François: Well, we’ve finally turned the corner this year. Premium rates are on the upswing—about time too, we couldn’t survive another 1999.
Mike: C’mon François, you said the same thing last year and the year before that. Of course you want rates to go up; you’ve all got negative loss ratios—but you’re still making good profits, aren’t you? There’s still excess capacity, isn’t there? So what makes you think all of a sudden premiums are going to go up?
François: No, no, this year is different. Look at 1999: earthquakes, hurricanes, a hailstorm in Australia that cost us a billion, and then two of the most powerful storms in 200 years flatten France and half the rest of Europe. Everybody lost a bundle last year. Plus, what about retrocessional capacity? There sure isn’t any excess there.
Pam: He’s right about the cat losses, Mike, you’ll have to give him that. Most of our clients understand why those premiums will be going up, but look François, you can’t justify raising them all across the board—that just won’t fly.
Mike: Yeah, that’s a good point. We’ll always find somebody cheaper, or if we can’t, we’ll just keep larger retentions, or find other alternatives. Reinsurance isn’t the only game in town any more.
François: I didn’t say we’d raise all the rates, but you’ve been getting a great deal from us for the past five or six years. Look at workers’ comp, auto, medical malpractice—the losses go up and the rates go down; that can’t last forever.
Pam: Any raises other than cat premiums, you’re going to have to justify on an individual basis. Maybe you can in Europe, but maybe not in the U.S. or Japan.
Mike: There’s another problem too, François. You raise your rates, we’ve got to raise ours, but you don’t have 50 insurance commissioners looking over your shoulder like we do. We’d have to justify any hikes, so we’ve got to find the cheapest rates, or look at other solutions. For instance, why not securitize workers’ comp? Aon and XL did it in Nevada.
François: Securitization? I don’t buy it; it’s too complicated, too expensive. We only see it in special situations.
Pam: But I see more people interested in it than ever before; plus the market’s changing. Look at some of the big multi-risk, multi-year programs we’ve put together. More and more clients are going that route.
François: Well, we’re into programs too, but you still need to spread the risks, and that means reinsurance—securitizing those deals won’t do it.
Mike: No, but using the capital markets does give us lots of flexibility. I’ll say one thing though, François, what scares me about those deals is when a really big loss hits and all those institutional investors lose their shirts. Just like that, there’s no more market. That may be the main reason we’re sticking with the Re’s…
This fictitious dialogue reveals a lot about the state of the reinsurance industry at the beginning of the 21st Century. Rates are increasing, but in limited areas—mainly property catastrophe reinsurance, certain particular lines and retrocessional coverage. Otherwise the market is pretty gloomy.
“World Catastrophe Reinsurance Market 2000,” a report from Guy Carpenter, the reinsurance arm of Marsh Inc., examines the state of the property catastrophe reinsurance industry on a country-by-country basis.1
It confirms insured economic losses in 1999 of $23 billion, while total losses topped an estimated $100 billion, and includes these “key findings”:
• Renewal rates have increased in most property catastrophe reinsurance markets in 2000. Market firming, which has so far been characterized by general mild price increases, reflects cumulative years of underpricing, substantial catastrophe losses in 1999 and a severe tightening of retrocessional capacity.
• The market turn has been buyer-sensitive and the degree of firming varies by country and peril. In general over 1999, higher renewal rates corresponded to higher catastrophe losses. Markets heavily reliant on retrocessional capacity saw the most substantial increases.
• Worldwide, cedents continue to indicate a strong preference for multiyear contracts, but reinsurers are reluctant to grant them.
• While many countries are considering new state-run mechanisms to fund certain catastrophe exposures, little concrete progress has yet been made.
Pressures and cycles in the re market
Paul Walther, the internationally known chairman and principal consultant of Reinsurance Directions Inc. (RDI), agreed that the market is firming, but doesn’t think that this alone will fundamentally alter current trends. “The reinsurance business has always gone through cycles,” Walther said. “In the 30 years I’ve been in it I’ve seen a lot of them, but what I’ve noticed recently is that the troughs [periods of low premiums] are getting longer and the tops are getting shorter.”
