Fitch Comments on New Reinsurers

Fitch ratings has issued a statement analyzing the prospects for the new reinsurance companies, established in the wake of Hurricane Katrina. The rush to set up what Fitch calls the “Class of 2005” resembles similar start-ups formed after Hurricane Andrew and Sept. 11. Investors are seeking to capitalize on increased demand and rising premiums. Fitch believes that the Class of 2005 may total as many as 10-to-12 reinsurers.

Fitch noted that while its “rating methodology does not impose a ceiling on start-up reinsurers’ ratings, the agency believes that the following factors would make it difficult for the majority of the Class of 2005 to achieve insurer financial strength (IFS) ratings as high as the ‘A’ range but likely would not preclude ‘secure’ ratings in the ‘BBB’ range.”

The following is a summary of the rating agency’s views:

Fitch indicated that “premium rates are unlikely to experience significant and sustained increases across a broad spectrum of business lines in response to 2005’s hurricane related losses. While the agency expects significant rate increases on property exposures in hurricane-prone areas, it believes that premium rates on property exposed business outside of these geographic areas, and premium rates on casualty-related business, are unlikely to increase materially in response to 2005’s hurricane-related losses. Further, Fitch believes significant uncertainties exist as to how long hard market conditions may last in the noted property lines that are expected to harden.

“This contrasts with market conditions that existed following Sept. 11 when premium rates increased significantly across a broad spectrum of business lines. This resulted from a confluence of several factors, including years of inadequate pricing and subsequent adverse reserve development, equity market declines, and Sept. 11 related losses. These factors eroded the reinsurance sector’s capital base and essentially imposed underwriting discipline on the reinsurance sector which became evident in the form of rate increases.

“In contrast, the global reinsurance sector’s 2005 hurricane-related losses, while staggering, followed two years of very strong earnings and capital formation. Fitch notes that the aggregate equity of approximately 30 global reinsurers it tracks on an on-going basis increased to $261 billion at year-end 2004 from $173 billion at year-end 2002.

“Thus, to the extent the market opportunity leading to the formation of the Class of 2005 is narrow, and ultimately proves to be short-lived, this adds greatly to the uncertainty these reinsurers face in successfully executing their business plans.”

Fitch also said that the “Class of 2005 is likely to be narrowly-focused on property/catastrophe related business lines. Fitch views this as a natural situation given the events that have lead to the Class’s formation (i.e. very large property/catastrophe related losses) and corresponding lack of broad-based rate increases across other business lines. However, Fitch also views this as a risk concentration that has negative implications from a rating perspective.

“Additionally, Fitch notes that these concentrations are arising during a period in which its capital requirements for reinsurers with exposure to extreme events have increased. As discussed in Fitch’s Nov. 9 special report, ‘New Thinking on Catastrophic Risk and Capital Requirements’. Fitch is adopting a tail-value-at risk (T-VaR) approach to measure capital levels required to support catastrophe exposure at different rating levels. Fitch believes that T-Var is a robust way to assess capital required to support exposure to potential extreme events and Fitch believes that its adoption is likely to result in heightened capital requirements for property catastrophe reinsurers.

“Prevalence of Short-Term High-Risk & High Reward Capital Providers: Fitch believes that the proportionately large amount of capital contributed by hedge funds and private equity investors to the Class of 2005 has negative rating implications. Fitch views hedge funds and private equity firms as opportunistic, shorter-term investors. Thus, long-term ownership remains a significant uncertainty with respect the Class of 2005, as does the risk the companies will be managed with a short-to-medium term business focus, mainly to support an IPO or other exit strategy.

“Further, Fitch believes that because of comparatively narrow and shorter-duration market opportunities, the time horizon during which investors in the Class of 2005 can expect to meet their return requirements is shorter than the time horizons available to investors in previous sector re-capitalizations, including the Class of 2001 and the Class of 1992. As a result, the agency’s view is that there are significant uncertainties as to how the Class of 2005’s strategic direction will evolve. This in turn makes the Class of 2005’s credit profile less certain.”

Fitch’s comment also points out that capital isn’t the only consideration in setting up a reinsurance company. There’s also the need to recruit experienced management to run the company. In this respect Fitch said that among the “class of 2005’s greatest challenges is obtaining management talent, especially in light of the comparatively large number of companies being formed in such a short period of time.”

The rating agency added that its “primary concern about management is whether or not it has the depth of experience required to adapt to changing market conditions or to reposition the company since history suggests that relatively few start-ups exist in their original form three-to-five years after incorporation.” Fitch also indicated that its concerns “include management’s operational capabilities since start-up reinsurers are often dominated by entrepreneurial underwriters that sometimes lack a strong operational focus. Such risks become especially pronounced when market conditions inevitably start to soften.

“Favorably, Fitch believes that underwriting talent is generally present among these reinsurers, at least in limited scope, and that without a proven level of underwriting expertise the reinsurers would not have been able to raise their substantial amounts of capital. The flip side of this is that this underwriting talent may be very concentrated and as a result, generate a significant amount of key-man risk.”

Topics Catastrophe Reinsurance Property Hurricane Training Development