The Reinsurance World 2003 – Capacity, Profitability and ‘The Cycle’

A year ago the reinsurance world had an optimistic side most companies had survived their exposures to 9/11 and premiums were rising. A pessimistic side reflected a 25 percent decline in capacity, thus limiting new business opportunities.

Now, as the end of 2003 approaches, capitalization remains an overriding concern, but increased efforts to restore profitability, and to end, or at least to moderate, the hard/soft market cycle, as well as the growing role played by the rating agencies, are also influencing the future direction of the reinsurance market.

Some of the most insightful analysis has actually come from the rating agencies. A.M. Best issued a bulletin on Sept. 8, coinciding with the annual Monte Carlo Reinsurance Rendezvous, that listed what it felt were the determining factors in setting conditions in the market: “Reductions in capital following losses on equity portfolios, adverse development in casualty lines and the World Trade Center loss; Limited willingness of institutional shareholders to restore capital reflecting both the demand for maximum returns on capital provided and fear of further adverse development; Low levels of likely investment returns given the interest rate environment; and Improved underwriting performance but [it expressed] doubts that this will be sufficient to support high levels of risk-adjusted capital adequacy over the cycle.”

In short, Best believes that capital, or the lack thereof, is the crucial component in the reinsurance market.

Standard & Poor’s (S&P) also issued a bulletin coinciding with the Rendezvous: “Global Reinsurance: Calmer Waters Ahead?” Commenting on the parlous state of the industry it observed that ratings seem to be reaching stability, and that the “downgrades in the global reinsurance market over the past few years reflect the market’s failure to establish a sustainable level of profitability.”

Three weeks later S&P issued another report that was even more specific: “Profitability, Not Capital, is the Driver Behind Recent Reinsurer Downgrades.” It quite sensibly pointed out that, “profits are central to the long-term financial strength of any (re)insurer. In any industry, profits are required to pay an adequate return to the providers of capital. Prospective profitability is also critical, because it is the sustainability, or otherwise profits, that largely determines whether a company is able to raise fresh capital if required.”

S&P also noted that the increased capacity “hasn’t been equally distributed and we are now witnessing an incipient excess of capacity in sectors such as property, while capacity in the casualty sector, particularly for specialized classes such as protection indemnity and directors and officers, is still limited.”

In an address to delegates at the Rendezvous Lloyd’s Chairman, Lord Peter Levene, stated, “It is critical that we stop behaving like slaves to the cycle. If we act now, and act decisively, we can abolish the worst effects of the insurance cycle within a generation, and secure a much more stable environment in the future.”

Capital, profitability and the cycle are related. There’s an old saying among poker players: “If you ain’t got the tickets, you can’t ride the train.” While no one would dare to suggest that the reinsurance industry is the equivalent of a big poker game, there are certain similarities. If you don’t have the capital you can’t get into the game to begin with, and you may be forced out of it entirely if your capital becomes inadequate. P/C losses over the last two years—from the WTC attacks, asbestos, hurricanes, etc.—have exceeded $50 billion, but capital losses from the global fall in equity values have been far worse—over $180 billion. Best’s report indicated that despite the fresh capital that has come into the market since Sept. 11, there is still a shortfall in capacity.

The fallout has been significant. Gerling Global, once the world’s 7th largest reinsurer, put its P/C divisions into run-off last year. Trenwick is also in run-off, as is Overseas Partners. The St. Paul spun off its reinsurance operations into Bermuda-based Platinum. France’s SCOR adopted a thoroughgoing restructuring plan and is exiting some lines. Axa restructured its reinsurance operations, closing its corporate solutions division in the U.S. The Hartford sold its reinsurance operations to Bermuda’s Endurance Specialty, and many companies are exiting some lines, or reducing their exposures, notably financial guarantees and professional liability.

As a result demand continues to run ahead of supply, and premiums continue to rise. The industry is in a classic hard market period. Swiss Re CEO John Coomber, told delegates at the 102nd Chartered Insurance Institute (CII) Conference in London in September that “such a major reduction of capital adversely affects the insurance pooling mechanism.” It curtails the industry’s ability to perform its role in society.

