Industry consolidation threatens the independence of Scandinavian reinsurers, but the few that remain have developed successful strategies, says Rafael Villarreal.

The existence of the last few1 remaining Nordic professional reinsurers is supported by the basic need of Nordic, and other, primary insurers to spread losses, and by the needs of small and medium-sized insurers who may not be adequately served by larger players. Consolidation trends, however, threaten the independence of these reinsurers.

Nordic reinsurers face a difficult choice: either specialise and cater to small and medium sized clients and markets, where the large players do not have sizeable operations, or become part of a larger organisation. Both of these choices reflect the consolidation trend in the industry, and are briefly reviewed below.

Moody's believes that consolidation is a natural and irreversible process in most industries. The pressures behind this trend are many and varied. Some of the most prominent forces acting on Nordic reinsurers are:

* Soft primary markets.

* Low economic growth rates in Europe.

* The effect on capacity of the absence of major natural catastrophe losses.

* Demands from shareholders for enhanced economic returns.

Other pressures include the threat of alternative risk transfer products and markets, greater transparency about costs and more discerning customers - increasingly unwilling to share their premiums and margins with reinsurers.

In any country, the leading domestic carriers often have large accumulation exposures and, thus, prefer reinsurance protection from reinsurers providing large net lines. Reinsurer consolidation enables small players to meet the growing desire of ceding insurers for larger limits and fewer participants on their reinsurance programmes.

For most reinsurers, however, this trend represents increased business risk, as good opportunities become harder to find as ever-larger players, offering abundant capacity, crowd out the smaller firms. Although this seems to bode ill for smaller reinsurers, there are also dangers for the consolidating firms. In theory, larger reinsurers have an opportunity to enhance the diversification of their risk portfolios, on a more cost efficient basis. However, reinsurers who have historically had little interest in retrocession - given relatively modest-sized programmes underwritten - may be slow to adjust their risk management strategies to account for material increases in gross limits offered. This could leave them exposed to natural or man-made catastrophes that highlight unanticipated aggregations within their combined portfolios of risk.

The movement by primary insurers, to pare down their lists of approved reinsurers, and cede larger amounts of limit, increasingly on an excess basis, precludes the active participation of small reinsurers like the two Nordic reinsurers, who with their comparatively small capital bases, could find it increasingly difficult to establish a relationship and to participate in these programmes on a regular basis. Further, even if they were to participate in the larger programmes, their lines would either be small or heavily retroceded. In either case, there is a clear risk of sooner or later being disintermediated.

What do Nordic reinsurers offer to a potential acquirer? It would have seemed improbable 10 years ago that by 1998 there would be only two Nordic firms competing as professional reinsurers in the global reinsurance markets. Yet, after Skandia's complete exit only Sirius International (Sirius), the main operation of ABB Financial Services, and Copenhagen Re, the main operation of the Danish Alm. Brand Group, remain as dedicated reinsurers. If even large reinsurers such as Cologne Re (General Re) and General Re (Berkshire Hathaway) can be acquired, it is likely that Sirius and Copenhagen Re will also end up as part of a larger group at some stage. Some of the considerations that would weigh, both for and against, on the attractiveness of reinsurance acquisitions in the Nordic market are enumerated below.

Financial fundamentals - both Sirius and Copenhagen Re have reported good profitability in recent years. For instance, they have little or no financial leverage, little or no US liability exposure, and have good asset quality.

Responsiveness - small companies like Sirius and Copenhagen Re can often achieve faster response times for their customers, be more flexible in tailoring products and as a result be more innovative than larger ones.

Specialisation - This talent is a fundamental strength on which Moody's places considerable weight when analysing the ability of a company to perpetuate its competitive advantages. The acquisitions by Munich Re of American Re, with its expertise in ART and its entrepreneurial bent, and by Hannover Re of Skandia's aviation and other select reinsurance business, are examples of how this talent is valued among large and highly rated reinsurers.

Unlike large European reinsurers, Sirius and Copenhagen Re do not derive most of their business from writing domestic motor and fire business written on a proportional basis. Their books include proportional, non-proportional and facultative business, as well as direct insurance on speciality lines. Because of the need that Sirius and Copenhagen Re have had to specialise, their resultant business mixes are unlike those of other reinsurers; and perhaps too exotic for some. This could be an attractive feature for reinsurers of any size wanting to merge with or acquire the Nordic players. If talent is what a company needs, however, hiring the underwriting teams may be easier.

In the case of finite reinsurance (Sirius owns Scandinavian Re in Bermuda), in particular where there is no risk transfer, or of various forms of financial guarantee, trade credit and political risk products, the business resembles that traditionally provided by banks, who reduced their participation on some of these lines of business years ago because of their high capital requirement and slim margins.

The business could again become increasingly threatened by investment banks and other financial institutions, who have already made strides in establishing virtual reinsurance firms in tax-advantaged locales.

Geographic diversification - This could be one of the attractions of Sirius and Copenhagen Re to an acquirer. Both companies operate globally. If the acquirer is already diversified geographically, an acquisition of a small reinsurer may not add value to its business (i.e. new relationships or meaningful volume). Geographic presence could be of greater significance to small and medium-sized players than to large reinsurers. Part of Sirius' business is tied to ABB's business. In addition, Sirius has a finite reinsurer in Bermuda, and can write business through the London market. It has also opened other offices in Germany and Switzerland. Copenhagen Re has offices in Denmark, the United Kingdom, Singapore, Australia (branch) and Chile (representative office). Its book is well diversified geographically.

Tax advantages - reinsurance, like life assurance, depends strongly on tax advantages. The largest reinsurers, bar the US companies, are located in places like Germany, Switzerland and Bermuda, where tax authorities have traditionally supported the insurance and reinsurance businesses. In this regard, Swedish tax laws are currently supportive of Sirius.

Lack of Nordic presence - Sirius and Copenhagen Re do not focus on their domestic markets, and just as well because the prospects for business in the Nordic region are limited. Insurance premiums in the region amounted to approximately $16 billion and retention levels are about average 90% and rising. A focus on personal lines and property business, the less litigious nature of societies in the region which removes considerable uncertainty in setting loss reserves and the virtual absence of natural disasters such as earthquakes and hurricanes all influence the high retention level, among other things. This means that the entire Nordic reinsurance book is only about $1.6 billion in premiums and the margins a fraction of this amount.

Parent's needs - in the case of Sirius, the company brings a core expertise (such as political risk, trade and project insurance) to ABB, as well as some fiscal benefits, which suggests that the parent may be guided by strategic, as well as financial considerations in its ownership plans.

Conclusion

Small reinsurers like Sirius and Copenhagen Re have captured a position in the market providing support to small and medium sized clients worldwide, and they are likely to retain this role, whether operating independently or as members of a larger group. This means that specialisation, risk segmentation, and underwriting skill are as important for these players as for the larger ones. Perhaps even more so.

Smaller reinsurers are being forced down the league table to service smaller insurers who can benefit from their capacity, attention, flexibility and expertise. Given the consolidation trend that has resulted in new combinations being announced seemingly every day, it would not be surprising to see these two companies merge with others. At present, however, they continue to benefit from their global risk spread and client focus. The Nordic reinsurers provide a good example of companies benefiting from exploration of emerging markets and from providing more innovative solutions than simply extending proportional reinsurance to large books of commodity coverage.

Rafael Villarreal is a financial institutions analyst with Moody's Investors Service Ltd. Tel: +44 (0) 171 621 9068. Fax: +44 (0) 171 621 1501.

1. We have concentrated on the two professional reinsurance companies, but Folksam also writes reinsurance.