In return the primary insurer cedes the premiums earned relevant to that business to the reinsurer. They share premiums and losses on a pro rata basis. Surplus share coverage, by which the reinsurer takes a proportion of policy limits, or “lines,” is also considered part of the quota share market.

Non-proportional or excess of loss coverage, “which involves more contracts, but less money,” said Walther, is a straightforward purchase by a primary carrier of coverage for losses that exceed specific retentions on designated classes of risk.

Both types of reinsurance enable a primary carrier to write business that exceeds their own in-house capacity, as they have shifted the risk of loss to the reinsurer. As long as that market has sufficient capacity and doesn’t charge too much it works fine, and the brokers who place the coverage haven’t had to worry about it. But it’s getting tougher to place.

“Now, however, especially in Florida,” Walther continued, “the market is extremely reluctant to conclude any new quota share treaties, and they are closely examining the ones they have [when they’re due for their annual renewal]. They are also closely examining their own internal cat limits and are generally reluctant to accept more risk from their cedants.”

Higher costs
In addition to the reinsurers’ general reluctance to increase their quota share exposure, they are also charging more for what they do write, he added. The premiums ceded aren’t in effect like-for-like, as the carrier generally keeps a certain percentage to offset the costs of doing business–about 35 percent typically. As an example, a 10 percent quota share treaty requires payment of 10 percent of the premiums received less the primary’s costs.

But those amounts are also being reduced, according to Walther. In the example, a carrier might get to retain only 25 percent; i.e., “they’ve taken a 10 point hit.”

With less reinsurance capacity available, primary carriers can’t write as much coverage, and what they do write costs more. Some carriers can’t, or won’t, even write homeowners coverage in high-risk areas.

Florida has the highest profile (and the most exposed coastline) but it is not the only state with reinsurance woes. Coverage is tight and premiums are rising all along the Gulf Coast, the Atlantic seaboard, and in other geographical locations where earthquakes, brushfires, tornadoes, floods and other natural disasters pose threats.

“Across the board, all the players [reinsurers] have taken stricter underwriting risk selection to heart,” Walther said. “They’re taking less risks, so the carriers are scrambling to find coverage.”

Fewer carriers
There are also fewer carriers. In Florida, at least two companies–Poe Financial and Florida Select–have gone into receivership. As a result, the Florida Catastrophe Fund floated a $2.5 billion bond, while Citizens, the state-run insurer of last resort, floated one for $3.5 billion–all to cover future exposures.

It’s those future exposures that may cause problems across the reinsurance market. No one can really predict what they’ll be. The primary carriers, the cat modelers and the reinsurers, basically “got it wrong,” Walther observed, speaking about the hurricanes of 2004-05. “You can no longer assume that it’s a 100-year storm, or a 250-year storm. 2006 might be as bad as the last two years, and what about storms three and four, the frequency is increasing as well as the severity.”

As the frequency of storms increases, primary carriers must also factor in the costs of reinstating coverage if they use up their coverage before the storm season is finished.

“Reinstatement provisions become important when you’ve used up all, or most of, your coverage following a major loss event,” Walther explained. “The reinsurers will reinstate it but they charge according to the percentage that’s left; so, if you still have 70 or 80 percent of the [hurricane] season left to go, the premium is going to be proportionately larger.”

Companies might elect to purchase third, fourth of fifth coverage before a loss event, if it’s available. But, Walther noted, this is hard to find because reinsurers are not quite sure how to price it.

The uncertainty hanging over the property cat market has lead cat modelers–AIR, RMS and EQECAT–back to the drawing board to come up with more accurate models for predicting future disasters, calculating the damages they could cause and the potential losses.

The rating agencies–A.M. Best, Standard & Poor’s and Fitch Ratings–have modified the criteria they use in assessing a reinsurer’s capital adequacy (a major ratings component) to take into account in the likelihood of more than one catastrophic loss event occurring in a given year.

Reinsurers also squeezed
As primary carriers scramble to find and pay for reinsurance, reinsurers themselves are also in a bit of a squeeze. The cost for excess of loss policies has skyrocketed and the retrocession market–where reinsurers offset their own risks by reinsuring portions of them with other reinsurers–has “really contracted,” Walther said. Catastrophe reinsurance excess policies are usually bought in layers, with the higher layers, as they are farther away from the potential loss, being less expensive. “The reinsurers are looking at all their commitments,” he continued, “and the carriers have found that in many cases the prices are prohibitive.”

In the absence of affordable retrocession coverage, reinsurers are turning to alternatives, which could explain the renewed interest in cat bonds. Guy Carpenter’s report on the January renewals, in addition to confirming the decreased capacity and the increasing rates, also noted that a record amount of nearly $2 billion of catastrophe bonds were issued in 2005. Guy Carpenter predicted continued growth in the cat bond market for 2006.

There is also a resurgence in the use of “sidecars” as an alternative to retrocession, according to A.M. Best. Best defines a sidecar as a “limited-life special purpose entity that generally provides property catastrophe quota-share reinsurance exclusively to its sponsor.”

More analytical underwriting, heightened awareness of risk, better use of capital and the lack of retrocession capacity have combined to cause policy cancellations, a contraction of quota share capacity (despite, as Walther observed, a surprising number of new players entering the market) and greatly increased premiums. As a result–since they can’t get the reinsurance they require to write coverage in riskier areas–the primary carriers, too, are canceling policies, refusing to renew others and seeking to raise rates.

Now, Walther fears, a crisis point has been reached.

“Another big one, and all bets are off,” Walther said. Private catastrophe insurers and reinsurers cannot continue to pay $30 or $40 billion a year in hurricane losses and still stay in business, he adds. The money just isn’t there.

Topics Florida Catastrophe Carriers Profit Loss Reinsurance Hurricane