Reinsurance Market Tries to Reel In Profits

A year ago the reinsurance industry faced the biggest loss event in its history – the attacks on the WTC and the Pentagon. Nevertheless, commentators were almost unanimous in predicting that the market would harden, rates would rise, and eventually the industry would recover and prosper.

September 11 – then and now
They were right. Premiums have risen, sometimes dramatically, but their predictions of an early recovery seem to have been somewhat premature. After what was generally acknowledged to have been a very good first quarter, the sharp downturn in the world’s equity markets in the second and third quarters caused many companies to report losses. There are other concerns as well, but the fall in equity values and the low rates of return on investments are currently the reinsurance industry’s biggest headache.

“It’s still a great improvement on last year’s chaos, however,” said Paul Walther, the head of Reinsurance Directions in Heathrow, Fla. He explained that after the attacks of Sept. 11 many companies were at a loss as to how they should react. All of their rate structures, risk analysis and portfolio management seemed suddenly to have become inoperative. Everything needed to be reappraised.

“The sense I now have,” said Walther, “is that the companies have gotten their act together, they know what they’re doing, and they know what prices they need to get.” As a result brokers and ceding companies are much less confused over coverage than they were at the same time last year.

Walther, who recently attended a conference of reinsurers and brokers in Bermuda, said that the people he met with, notably Arch Capital’s Dwight Evans, were calling current conditions a “crème brûlée” market. “Once you crack through the surface, you can do anything.”

The “surface” is the “perceived adequate price.” He explained that “once the price [for coverage] is set and the terms have been established and finalized, there’s no problem for the cedants in placing their program.” While rates have climbed sharply, in many instances between 50 and 60 percent, once that threshold is reached, most reinsurers are accepting the risks. “If the rating level is adequate, and the lead [reinsurer] signs on, the rest of the players have no problem in taking up the cover,” said Walther.” In other words “cover is available for the right price.”

There also appears to be enough capital to satisfy that demand. Although a Swiss Re Sigma study, published earlier this month, asserted that “capacity has declined by about 25 percent since [the highest levels in] 2000,” i.e. by about $180 billion, figures from the Reinsurance Association of America estimate that, at least for U.S. reinsurers, there’s currently a $38.2 billion surplus, higher than the $25.1 billion at the end of the year 2001. Their results show a general improvement as well.

The reinsurance industry is subject to both internal and external pressures, many of them negative, which influence its future course. While catastrophe reinsurers have generally had two rather benign years from Mother Nature, the shadows of terrorism, as recent events have shown, and long tail liabilities continue to haunt the industry.

First there’s the ongoing necessity to settle claims. No one has yet determined how much the industry will eventually have to pay out, and as a consequence the reserves put in place after Sept. 11 need to be maintained, and in many cases increased. A recent report from PricewaterhouseCoopers found that between 25 and 30 percent of the total WTC claims were for business interruption. “BI coverage continues to represent the largest portion of WTC claims, representing approximately 30 percent of the insurance industry’s total associated losses,” said PwC. That’s up five percent from their initial estimate last February.

“Liability, property and life comprise the remainder of overall insurance loss estimates. Total overall WTC loss estimates continue to fluctuate, but have been revised down from approximately $70 billion to $40.2 billion. To date, approximately half of this amount has been paid against the more than 33,000 Sept. 11th related claims,” the report continued.

Secondly, there’s the uncertain future to deal with. As many people belatedly realized, reinsurance is a prime component of the global economy. Without it airlines can’t lease planes, let alone cover accident losses, buildings can’t get built or leased, and the entire economy suffers. So far Congress is stalled on adopting an insurance scheme for terrorist coverage, and while the private sector offers some limited coverage, it’s no longer a standard policy provision, nor is it cheap.

Then there are the “other” specters haunting the industry – asbestos, mold and Directors and Officers liability. Standard & Poor’s summed it up in a recent report as follows, “As the payouts from Sept. 11 continue creeping higher, the [reinsurance] industry is also dealing with inadequate reserves, soured investment portfolios, costly payouts on professional-liability business, and the scramble by diversified companies to void their reinsurance operations.”

