Despite a year of record losses, ACE not only made a profit in 2005 but kept its combined ratio under 100%. Nigel Allen finds out how.

Benfield's recent Bermuda Quarterly report, “Shaken and stirred” paints a fairly grim picture of the devastation caused by the catastrophes of 2005 on the balance sheets of Bermuda's reinsurance community. Losses of some $11.3bn from hurricanes Katrina, Rita and Wilma, saw the island's reinsurers report a total net loss of $2.8bn for 2005 compared to a 2004 profit of $5.5bn, with 11 of the companies surveyed recording a loss for the 12 months, compared to only one for the previous year. Combined ratios for the year peaked at 282.9%, with the average being 118%. Only two companies managed to keep their combined ratios below 100% – Arch which recorded a combined ratio of 95.9% and ACE, which was a whisker away from crossing the 100% line, with a combined ratio of 99.7%.

Despite catastrophic losses for the year topping $1bn, compared to a mere $437m in 2004, ACE still succeeded in reporting net income of $1,029m, down some 11% on the previous year. The group also reported a 20% rise in shareholders' equity for the 12 months, rising to $11.8bn, which was largely influenced by the $1.5bn of new common stock issued in October.

Commenting on the 2005 results, Evan Greenberg, ACE's president and chief executive officer, highlighted the fact that the group had held its combined ratio below 100% during a year which he described as “the worst in history for insured catastrophe losses”. While acknowledging that the group's financial performance had “failed to meet our standards”, Greenberg cited the ratio, plus ACE's ability to record a return on equity of almost 9% and record book value growth of 7% as factors which prove “a testament to the underwriting discipline of our organisation”.

Under the microscope

“We are a company which has always stressed the importance of underwriting”, explains Brian Duperreault, chairman of ACE, “it is embedded in our DNA. We know the business and have the discipline to say no when the price is clearly not adequate.” A review of ACE's most recent 10-K filing gives an insight into the underwriting strategies employed by the company. For example, in its general overseas insurance operations, the group has implemented a system in which the consistency of the underwriting standards and guidelines in each local operation is monitored by global profit centres and product boards, with regular underwriting reviews being undertaken to ensure levels of compliance.

In its reinsurance operations, the group states that in addition to “substantial” management oversight, the underwriting environment is subjected to “regular by peer reviews, actuarial pricing and reserve support, catastrophe exposure management… and regular reviews by our corporate internal audit department”. The group also applies a system of restrictions on zonal and peril accumulations to limit potential concentration risks for natural catastrophes. A key element in this process is the proprietary risk management platform Heuron that analyses the output from the catastrophe analysis tools, and measures accumulation exposure from each risk underwritten and assigns risk-based capital. The system requires each cedant to supply extensive exposure data.

ACE has been accused in the past, however, of employing an “aggressive” underwriting strategy. Most recently, Standard & Poor's said that it remained concerned about the group's aggressive pricing strategy in relation to certain lines of business, including Directors' & Officers' and Errors & Omissions in the US. “We will be aggressive when we think that the market environment is right,” says Duperreault. “If the terms and conditions, and pricing are good, we want to write that business.” Duperreault also cited the fact that since ACE went public in 1993 the group has kept its underwriting ratio under 100%, a fact which clearly counters any suggestion of aggressiveness in pricing, “and I hope that eventually we will get [S&P] to retract that.”

Underwriting after the storms
As a consequence of the 2005 Atlantic storms, ACE has sought to revise its catastrophe risk models to factor in changes to its risk perception. Speaking after the announcement of the group's 2005 financial results, Duperreault stressed that while ACE's appetite for risk had not changed, “our view of potential loss has, and we have to adjust our portfolio and, in fact, we are doing just that.” The knock on affect of the adjustments to the risk models, coupled with the loss reassessment is threefold: the changes will see prices raised, a reduction in the group's aggregate exposure and an increase in the amount of reinsurance protection purchased. “As far as catastrophe pricing is concerned, we have raised rates to reflect our current view of both frequency and severity, and increased ROE targets for catastrophe-related business,” said Duperreault, adding that target returns had also been raised to reflect the volatility and uncertainty in this sector.

Speaking subsequently to Global Reinsurance in March, Duperreault reiterated this strategy. “We looked at the risks which we were taking on and decided to either cut back or raise the price against it in the loss-affected lines,” he explained, but was keen to point out that despite these measures, “we did not short-change the other lines.”

Interestingly, despite the fact that the reinsurance sector affords by far the greater opportunity for rate increases, Duperreault is adamant that ACE will refrain from breaking its 80/20 rule in terms of its insurance and reinsurance split. Describing reinsurance as the “hotter area” when compared to the direct market, and adding that the group will certainly be seeking to take advantage of the pricing potential of this sector, he said that they were comfortable with the current balance.

The risk of recoverables
In a research update on ACE produced by Standard & Poor's, which saw the group's rating outlook revised to stable from negative, the rating agency cited, under the heading of “Major rating factors”, concerns about the high level of reinsurance recoverables and intangibles, which it said “anchored the current rating”, adding that this risk had intensified following the 2005 hurricanes, which have seen the group further raise its recoverables level. “As far as our reinsurance strategy is concerned,” Duperreault said, commenting on the financial results, “as I said previously, our retention is increasing and so is the amount of reinsurance cover we are purchasing.”

ACE has always valued strongly the role of reinsurance cover in its overall risk management strategy to mitigate loss exposures. As of 31 December 2005, the group's net reinsurance recoverable balance totaled $15.5bn, including $15.1bn of recoverables on unpaid losses and loss expenses, less $451m of “uncollectible reinsurance”. This compares to reinsurance recoverables of $14.9bn in 2004. Of the current sum, $3.4bn or 22% of the reinsurers providing cover are rated below “A-” or are not rated. The top ten reinsurers, as at 30 September 2005, accounted for $5,272m, of which bad debt constituted a mere $84m, or 1.6%. This list of the top ten includes: AIG, Berkshire Hathaway, Munich Re, Swiss Re and Lloyd's. Commenting on the concerns over the degree to which the group is reliant upon reinsurance, Duperreault flagged up the fact that the rating agencies “gave us very good marks for the quality of the reinsurance which was available for these current losses resulting from Katrina, Rita and Wilma – both in terms of the quality of the reinsurers and the security we had against it.”

The year ahead
On 15 December 2005, ACE released its forecast for 2006, predicting that the group would achieve a property/casualty combined ratio for the year of between 88% and 90%, which included $400m for catastrophe-related losses resulting from both insurance and reinsurance exposures. Asked in March whether ACE still stood firm on this forecast, Duperreault said, “We think that 2006 will see price increases clearly on the affected lines and possibly on the affected lines as a follow on. But if they don't, we believe our underwriting process would allow us to still produce the 88% to 90% combined ratio but maybe not at the same ‘flying' level.”