Can the US property reinsurance market survive another active season? Peter Middleton examines the chances.

Writing about US property reinsurance at the beginning of August of any year may be considered an act of folly, but there can seldom have been a year when so much of an industry's future hangs in the balance.

US property catastrophe reinsurance is a market in crisis. The possible ramifications of a third disastrous hurricane season have not yet been fully absorbed by the market, whether buyers, brokers, reinsurers or investors, nor by local regulators, insureds and their mortgage providers. In theory, the reinsurance market will adjust to further losses as it has in the past, but we cannot be far from a tipping point where credibility is exhausted. Another active hurricane season like 2004 and 2005 would result in the complete withdrawal of some significant catastrophe writers and a further tightening of capacity by most of the remainder of the market.

2006 has been a chaotic year for reinsurers, which are dealing with new uncertainties regarding the fundamentals of catastrophe underwriting. The market faces conflicting pressures with homeowners, mortgage banks and local regulators reinforcing the need for adequate supply while rating agencies, new models and fresh risk management approaches raise the capital hurdle for both insurers and reinsurers.

The reaction of most reinsurers reflects the need to maintain their "A" rating through a display of underwriting discipline involving the effective control and reduction of retained exposure to catastrophe. Reinsurers that continue to suffer unexpectedly high catastrophe losses will lose rating agency and investor support.

The turbulence in the market has arisen not solely as a result of the 2004 and 2005 losses, but also as a result of the unforeseen nature of hurricane Katrina. This catastrophe placed question marks over the reliability of the proprietary models available in the market, underwriters' understanding of the vulnerability of commercial portfolios and the sheer size of the personal lines impacted. Hurricane Katrina also exposed extreme differences in commercial underwriting approach between the domestic admitted insurers and surplus lines writers, including the London market.

The effect on reinsurance programmes of the new models, adjusted for 2005 hurricane activity, has not yet been fully felt. Some reinsurers will already have adjusted their underwriting policy, aggregates and price controls correctly for 2006 business, while others will now have to amend their approach as of 1 January 2007. Capacity is being even more rigorously controlled at a corporate level to ensure that each operating unit stays within its predetermined risk appetite. Using the recent losses as invaluable data points, reinsurers are focusing in on discrepancies between the expected and actual losses by revisiting the original portfolio information supplied by insurers at the time of underwriting.

The capacity squeeze

Driven by the shortage of capacity, market pricing is at a historical high point. There is little available capacity or choice of provider at the retrocession level and this is coupled with extortionate prices and unrealistically high deductibles. The view for the reinsurance buyer is little better, with high prices and deductibles and a dearth of capacity for the Gulf of Mexico, Florida and Northeast US. As a result, domestic insurers are examining all possible means of reducing catastrophe exposures in these areas.

US property reinsurance business outside the peak catastrophe zones is in demand, as reinsurers seek to spread their risk. And the property reinsurance market outside the US continues to reflect wider industry considerations with plenty of available capacity, active competition and softening prices. But it is difficult to imagine significant softening of the position in the peak zones over the next few months, even with a loss-free autumn. Most US reinsurers envisage continued tight capacity and high prices for the foreseeable future.

The capital squeeze has provided an opportunity for creative minds to produce a string of innovative concepts in seeking to align fresh capital with the existing portfolio of risks, such as the sidecar, which matches an investor's appetite with a customised segment of the reinsurer's existing portfolio. By creating a separately capitalised entity, the risk is removed from the reinsurer's balance sheet.

In the new regulatory environment, risk transfer on a finite basis is no longer considered an appropriate solution. However the long heralded entry of the major capital markets into the catastrophe reinsurance arena can be seen more clearly than ever with the increasing level of interest shown by hedge funds.

- Peter Middleton is managing director, specialty division, Markel International.