Swiss Re published a sigma study in September that examined the “key role” reinsurers play in absorbing major risks in the insurance sector. It focused on “the reinsurer’s role during capacity shortages and the effects this has on the primary insurance sector,” and examined the “impact of reinsurer bankruptcies on primary insurers and whether reinsurers could disrupt the financial markets in their role as investors or insurers of credit risks.” While the conclusion is a qualified “no,” the overriding concern is the distortion in the reinsurance market caused by the lack of capital.

Companies are directly addressing the situation. Munich Re, the world’s largest reinsurer, announced in October that it will undertake a 3.8 billion euro ($4.42 billion) rights offering, the biggest single increase in its capital that it has ever made. $300 million will go to its U.S. subsidiary American Re. The announcement was no surprise. Five quarterly loss periods and a series of write-downs in the value of its equity holdings had resulted in serious erosion of Munich Re’s capital.

The reduction in capital also triggers responses from the rating agencies. Standard & Poor’s recently lowered its ratings on Munich Re to “A+.” Two years ago it was “AAA.” Best downgraded Swiss Re last month from “A++” to “A+”, both of which are still in Best’s “Superior” category. As of July Best had downgraded 11 other reinsurers, including Employers Re (from “A++” to “A”), SCOR (from “A+” to “A-“), Axa Corporate Solutions (from “A+” to “B’), and PMA Capital (from “A” to “A-“). Among reinsurers, only Berkshire Hathaway’s Gen Re and its affiliates are still in the highest rating category.

In order to reverse fortunes companies must seek more capital, and, as S&P pointed out, to do so they must maintain profitability. However, despite the hard market the reinsurance industry’s profit picture is decidedly mixed. Newer companies, many formed in Bermuda after Sept. 11, are doing better than the older and more established ones, including the two biggest.

Lloyd’s, which Best lists as the world’s 5th largest reinsurer, and S&P puts in 6th place, is also making money. Based on a pro forma annual accounting report, it posted its first net profit, £834 million ($1.376 billion), in six years in 2002, and its best results ever. In the U.S. Gen Re has recovered nicely, and is once again earning money for Berkshire Hathaway.

More informative conclusions, however, come from the new Bermuda companies, all of which are quite profitable. Why? Well, none of them suffered big losses on investments as older companies did, because they had none. They were the investments—with capital coming from companies like AIG, Aon, Marsh and Goldman Sachs. Flight to quality? Those four companies will do for a start. Long-tail liabilities? Virtually none. Management? All of them are being run by experienced management teams who know the reinsurance business. Capital? As much as they need, and, as AXIS Specialty proved with its IPO in July, investors will buy shares in companies that make money.

In contrast bigger, older, and, until now, presumably richer and more experienced companies can’t seem to make money even in a hard market that’s now going on two years. Again, why? The answers are complex, but Paul Walther, who heads Reinsurance Directions in Heathrow Fla., observed that “the longer a company has been in the business the bigger challenges they seem to face. Many of them are facing the legacy of the past, the skeletons in the closet.”

The hard market and the rise in premiums hasn’t been sufficient to overcome the losses on investments, and the necessity to increase reserves due to claims from past exposures, involving asbestos, workers’ comp and other long-tail liabilities. XL Capital recently provided a case in point. It isn’t that old a company, but it just announced it was setting aside $160 million (after tax) for additional claims related to NAC Re, a company it bought in 1999, but whose exposures go back to the ’80s if not further.

Again the rating agencies have taken notice. “The divergent fortunes of the old guard and the younger generation of reinsurers have led Standard & Poor’s to question whether the old reinsurance model, based on global diversity and financial muscle, is the right paradigm in a marketplace where the rules are changing,” wrote S&P credit analyst Stephen Searby in the “Calmer Waters” report. He also observed that while the four largest global reinsurers had an average combined ratio for 2000-2002 of 127 percent, the Bermuda companies averaged 108 percent.