Walther noted that the prolonged troughs haven’t had much effect on the problem of excess capacity. Some of this is due to the presence of the capital markets, but he feels that the main reason is the nature of the reinsurance market itself. “As long as the demand for capacity is there, the capacity will be there, but there will be fewer and fewer players in the game, as the big companies through mergers, acquisitions and just plain competition squeeze out the smaller guys.”
Robert Mebus, managing director of Standard & Poor’s (S&P) New York office, in his foreword to “Global Reinsurance Highlights 2000” indicated that 1999 saw increased ratings downgrades and accelerated the acquisition of weakened reinsurers, putting increased pressure on those that remain.
“Although reducing supply will be the key component of a sustainable improvement in rates, the demise of excess capacity can be painfully slow,” Mebus stated. “The reinsurance industry finds itself in a difficult squeeze. Their clients, the primary insurers, demand strong balance sheets and, in many cases, stronger insurer financial strength ratings than their own. Unfortunately, some are not willing to pay a premium for this costly protection. “The ‘Pac-Man’ theory suggests that reinsurers have to get bigger to offset consolidation of their clients. Of course, it would be a fallacy to suggest that big is better and that anything else will follow the dinosaurs. There is no single key to long-term success, but large companies can usually afford to take risks and make the investments required, while small companies must refresh their focus in a market that constantly changes.”
Has the re market become a zero-sum game?
Experts generally agree that the larger companies are the least affected by the pressures on the reinsurance market, because most of them are essentially “financial service providers.” Reinsurance is only a portion of their business. Even so, they cannot entirely escape the consequences of underwriting policies that have led to too many years of negative returns.
Moody’s Investors Service released a report shortly before the Monte Carlo Rendezvous, with the principal conclusion that: “a major challenge facing reinsurers is that the market is mature, with few prospects for real growth, outside of some limited opportunities in the emerging markets and a few product segments such as life insurance, health and credit insurance.”
“Overcapacity” actually describes ongoing conditions in the reinsurance market, which, while it may be cyclical to some extent, has tended to stagnate over the long term; there’s been little real growth. Why, during the longest period of economic expansion in U.S. history, have combined ratios continued to worsen? According to a report from A.M. Best, 1999 saw a deterioration in p/c combined ratios of more than two points from 105.6 percent in 1998 to 107.7 percent. Reinsurance did even worse, registering a combined ratio of 114.8 percent for the year.
One result, Walther noted, is that anyone “for whom reinsurance isn’t a core business is thinking seriously about getting out of the market, which can be seen in the number of acquisitions and the number of companies leaving the business and going into runoff.”
Another result is that reinsurers are in the process of re-examining their operations. In S&P’s “Global Reinsurance Highlights,” William J. Adamson, CEO of CNA Re, suggested that a “return to underwriting basics” might provide the answer. He ascribed industry problems to the “increasing use of self insurance and higher retentions by customers in some lines, (which) has reduced demand for primary insurance, which in turn has dropped demand for reinsurance.” He also recognized that most reinsurers, particularly the larger ones, are still making profits but these are coming from investments, not insurance activities.
If the market is in fact stagnant, as Moody’s opinion suggests and other factors indicate, it gives another dimension to Mebus’ “Pac-Man” analogy. If there is no overall growth, reinsurance becomes a zero-sum game. If one company writes more business, others write less. It is the scramble to avoid this result and maintain market share at any cost that has produced the downward spiral in rates, which paradoxically comes full circle and results in excess capacity.
Operational changes and initiatives may provide solutions
Some initiatives can improve underwriting results. One, already mentioned, is to pay greater attention to the type of risk and the costs involved. A “simple solution to all these problems,” Adamson stated, is that “insurers and reinsurers alike must return to the rationally based underwriting and pricing principles that have served our industry well since its beginnings.” By becoming more efficient, and by diversifying their capital commitments beyond reinsurance, results have improved.
Even before implementing its “Triple 20” program—to cut costs by 20 percent, reduce catastrophe capacity by 20 percent and renegotiate at least 20 percent of its least profitable policies before 2002—industry leader Swiss Re posted good first-half 2000 results: a 5 percent gain in premiums, a substantial 22 percent gain on investments and a reduced combined ratio from 112 to 111.
Munich Re has taken a firm line on writing marginal business. First-half results showed it had increased premium revenue by 15 percent, beating analysts’ expectations, and it upped its revenue growth forecast from 6 percent to 9 percent for the year. However, less than half of Munich Re’s turnover now comes from its reinsurance business.
