2006 is being hailed an abundant year of profits for reinsurers with Mother Nature providing some respite following record losses in 2005. But it's too soon to start celebrating, warns Mairi Mallon.

The markets appear to have more than coped with the financial pounding given to them after huge payouts in both 2004 and 2005, with the combined ratio in 2006 falling to its lowest level since 1953 (to 93.3% from 100.8% in 2005). With rates soaring on all catastrophe-exposed lines, particularly for the Gulf of Mexico and US, and despite some softening on non cat-exposed lines, the property casualty (P&C) industry is expected to report an unprecedented underwriting profit of nearly $28bn in 2006, according to AM Best. This is in stark contrast to a net loss of $5.8bn in 2005. With the US P&C industry expected to report such solid returns for 2006, the industry's net income after taxes is projected to increase by around $19.1bn, or almost 40%, to $68bn. This is up from $49bn reported in 2005 (see figure 1).

But while the reinsurance industry is enjoying a return to calm following the 1 January renewals, it may be premature to begin celebrating. A severe hurricane season in 2007 could have a devastating effect on the industry, reversing the current stabilising of rates and returning to the massive price increases witnessed in 2005.

Another year of such huge losses could tip the industry once again into chaos. "If the winds blow ... we would be back smack in another crisis in the insurance industry," said Garry Marchitello, managing principal at Integro, a new US insurance broker. "There is no question that if it was a significant hurricane (hitting) you'd see another shrinkage of supply, and you would start seeing increases again, much like in 2006, from 50% to several 100%." But he added if it is a mild season, then beginning in July the industry might start to see a flattening out of cat rates and maybe even the start of some pricing decline.

AM Best issued a report in the middle of January "The calm after the storms", which fired a note of caution across the bow of P&C reinsurers, despite the profitable year gone by. "Although the industry was spared in 2006 from a major event, it would be naive to think these exceptionally strong results will continue in 2007 and beyond," it said. "In the volatile and cyclical P&C industry, another devastating event is sure to come." Best said the event could be in the form of terrorism, a natural catastrophe, a stock market crash, under-reserving or simply undisciplined underwriting. "The impact of this event, or events, will be split unevenly between those companies that have prepared themselves through enterprise risk management and prudent underwriting, and those that continue to ride the market cycle with their fingers crossed," it said.

Patrick Gage, active underwriter of new syndicate 38Twenty at Hardy Underwriting agrees that something could come out of left field. "The indication is that the rates have peaked and are stabilising," said Gage. "It always depends on what happens. Most people's capital models are determined over a period of time, therefore the pricing reflects that." But, he added, there was always the possibility of something happening that had not been factored into the capital costs of the pricing, and emphasised that "it is not an exact science".

Rates stabilising

While the reinsurance industry saw a spectacular year for profits in 2006, rates in US coastal areas levelled out after the huge increases following Hurricanes Katrina, Rita and Wilma. In 2006, rates went up between 35% and 400% in affected areas, while at the January 2007 renewals some prices, which had not gone up at the 1 January 2006 renewals due to market uncertainty at the time, rose by between 35% and 50%, with prices here playing catch-up with the rest of the market.

A moderate hurricane year in 2007 could stabilise prices, but with global warming ever-present and predictions for more violent hurricanes making landfall more often, prices for US property catastrophe are unlikely to slip, no matter how lightly the Gulf and East Coast of the US might get off with this year. "2006 was an unexpectedly benign year for catastrophe losses and reinsurers would appear to have recovered well," said Grahame Chilton, chief executive of Benfield. "Demand for reinsurance remains strong as buyers continue to reassess their risk exposures and seek to manage volatility." According to Chilton, in 2006 the London broker witnessed a gradual easing of traditional reinsurance capacity and a further development of capital markets alternatives.

One of the lasting effects of 2004 and 2005 hurricanes was the wave of new entrants offering capacity out of Bermuda. Four of the so-called "Class of 2005" startups, flush from a year without catastrophic storms and experiencing higher premiums, are already looking for US stock listings. The four reinsurers, Validus Holdings, Greenlight Capital Re (based in Cayman), CastlePoint Holdings and Flagstone Reinsurance have filed for initial public offerings (IPOs). The companies, many backed by hedge funds or private equity investors, are racing to capitalise on the record year in profits, with the expected rise in reinsurance rates still to come. "When these companies were formed, we felt the exit strategy for the initial investors was likely to be an IPO," said Mark Rouck, an analyst with Fitch Ratings. "But it has happened quicker than we thought."