Reinsurance and investments
The losses on investments may cost reinsurers far more than Sept. 11. As an example of what the stock market slide has meant in terms of losses to the industry, consider the first half results of Munich Re and Swiss Re.

Munich Re reported varied first-half operating results. While it had an overall net income of €4.098 billion ($4.03 billion) for the full period, it posted a second quarter overall loss of €1.231 billion
($1.212 billion) and a net loss of €383 million ($377 million), despite a 19.2 percent increase in gross premiums written.

First quarter figures included a €4.7 billion ($4.625 billion) capital gain on the sale of its shares in Allianz, but then it was hit by a triple whammy in the second quarter. Losses, essentially the €2.6 billion ($2.56 billion) the company has estimated it will incur from the WTC attacks, required increased reserving at it’s U.S. subsidiary American Re. This, combined with the steep fall in global equity values, and the estimated €500 million in Eastern European flood losses, caused the company’s earnings to drop into the negative category.

The fall in the world’s stock markets forced the company to write down the value of the group’s equity holdings by €1.5 billion ($1.47 billion). The bad news, which had been foreseen by analysts, obscured the fact that Munich Re’s operating results saw a rise in gross premiums written from €17.1 billion ($16.82 billion) in the same period of 2001 to €20.4 billion ($20.07 billion) this year. Its reinsurance operations lead the way with a 30.2 percent increase.

The company forecast that its annual premiums from reinsurance would increase by 14 percent to €25bn ($24.6 billion), but given the uncertainty in the equity markets and the problems in the U.S., it declined to even confirm its original full year net profit forecast of €1.7 billion ($1.67 billion).

Munich Re’s own statement on its combined ratio further illustrates the problem. “The combined ratio for the first half year amounted to 133.1 percent; excluding the reserve strengthening at U.S. subsidiary American Re and the additional reserving for the losses resulting from the WTC attack, it amounted to 102.0 percent. On a comparably adjusted basis, the combined ratio for the whole of 2001 was 112.7 percent.” How do you make accurate forecasts with that kind of variance?

Swiss Re reported its first half operating results with the same kind of good news/bad news. While premium income grew 16 percent during the period to SwF13.836 billion ($9.23 billion), the company’s net income was an anemic SwF118 million ($78.66 million), compared to SwF 1.345 billion ($896.6 million) for the first half of 2001.

The company attributed the decreases mainly to the “equity market decline during the first-half,” which required SwF 917 million ($611.3 million) in write-offs. Investment results declined by SwF1.327 billion ($885 million), while dividend income dropped by SwF243 million ($162 million).

The relationship between capital, capacity and reserves is complex. “A reinsurer’s ability to write new business is a function of its capital surplus,” said Michael Murray, senior economist at the Insurance Services Office. “Reserves relate to claims that are known. If [a company] has to reexamine its loss reserves and put new funds into old business, it cuts into their surplus, and reduces the additional business they can write.”

Murray also indicated that “generally insurance is tied to the stock markets,” but cautioned that the “markdown in the value of an investment portfolio is not a write-off.” While these “paper losses” can have a real affect on earnings, they may fluctuate as the market fluctuates. Only when an asset is sold is there a gain or loss based on the acquisition cost. However, if you have to sell assets to raise cash to increase reserves, a depressed market is not the ideal time to do so.

The decline in the equity markets and the lower returns on investments from dividends and interest coupled with the long-tail claims liabilities and Sept. 11 have changed how reinsurers operate. “It’s a sea change from a few years ago,” Murray observed. “The stock market decline plus the lower interest rates mean that you [need to achieve] a very healthy underwriting result, because you can’t rely on getting an adequate rate of return on investment.”

His colleague at the ISO, its principal for reinsurance Nolan Asch, observed that the market had been heading in this direction even before Sept. 11, “after that it became a stampede. In 2000 in average combined ratio was 115.3, but the cycle has definitely turned.” The industry knows it can no longer support such a wide variance. It can’t continue to pay out $1.15 in costs and claims for every $1.00 it takes in. Asch, who works a great deal with ISO’s clients in the London market, said he’s never been more warmly welcomed there.

