A.M. Best: Cycle Management Key to Reinsurance Industry Financial Strength

October 22, 2004

The reinsurance industry is facing a key test from the 2005 renewal season in terms of how it reacts in practice to pricing pressure from cedents, according to A.M. Best Co..

While the material levels of catastrophe losses seen in the second half of 2004 will slow the descent into a soft market, A.M. Best believes that, fundamentally, this trend is well established. Many cedents and brokers expect reduced pricing for 2005 in property and are showing an increasing resistance to casualty pricing and to the restrictive coverages introduced during the recent hard market. A particular concern is any material weakening in terms and conditions, as this has typically been the leading indicator of a return to uneconomic underwriting in casualty/liability lines.

Moreover, while some of the more specialised or start-up reinsurers have achieved low or very low combined ratios in the recent period, the major reinsurers have generally been writing in the mid to low 90’s. While a very healthy result taken in isolation, A.M. Best believes this level of return at the peak of the market is not supportive of the idea of “through the cycle” underwriting profitability.

Most reinsurers stress that they will not write at unprofitable levels. But this begs the question as to what they do with their risk capital? If a reinsurer reduces volume as pricing and terms retreat, then they will feel pressure to return capital to shareholders. But, since the reserve risks and asset risks associated with longer tail lines would not be likely to reduce as quickly as current premium income in a soft market, reinsurers will be challenged to “square the circle” of providing shareholders with acceptable returns on capital employed while maintaining risk-adjusted capital strength.

A clear, related risk is that the desire to keep capital in the business will lead to unprofitable business being written, notwithstanding the strong commitment on the part of senior managements to avoid this. This risk is enhanced by the growing tendency of brokers to compete for outwards reinsurance business by offering improved terms, A.M. Best added.

Despite clear direction to the contrary coming from most reinsurer boards, there is a strong sense that many “on the ground” managers and underwriters are prepared to cut rates or terms to defend market position, the rating organization reported. The challenge all management teams face is one of communication of the long-term goal and the alignment of senior management’s focus with the underwriter’s reality, A.M. Best said..

This challenge for reinsurers comes at a time when the risk of further adverse development from U.S. casualty business remains, either from the 1997 – 2001 accident years across a range of lines (D&O, E&O, Workers Comp., Medical Malpractice), or from the continuing problems in asbestos.

The scale of the ongoing challenge of prior-year U.S. casualty development was highlighted in A.M. Best’s recent report on U.S. property/casualty reserve adequacy, which estimated a potential shortfall of $67 billion for the total industry.

In theory, the combination of the ongoing risk of adverse development in casualty, the asset losses of recent years and low levels of absolute investment returns available in a global low inflation environment should all have combined to reduce the cyclical nature of the business. But, as A.M Best has been stressing for some time, cyclical pricing behavior is unlikely to have disappeared. The fundamental issue, therefore, will be whether the industry can hold the line at rates that are still economic, or, if the market becomes truly soft, whether the soft market can be kept both short and shallow. Pricing behavior over the next twelve to eighteen months from the 2005 renewal will be crucial to that.

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