Prices will continue to soften barring a megacat; merger and acquisition buzz will continue

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 current 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, as assessed at the January 1, 2008 renewal, price deterioration, competition and increased cedant retentions are drivers of concern relating to the sustainability of the sector’s long-term operating performance.

The global reinsurance sector has benefited from two years of moderate catastrophe losses and solid operating earnings.

The capitalisation of the sector and the majority of its participants are currently healthy when just a few years back, many reinsurers were struggling to find capital.

In large part, improved loss reserve adequacy is apparent for several companies benefiting from the hard market years and intensified risk management strategies. Though still nagging a handful of companies, legacy issues from soft market years continue to subside.

Nonetheless, with rate declines in both property and casualty business lines, it is unlikely that current reserving levels can be maintained or be relied upon to boost earnings in outward years.

Depending on catastrophe activity, it is AM Best’s expectation that the sector is poised for a profitable 2008 given that technical rates of most major lines of business are still profitable to this point. Investment income fueled by strong cash flow should also support earnings.

AM Best believes that 2008 results will reflect more accurately current market trends as margins are expected to moderate.

Barring a mega-catastrophe that removes enormous amounts of industry surplus from the market, AM Best does not expect an improvement in pricing levels for some time.

The success factors for navigating these rough waters are for reinsurers to maintain underwriting controls and standards to determine pricing adequacy and maintain discipline in a challenging environment. History indicates these are not easy tasks to accomplish.

A critical factor of managing the market cycle is capital management. While share repurchase programmes and increased dividends have given a sizeable portion of accumulated earnings back to stakeholders, there is considerable pressure on reinsurers to achieve targeted return on equity.

Many carriers since have established diversified operating platforms, while newer formations have looked to build underlying capabilities to manage the cycle and deploy capital. AM Best expects that the merger and acquisition buzz will continue through 2008 with the possibility of more deals.

Despite the improved position of the reinsurance sector, challenges remain in light of the increased capacity of industry participants, new entrants and forms of capital.

It is no longer easy to ignore the reality of the capital markets as an alternative solution for primary markets. After paying high reinsurance costs over many years, financially improved cedants are more sophisticated and are assessing how much reinsurance coverage to buy in more economic terms.

Although the reinsurance sector’s capital position is strong, recent history indicates the pain that soft casualty markets can inflict on required capital year after year, and how large-scale catastrophes can remove massive amounts of capital from the market in the blink of an eye.

AM Best believes that 2008 will be an important year for the global reinsurance industry, as it can influence the direction of the market for years to come.

The rating agency has witnessed the reinsurance sector’s embracement of ERM practices and the subsequent improvement of data capture risk modeling and correlation analysis.

However, it is important to note that ERM enhancements have not been tested by a mega-catastrophic event as two category five hurricanes did strike landfall in 2007, but the dynamics of these storms—to a great extent—limited insured losses.

The true success of reinsurers achieving value through ERM is the ability to adhere to its role through all phases of the pricing cycle. If this can be achieved, perhaps this soft market will not be as painful as the previous one.