No one, however, is in a position to do much about the global financial markets. Interest rates and equity values are influenced by economic, political and social factors that are beyond anyone’s effective control, including most governments. So, while their CFO’s and economists may watch the daily averages with varying dismay, or possibly delight, as they seem finally to be heading up, industry executives are concentrating on what they can do to improve their own conditions.

Info. processing, modeling and expertise
RI3K CEO Alex Letts noted that while the company and broker representatives who attended the Annual Reinsurance Rendezvous in Monte Carlo “were obviously obsessed with mold and asbestos [liability claims] coming to Europe,” they were also very much aware of the challenges posed by a hard market. “All of them realize the necessity of getting better information,” said Letts.

Letts pointed out that the information itself isn’t the problem; “it’s always been there.” The problems occur in drawing that data together and analyzing it. “Many companies have a number of different data bases,” said Letts. “What they need to do, and they’re all very aware of it, is create unified systems to manage the flow of data.

“The reinsurance companies are obviously quite clever,” said Letts. “They’ve all figured out that they have to underwrite better and that they need better information if they’re going to do so.” He pointed out that it’s not just the reinsurance companies or brokers that have figured this out, most cedants have as well, and they can use the information to retain greater amounts of risk, and to choose which portions to cede, and at what price.

The solutions are there. Instead of a dozen or more information platforms, standardize all data into one useable system. “You’re going to have to save that data for 30 years or more,” said Letts, “and it has to be available on one platform.” He noted that many companies were already writing all new contracts through a single database, as they slowly changed older contracts over to a single system.

More use of modeling and analytical programs is a second step companies are taking to increase underwriting efficiency. One only has to look at RenaissanceRe, arguably the world’s most successful reinsurer with an average 18-20 percent return on equity, to see why. Asch said that CEO Jim Stanard, a mathematician, “probably has every CAT model ever written.”

Martin J. Merritt the company’s Sr. VP-Finance said “We try to use it [modeling capabilities] for every single risk we write, and we get as many details from the broker as we can.” Using several models avoids the built in bias every model has. It works. RenRe announced preliminary third quarter estimates of $1.10 to $1.15 per share, and full year 2002 operating earnings in the range of $4.65 to $4.80 per share, over 20 percent higher than last year. [Note: The company split its shares 3 for 1 last May]

While RenRe is almost exclusively a property catastrophe reinsurer, there’s no reason modeling can’t work for casualty, D&O liability, workers’ comp and even terrorism. In fact both Applied Insurance Research (AIR) in Boston and California’s Risk Management Solutions (RMS) have done just that. In September, AIR unveiled its “Terrorism Loss Estimation Model” and RMS launched its “U.S. Terrorism Risk Model.” Both products are aimed at quantifying the potential risks for property, workers’ compensation and life insurers and reinsurers.

Walther pointed out that a third essential element in managing risks is experience. Talking about the number of new companies that have started up since Sept. 11, mostly in Bermuda, he observed that “you have to have the funds and the talent. Brokers and cedants consider their relationships important; it amounts to more than money.”

He made a distinction between “old/new companies” such as ACE, XL and RenRe that were started after hurricane Andrew, and the “new/new companies” that have started in the last year. Most of them, he stressed, were being run by people with a long history of experience in the reinsurance industry. “They’re going to stick to what they know, and avoid making mistakes.”

Asch concurred. “The new capital that’s come into the market is not naïve. The people [who manage the new companies] are pros; they’re very sophisticated. They haven’t made any moves to disturb the market, they’ve been very restrained.” He went on to explain that people like Paul Ingrey, who came out of retirement to head Arch Capital Group’s reinsurance operations, Arch Worldwide, and many others, “have seen many a problem,” and have the experience to try to avoid repeating past mistakes.

Asch also pointed out that the reinsurance market has become truly global, with the same constraints, and the same discipline, appearing in all the main market centers, New York, Bermuda, London and Europe. He described the market as “using better information and communications,” and becoming much more efficient.

Now if the stock markets would only turn around, maybe the reinsurance industry’s return to overall profitability isn’t so far away after all.

Topics Catastrophe Carriers USA Agencies Profit Loss Europe Agribusiness Reinsurance Market Risk Management