Yet despite the start-ups and all the new capital coming in (with Benfield estimating that over $30bn of new capital in various forms has been raised since Hurricane Katrina struck), on the supply side, brokers say capacity for the US Southeast and Gulf Coast has been short by at least half in 2006. "I would say it's been average for an account with a significant proportion of Southeast or Gulf Coast exposure, then the increase would be somewhere between 50% to 400%. And for 2007 I would predict we are still going to be seeing increases forecast between 20% to 50% in the first half of the year," said Marchitello.

Plugging the gap

Trying to plug some of this gap in supply is the latest of the new Bermuda start-ups, Ironshore, backed by industry veteran Robert Clements and his financier son John. Bob Deutsch is chief executive officer of the new insurance venture. He said that the impact of a quiet year in 2006 had not really had much effect because people still remember the recent spate of hurricanes. "The forecasting people are all saying greater frequency and severity are here to stay," he said. "For 2007 they are already talking about an above average storm season. 2006 was very benign, but should not reduce pricing because the risk is very real and the severity of the storms is tremendous." He said that a quiet 2007 might change that situation and prices start to slip, and more capacity might come into the market. "It is possible that other people might decide to enter this business, we will have to see."

Deutsch said the reason there had been fewer insurance companies than reinsurance companies set up was because of the greater requirement for infrastructure in insurance than in reinsurance. "The increase in capacity we bring is a drop in the ocean, so to speak," he said. "So you could certainly have other players. We think our underwriting skill and our technology will be competitive advantages for us if they do."

Marchitello said that because of the benign season in 2006, early reports of expected earnings are that they will be "spectacular". But he added: "Despite all of that it is going to continue to be tough, especially for catastrophe risks, until at least mid-year of 2007. "It would probably be worse if there were storms in 2006, there is no doubt about it. It will continue to be a tough year through July at least - that is assuming no storms or large catastrophes between now and then. Pricing will remain tough at least through July."

Stormy seas ahead

And predictions are that 2007 will be an active season - even before earthquakes are factored into the mix - adding to a feeling that pricing may not stabilise for long.

All the modelling agencies predict there will be an escalation in US hurricane activity with the impact of global warming becoming more real. And the southern hemisphere could be lashed by El Nino, which is building again.

Risk Management Solutions continues to stand by its five-year prediction of landfall hurricane risk for 2007 to 2011. The company said that compared to its long-term average base it expects insured losses to be 40% higher for the Gulf Coast, Florida and the Southeast, and 25% to 30% higher in the Mid-Atlantic and Northeast coastal regions. This is based on an assumption of an increase of more than 30% in the modelled frequency of major category three to five hurricanes making landfall in the US. In fact, many market watchers do not see that this trend of more frequent and more severe storms is going to change - which could price US coastal reinsurance so high no one will want to buy it.

"I think that global warming may be increasing the volatility and frequency of storms, but there were factors that came into play in 2006 that meant that the storm season was a lot less active than predicted," said Hardy's Gage. "Nobody knows exactly why but the sea temperatures were cooler than they were expected to be, and that is a big factor in the energy that is created around these storms. One of the theories is there was a major dust storm affecting the African coast and that kept the sea cool there." He said there were all sorts of reasons why the storm season is difficult to predict - and they can only really be predicted just before they happen. "It is a very difficult thing to predict with any degree of reliability and precision."

While in the US, P&C prices have risen dramatically, especially in coastal areas, in the rest of the world prices have been flat or falling. This is in part due to large European reinsurers, such as Munich Re and Swiss Re, holding firm with their pricing and bucking the normal trend for prices to go up globally after costly disasters (as happened post-Hurricane Andrew and post-9/11). They are keen not to lose their market positions to rival companies in Bermuda, which are out looking to diversify their portfolio and have turned to Europe, further depressing pricing.

Presently, there is downward pressure on international catastrophe business in Continental Europe and in other regions. The UK appears to be stable and in some areas there was a small increase in pricing due to more demand for cover. "So there is a current disconnection across the market with the US having had big increases, and the rest not having had the same situation. And that is quite an unusual set of circumstances," said Gage. This tale of two markets, as described by Willis following the 1 January 2006 renewals, is set to continue for some time. According to Marchitello, it bodes well for clients. "Generally speaking you are seeing moderation and decreases in rates for non-cat business," he said. "I think that is the most immediate impact, that is where insureds will enjoy a pretty good year in that respect. They should see at least flat to maybe 10% to 20% decreases on their insurance costs outside of cat-exposed areas - so there is good news buried in there."

- Mairi Mallon is a freelance journalist.

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