Reinsurance 2007 – A victim of success?

If the reinsurance industry were a game of golf, one would say that after three rounds — the two halves of 2006 and the first half of 2007 — it tops the leader board. But as any golf buff knows the final 18 holes frequently decide the outcome. Despite, or perhaps due to, record earnings from a benign year for natural catastrophes, increased capitalization, bulging reserves and a series of premium increases, the industry faces the consequences of its own success.

Reinsurance, however, is not a unitary industry. Trends in one area, property, for example, frequently don’t manifest in other lines, such as aviation. The United States is the largest market for reinsurance, but, paradoxically, the majority of P/C reinsurance treaties ultimately originate from outside the country. With the acquisition of GE Insurance Solutions by Swiss Re, Berkshire Hathaway’s General Re and its affiliates are the last major P/C reinsurance group based on U.S. soil.

In a bulletin released in mid-July the Reinsurance Association of America noted that in 2006, total U.S. premium ceded to offshore reinsurers was $54.7 billion and ceded recoverables totaled $114.2 billion. That represented an 11.9 percent decrease in premiums and a 7.8 percent decline in recoverables since 2005.

That year, of course, was the worst on record for natural catastrophes. However, even with the huge premium increases in some areas, mainly property coverage in Florida and along the Gulf Coast, the premium and recovery levels still declined.

It was an industry decline. There were simply fewer premiums paid. In fact, according to the RAA, “offshore companies’ share of U.S. unaffiliated reinsurance premium increased to 53.1 percent in 2006 from 51.8 percent in 2005, while the market share of offshore companies and U.S. subsidiaries of offshore companies decreased to 84.5 percent of U.S. unaffiliated reinsurance premium in 2006 from 85.4 percent in 2005.”

The RAA identified the United Kingdom and Ireland, Germany, the Cayman Islands, Switzerland, and Barbados as the “largest markets for unaffiliated premiums ceded and recoverables due in 2006.”

Why the decline, when the need for coverage remains strong? Part of the answer lies in the market itself. “Why transfer some risks, if you can absorb them,” said Thierry Van Santen, head of Corporate Risk Management of France’s Groupe Danone, speaking at the European Insurance Forum (EIF) in Dublin last March. “Why buy insurance, if between the write-offs [from a loss] and the cost of rebuilding, the company can cover the risk?”

Another member of the same panel, Paul Taylor, head of Group Risk Management and Insurance at Tetra Laval added: “If big corporations have better ratings than the insurance companies, why transfer the risk?”

What they were saying validates the ongoing trend, especially among major multinationals, to take on increasingly larger shares of primary risk. They may buy only excess policies over certain limits, or they may establish captives, who then purchase reinsurance at much higher — and therefore cheaper — levels. As globalization creates bigger and fewer companies, this trend is set to continue.

Cat bonds, sidecars

The growing availability of the capital markets in the form of cat bonds, sidecars and other securitizations also offers an alternative to classic reinsurance. Although they remain expensive, such devices have the added advantage of removing large chunks of risk from the balance sheet.

In its recent review of the July reinsurance renewals, Willis Re identified four “macro factors” that are leading a downward slide in rates. It reconfirmed earlier findings that “favorable 2006 financial results, continued capital infusion, diversifying reinsurer appetites, and the populist movement in the United States, were working to depress reinsurance property pricing and in turn increase competition for other lines of business. These four factors continue to impact the marketplace unabated.”

Willis also identified a fifth factor that emerged with the July renewal cycle (which is dominated by North America/Caribbean property renewals). There is a “pronounced disconnect between the insurance and reinsurance markets. While insurance and reinsurance prices are both dropping there is a differential in the pace of each markets’ price decreases. Insurers are being squeezed and they are struggling to make their 2007 budgets. Insurers are getting less money for the insurance they sell and they have to pay more for the reinsurance they buy.”

As a result, one common solution has been to buy less reinsurance. There is, as a consequence, less premium in the reinsurance market. Reinsurers, trying to meet their own budgets are starting to compete more aggressively for the remaining more volatile business. This aggressive competition will soften the reinsurance market, and merger and acquisition activity will likely increase as pricing disciplines collapse.

So far, that hasn’t happened. At least since 2001 the major reinsurers have preached the mantra of adequately pricing risks, and rejecting those that don’t meet their underwriting criteria — even if it means a reduction in premium income. Lloyd’s Chairman Lord Levene, Swiss Re’s former CEO John Coomber and his successor Jacques Aigrain, Hannover Re’s CEO Wilhelm Zeller, Munich Re’s Management Board Chairman Nikolaus von Bomhard have all sworn that their respective companies will not lower rates to attract market share.

Solvency II

Willis might also have to add a sixth emerging factor to its list — the impact of the Solvency II Regulations on the European Union’s insurers. Even though companies like Swiss Re and Munich Re operate through U.S. subsidiaries, they remain European. Switzerland, although not an E.U. member, follows its regulations.

Solvency II will rewrite the book on insurance regulation. Yann Le Pallec, head of Standard & Poor’s European Insurance Practice, described it as “a revolution” at the International Insurance Society (I.I.S.) Conference in Berlin in July. When (and if) it comes into force in 2012, Solvency II will mandate that capital and reserve requirements be risk-based. It will require the E.U.’s insurers and reinsurers to accurately assess their risks, and fund them accordingly. The higher the risk, the higher the capital requirement. The process envisages a continual assessment of those risks.

Given the overwhelming presence of Europe’s reinsurers in the United States, how they keep their books will affect how they do business. In simplistic terms, “if you can’t get your prices, you must exit the market,” said Hannover Re’s Wilheim Zeller in his presentation to the I.I.S. Conference.

As Willis Re’s CEO Peter Hearn wrote: “One final observation, the reinsurance industry is undergoing a seminal change. The competitors are no longer merely other reinsurers. The competitors are capital markets, local governments, residual markets and self insurance.”

If the reinsurers hadn’t been so successful, they might have less competition, but now it’s up to the industry to meet the challenge. After all, there are 18 holes to play.

Topics USA Legislation Europe Reinsurance