“Companies with no legacy liabilities and abundant capital may rightly believe that this is a good time to competitively assert themselves. Since they do not have to make up for the sins of the past, they may be able to do so profitably. This could force the established players to compete more aggressively, thereby shortening the hard market,” Searby concluded.

Lord Levene, Lloyd’s CEO, Nick Prettejohn and other industry leaders see the hard/soft market cycle as undermining their attempts to wean the industry away from its dependence on investments by imposing stricter underwriting standards, which, theoretically at least, will generate profits. “Everyone who participates in the insurance transaction benefits from financially stable underwriting,” Prettejohn told delegates at the Federation of European Risk Management Associations (FERMA) conference in Rome in October. “The policyholder certainly benefits,” he continued, especially in a “world characterized by higher and more uncertain risk.”

Historically the insurance industry in general and the reinsurance industry in particular have relied too much on investment income to make up for weak underwriting performance. Anton van Rossum, who heads Fortis, the Belgian-Dutch insurance and financial services group, summed up the problem at the International Insurance Society Convention in New York in July. “Underwriters need to be able to price risks properly,” he said. They need to have the right level of risk at the right price level. He also stressed the need to control costs, to implement better claims handling procedures, to take advantage of technology and to depend less on the equity markets to generate profits.

Speaking at the CII Conference, Prettejohn stressed, “Our industry is based on trust—trust in a promise to pay, now and over the long- term. It is about security: the assumption of risk by balance sheets that can safely assume it. To discharge that function, underwriters need to make a profit.” In his analysis, “while rock bottom rates may seem attractive to policyholders in the short-term, in the long-term they are unattractive, fuelling uncertainty precisely where certainty is sought.” Lloyd’s, due to its unique structure, may be in a better position to control capital flows in and out of the market than other companies. Prettejohn specifically embraced the heretical notion that there ought to be capital limits. “I wouldn’t be disappointed [if Lloyd’s capacity stays the same],” he said at a press conference following his speech. “Even if the capacity is £20 billion [$33 billion], it’s much more important to make a profit—to not make losses,” he added later.

The cycle disrupts that goal, as it brings additional capital into the market, which must be put to use, creating either a perfect example of supply and demand, or an insidious financial “Catch-22,” depending on your point of view. Right now the latter description is in the ascendant, prompting the calls for control of the cycle. Paul Walther who’s been in the business over 30 years, doubts it can be done. “They say it every time, it’s like a broken record,” he said, but he also recognized that “things may be a bit different now.”

One major change has been in financial strength. “There has been a seismic shift in reinsurance credit ratings since 2001,” Lord Levene told the Rendezvous, noting that “ten of the top fifteen reinsurers [have been] downgraded, most by several notches. With triple “A” increasingly a thing of the past, buyers are using other factors to differentiate carriers.”

Van Rossum more or less summed up what needs to be done. “It boils down to discipline” he said, “and the ability to walk away in order to keep rates steady.” He reiterated the importance of making money by selling policies and managing risk at the right price, and observed that “we have a much better handle on pricing now than we did in 1992.” He’s still skeptical, however, as to whether the cycle can ever be managed.

Walther called some of the new conditions “extraordinary and scary.” He cited the withdrawal of many major players from the market, notably Gerling and CNA, and questioned whether the new players will have the staying power to ride out a soft market. He’s worried that their commitment(s) may be a lot shorter than those in the past, which could result in even greater volatility.

We may find out soon. A general consensus indicates that, while casualty rates are still rising and capacity is scarce, a good deal of capital has come into the market to cover property risks, and consequently rates are softening.

“So far there have been relatively few natural disasters,” Walther observed. “What will happen when there’s more than one in the same year?” If that happens, underwriting profits are not going to be enough to make up the losses. More capital will be needed, and Walther, along with the rest of the industry, wonders where it will come from.

Topics USA Profit Loss Excess Surplus Underwriting Reinsurance Market Lloyd's