The closure of sidecars is likely to hold back the inevitable softening of reinsurance rates, as witnessed at mid-year, explain Malcolm Payton and Bill Bennett. But where does that leave the reinsurance buyer?

Throughout 2006, the North American property treaty market was influenced by the shortage of retrocessional capacity, which kept pricing strong despite a mild hurricane season.

Between January and June 2006, reinsurance rates shot up by around 30% and, following a downturn in the second half of the year, were still higher in January 2007 than at the levels achieved 12 months earlier, in the immediate aftermath of Katrina, Rita and Wilma. Catastrophe layers had sustained the biggest hit: the difference in pricing between the bottom and top ends of programmes was relatively small, caused by minimum rate-on-line requirements.

Reinsurance buyers were hit by the double whammy of high prices and greater coverage restrictions. Coverage was limited to specific territories rather than being offered on a worldwide basis. Reinsurers were insisting on minimum retention levels (around 20% of maximum line for risk excess programmes), which was particularly uncomfortable for insurers with diversified portfolios. Many reinsurers had to curtail the number of available reinstatements, which severely impaired the sideways protection of treaty programmes.

Return of retro

Since January 2007, the treaty market has softened. The tight retrocessional market has started to show signs of weakness, and by April 2007 retro rates had fallen by 20% to 30%, partially driven by the late entry by several new retrocessionaires. Many retrocessionaires have not met their income targets and are now prepared to offer some rate reductions and broader coverage.

Still, the treaty market cannot breathe a sigh of relief yet. Some of the new sidecars are set to close operations in 2007 (such as Montpelier’s Blue Ocean), and others may follow suit later in the year. This new development, if it continues to spread, may limit the downturn in rates. In addition, the treaty market has a more limited scope for rate reductions given a number of external factors such as the recalibrated catastrophe models and the ever-increasing influence of the rating agencies on underwriting discipline.

Where does this leave reinsurance buyers? They have already significantly scaled back their core programmes and increased retentions. Throughout 2006, this approach seemed to work as primary rates on North American business were firm as well.

2006 was a great year for US property/casualty insurers: the clear skies led to $31.2bn of underwriting profit, compared with a $5.6bn loss in 2005 (according to ISO). Since then, primary rates have been under pressure as competition has returned to the hurricane-hit areas. Other factors that contributed to their downward movement include government-backed initiatives such as the expansion of the Florida Hurricane Catastrophe Fund.

There now appears to be a premium rate mismatch between the primary and treaty markets. Whilst the primary market is cutting rates, the treaty market is trying to hold on to the rate levels of 2006. Many reinsurers have been able to maintain underwriting discipline, a promise they made to the stock market, by exiting certain segments. For example, in March, Berkshire Hathaway announced that it was retreating from the Gulf Coast as competition was putting pressure on rates.

Tapping the capital markets

“The convergence of facultative and treaty reinsurance is
a quiet revolution that is changing the North American property market

There is a feeling in the market that the treaty product is moving further away from the primary product, and that primary insurers need to be more creative and open to new ideas to obtain adequate reinsurance protection. This has already manifested itself in the number of catastrophe bonds issued by primary insures in 2006 and 2007, the latest being State Farm that placed a jumbo catastrophe bond worth over $4bn through Merna Re.

Catastrophe bonds and sidecars are spectacular headline-grabbers yet there is another trend in the reinsurance market that has so far escaped media attention. As reinsurance buyers are faced with a rather stark choice of scaling back their treaty programmes or paying up for them, they are beginning to look differently at their reinsurance needs. For the most part, insurers are not looking for an alternative to treaty reinsurance, which has always been the core element of their risk transfer strategies. Rather, they have realised that today’s treaties suffer from a number of “chronic” issues and that a solution must be found to make treaties work for insurers.

Fac plugs the gap

This is where facultative reinsurance comes in. The market has seen a paradigm shift in the relationship between treaty and facultative reinsurance. It has been most pronounced in the North American property segment but the same trend has affected other classes of business as well.

In the past, facultative reinsurance was viewed as “reinsurance of last resort”. Apart from being cumbersome to administer, it also came with limited security. This is no longer the case. Facultative reinsurance has evolved into a nimble product supported by analytical tools and is now attracting first-class security.

More importantly, it is no longer perceived as a short-term fix used by cedants as a substitute for “proper” reinsurance, ie treaties. Instead, it is used as a way of enhancing treaty programmes, by managing the influence of peak exposures or by creating a mechanism to mitigate the impact of loss drivers.

The nature of facultative reinsurance is changing too. The process for placing facultative programmes has assumed some of the attributes traditionally associated with treaty placements. Buyers and sellers of facultative products are increasingly looking to develop long-term partnerships and the entire process has become more professional than it was in the past.

The convergence of facultative and treaty reinsurance is a quiet revolution that is changing the North American property market. There is a growing recognition among reinsurance buyers that pure treaty products no longer work for their portfolios. On the facultative side, the same is true for the old-fashioned, mainly opportunistic facultative products. Reinsurance buyers are now seeking blended solutions that combine the best of treaty and facultative reinsurance.

Over the past 18 months, the North American treaty market has seen dramatic rate movements and has been open to highly publicised alternative reinsurance solutions. However, by bringing together the previously separate forms of traditional reinsurance it may have found an effective mechanism for dealing with future upheavals and rating roller coasters. Whatever happens in the next few months, the reinsurance market will not go back to the old “treaty versus facultative” model, and the new blended solution is here to stay.

Bill Bennett and Malcolm Payton lead the non-marine reinsurance team at JLT Re.