Even Lloyd’s, despite warnings of exceptionally large losses over the last three years, is experiencing a boost from the restructuring it has undertaken, its strong capitalization and brand name. S&P recently reaffirmed Lloyd’s “A+” rating, citing the commitment of corporate capital—now about 80 percent—and the strong performances by some of the bigger syndicates.
First-half 2000 earnings statements mostly show that the larger reinsurers are making profits, and that initiatives aimed at stemming losses by being more efficient are having a positive effect, but this doesn’t assure growth in the reinsurance sector.
Insurance markets are changing. As “Pam” observed, clients want more sophisticated coverage and insurers are offering it. Roger Scotton, head of corporate communications at XL, said: “We’re part of a sea change in insurance buying. We offer solutions that we call holistic risk transfers.” These programs are part of an increasing trend in commercial insurance that transcends traditional lines of coverage.
“Our financial solutions unit handles insurance and reinsurance,” Scotton said. “We meet our clients’ needs by sitting down and analyzing the problem(s); then we’ll tailor a solution for them. For this we need a lot of expertise, and we have people who can design financial structures, build actuarial models and provide investment banking services in addition to traditional insurance considerations.” Scotton referred to this capacity as “XL’s intellectual capital.”
France’s AXA recently completed the consolidation of three units—AXA Re, AXA Global Risks and AXA Cessions—into AXA Corporate Solutions, to offer the same type of comprehensive services as XL. It also announced that, contrary to most reinsurers, it was actively pursuing retrocessional business.
As these programs increase, they reduce the demand for classic reinsurance. Plus, they’re mainly aimed at large commercial accounts, which normally consist of high quality business; this leaves the general reinsurance market with a greater percentage of more questionable risks.
Walther cites the growth of programs as another example of the advantages big companies enjoy. “The bigger companies will prosper simply because they’re bigger…they can take the opportunities that are there to create new products and methods like program business. They are more able to do these things, to take advantage of more sophisticated products, because they have the capacity to make the initial investments.”
He also pointed out that if a big company with good ratings exceeds its exposures, it can always go to the capital markets.
The role of securitization
Speculation about the role of securitization or alternative risk transfers (ARTs) continues. Their future is still ambiguous. “Since February 1994, investors have committed an estimated $4.1 billion to the capital markets to securitize insurance risk, most commonly with catastrophe or ‘Act of God’ bonds,” according to the Carpenter Report. “However…catastrophe bond activity seems to have stagnated in 1999 following a significant increase in 1998.”
Walther thinks that the reinsurance market needs to be a good deal harder than it is before there’s a real move to securitization. “I don’t know when the market is going to have a product that’s really attractive to investors, and you can’t expect the banks to invest unless they can get the rate of return on equity they want,” Walther said.
The Carpenter report concludes: “As long as relatively inexpensive reinsurance is available, the growth of insurance securitization will remain limited. Securitization will be reserved for situations where indemnity coverage is not available or capacity is tight, such as for Japanese earthquake risks.”
A Glass of Wine Before Dinner
Mike: Lots of people this year, François, but I miss some old faces.
François: Well, times change. But when you think about it, not all that much. Nobody’s come up with a better method than reinsurance for diversifying risks—it’s still the cornerstone of the insurance market.
Pam: But François, look around you. How many people from companies, or I should say groups, do you see that only write reinsurance? The real diversification is going on inside the companies themselves. They’re no longer just reinsurers; they’re all “financial service providers.” Their income streams come from reinsurance, primary insurance, life products, pension funds, capital management or whatever.
François: I guess that’s true, at least for the big boys—but I miss the old days when it was just reinsurance. What will happen to the smaller companies?
Mike: They’ll find a niche market, or they’ll become part of a big company. Besides, look at the new opportunities opening up. Look at e-commerce and the Internet—that’s going to be huge.
François: Yeah, huge exposures too—scares the heck out of me. Look at the potential liabilities! How are you ever going to underwrite coverage for a bunch of stuff nobody has any experience with? Any hacker can cause a Hurricane Andrew.
Pam: Oh, I think you’re exaggerating a bit, François; we’ve found a lot of companies with some very sophisticated programs, and it’s just starting.
François:As I said, that’s what scares me. Let’s go, they’re serving dinner.
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