With balance sheets looking strong in the reinsurance sector, Robert DeRose, Andrew Colannino and Richard Attanasio review the US property casualty industry.

AM Best is maintaining a stable outlook in 2008 for the global reinsurance sector for the second consecutive year. The affirmation of the sector’s outlook reflects generally strong balance sheets, continued improvements in enterprise risk management (ERM) and general earnings momentum through 2007.

This outlook implies that the majority of 2008 reinsurer rating actions are likely to be affirmations with stable outlooks and only a modest amount of anticipated rating or outlook changes. However, price deterioration, competition and increased cedant retentions are causes of concern relating to the sustainability of the sector’s long-term operating performance.

US reinsurance experienced strong operating results for 2007 following a very strong 2006 performance that resulted in many carriers reporting record earnings. The 2007 performance exceeded expectations, as concerns with a deteriorating pricing environment, and increased capacity, failed to constrain operating margins in a meaningful way. Although catastrophe activity picked up in 2007, the impact on US reinsurance was nominal as the major European and primary carriers assumed the brunt of the losses.

Growing competition

Results in 2008 will more accurately reflect the competitive conditions in the marketplace, as rates are falling in most property and casualty lines of business. Catastrophe-exposed accounts are also experiencing rate reductions, but to a lesser extent. As rates decline, concerns shift to terms and conditions, which have started to waver, but not to the point of widespread deterioration. The gap between the increased supply and uncertain demand for traditional, third-party reinsurance led to further softening of rates at the 1 January 2008 renewals.

Two consecutive years of solid operating results, in addition to a handful of major reinsurance transactions to affiliated and parent companies, have strengthened the balance sheet of US reinsurers. Luckily, no material storms have hit the United States since Wilma, and reinsurers had the opportunity to rebalance their portfolios after identifying and establishing their ultimate exposures and appetites for risk.

Athough the bleeding continues, the impact from the soft casualty market of the 1997-2001 accident years has diminished, with favourable development on recent accident years further offsetting the impact. Naturally, weather uncertainty remains. What would have happened if the paths of the two category five hurricanes that hit Mexico in 2007 had veered sharply to the north before reaching land?

The Bermuda market has an increasingly prominent impact on the global industry. Established players, members of the ever-maturing Class of 2001, and more recent entrants from the Class of 2005 continue to influence the reinsurance industry. Market conditions for Bermuda mirror the competitive themes of the US, with profitability trends that are similar in direction but more pronounced in absolute terms when assessing the very profitable results for the island’s companies.

“Although the bleeding continues, the impact from the soft casualty market of the 1997-2001 sccident years has diminished

Many Bermudian companies have entered the US primary market through the purchase of US primary companies, namely shell formations. The focus thus far primarily has been specialty excess and surplus markets that are sold through managing general agents.

Here to stay

Despite the improved position of the reinsurance industry, challenges remain in light of the increased capacity of industry participants, new entrants and new forms of capital. It is no longer easy to ignore the reality of the capital markets as an alternative solution for primary markets in the form of catastrophe bonds, industry loss warranties and sidecar formations. Issuance of catastrophe bonds reached an all-time high in 2007 and these products have become a viable option for risk managers of primary companies.

The increased retentions of primary companies further reduce the demand for traditional reinsurance. Additionally, many lines of business have demonstrated favourable trends in frequency and severity, such as workers’ compensation and medical malpractice. By retaining more business, primary companies can also better maintain volume. After paying high costs for reinsurance over many years, primary companies are not blindly purchasing coverage for the sake of it and are looking more closely at the economics of transactions.

Reinsurance has continued to shift from proportional quota share to excess-of-loss coverage. The market for first-dollar quota share has not expanded as primary companies keep their entire first-dollar retentions. The time will come, however, when the underlying primary trends will deteriorate and the demand for reinsurance will increase. The question is, which players in the reinsurance industry will bite too soon, and which will be disciplined and decline unprofitable business?

Commercial lines euphoria

Continued underwriting discipline, a relatively mild catastrophe year and favourable loss-reserve development resulted in another exceptional year for the commercial lines sector. The sector will report its second consecutive underwriting profit for 2007, a result that is almost unprecedented for the commercial lines industry.

Although premium growth has faded since its peak in 2002, the sector has exhibited generally strong fundamentals. Insurers have achieved adequate prices through several years of focusing on profit first and growth second. Underwriting discipline has remained generally intact throughout the sector, and the pricing and risk selection processes have been enhanced through investments in technology. Commercial lines companies have also monitored their aggregate exposures more prudently, with less of an appetite for catastrophic shock losses.

“Which players in the reinsurance industry will bite too soon, and which will be disciplined and decline unprofitable business

Nevertheless, underwriting profits and industry-wide, double-digit return measures will not last forever as the major concern continues to be the current position in the pricing cycle. Those companies that are able to execute their business plans by adhering to underwriting fundamentals and placing profit first, rather than giving in to the demands of the market, will thrive in 2008 and beyond. The veterans of the industry have had plenty of experience operating during soft market conditions, which appear to have become the norm rather than a bump in the cycle.

Despite this ongoing soft period in the cycle, the outlook for commercial lines remains stable. Commercial lines carriers have bolstered their positions after robust earnings in recent years by investing in price-monitoring tools, predictive modelling, distribution channels and claims systems. Additionally, the segment has embraced ERM, and the extension and permanency of the federal terrorism backstop have removed uncertainty regarding this exposure. While profits are likely to deteriorate in the coming years, the sector has in general positioned itself to meet the challenges of changing market conditions throughout the cycle.

Trouble ahead?

While both the homeowners and auto markets are projected to post favourable results in 2007, there are risks ahead. Key among them is the approach to pricing in a competitive environment in tandem with a shift in underlying loss-cost trends. Given indications that declines in auto loss frequency may be moderating – though severity is increasing – cycle management has become important. In addition, the regulatory response to the various risk management actions taken by carriers on the homeowners’ line has been significant. The number of legislative hearings and bills, as well as media attention on these initiatives, escalated in 2007 due to carriers’ various risk management actions combined with a relatively benign hurricane season.

Looking forward, 2008 is likely to be significant in terms of cycle management. As loss-cost trends continue to shift upward, the response of the market, particularly motor writers, will be critical. The amplitude and duration of the soft market cycle for personal lines is likely to be lessened, given the underlying structural changes in terms of underwriting and pricing segmentation, as well as improved frequency trends derived from safer cars and shifts in population.

The ability to accurately predict the cycle is tenuous, as the actions of just one or two market leaders could negatively impact the market, given that the top ten companies write close to 70% of personal lines net premiums. Based on loss-cost trends and competitive pressures, results are expected to deteriorate modestly in 2008 relative to prior years but remain generally favourable.

With initial indications of a flattening of the soft market, AM Best remains cautiously optimistic with regard to carriers writing predominantly personal lines and their approach to pricing in this environment. Some deterioration of results in 2007 and into 2008 is expected, while the firmly rooted price segmentation and movement toward product differentiation will limit both the amplitude and duration of the pricing cycle that has plagued the industry in prior years.

Certainly risks remain, including the possibility of accelerated price decreases, irrational pricing decisions, catastrophes and regulatory mandates. However, given the economics of the business, volatile investment markets and the recently displayed underwriting discipline, carriers should take a long-term focus during what could very well be a year of transition.

Robert DeRose is vice president, reinsurance, Andrew Colannino is vice president, commercial lines, and Richard Attanasio is vice president, personal lines, at AM Best.