As far as the reinsurance market is concerned, consolidation and competition forebode declining profitability, writes Grace M. Osborne.
The top 25 professional US property/casualty reinsurers generated $18 billion in net written premiums, representing 86% of the US reinsurance market in 1998. While individual companies have shown top line growth over the past several years, much of this has been accomplished through acquisitions of comparatively smaller entities. The quest to enhance and broaden distribution channels and consolidate “back-room operations”, good defensive strategies for combating declining prices over all lines of business globally, has yet to materialize into increased profitability.
Top line profitable growth remained elusive for US domiciled professional reinsurers, in the aggregate, in 1998. Capitalization levels, considered very strong, provide extensive capacity across most lines of business. The underlying economic need to employ the excess capital is accelerating competitive pressures to lower premium rates, expand terms and conditions, and broaden distribution channels and product lines. Standard & Poor's expects underwriting profitability to decline over the short term as historical underwriting benchmarks are modified to incorporate the new economics of world competition.
After four years of substantial growth, gross written premiums for reinsurers domiciled in the US decreased modestly by 0.3% to $25.6 billion in 1998. Pricing conditions continue to soften generally across all lines. Strong global competition, exacerbated by global excess capacity, and the shift to offering more excess of loss covers, that carry lower premiums relative to pro-rata treaties, have increased the difficulty for US domiciled professional reinsurers to grow the top line. The large reinsurers, those with a capital base greater than $1 billion, in the aggregate, generated 56% of the US gross written premiums ($14.4 billion) in 1998, consistent with a 5 year average of 58%. The large “triple-A” direct writers (General Re, American Re, Employers Re and Swiss Re) modestly increased their gross writings in 1998 to $9.0 billion, representing 35% of the US market, down from a 5 year average of 38%. Two underlying trends are responsible for the modest growth in premium writings. The large reinsurers, which have benefited most from the “flight to quality”, have exhibited a willingness to non-renew unprofitable risks while serving long-term relationships and cultivating new alliances. There has also been a general shift toward writing more excess of loss contracts.
Net written premiums for the US domiciled reinsurers decreased 4.2% to $21 billion from $21.9 billion the preceding year. Reinsurance utilization (defined as ceded written premiums to gross written premiums) almost doubled in 1998 from 1997 levels to 22%. Not surprisingly, softening reinsurance pricing has encouraged reinsurers, no matter their size, to cede risk at attractive rates. The largest increase in reinsurance utilization was generated by medium-sized reinsurers (capital greater than $500 million and less than $1 billion) who are finding their operating profitability most challenged. Standard & Poor's anticipates that the level of retrocessional protection will continue to increase.
Limited top line growth and more normalized losses combined to hold earnings back for US domiciled reinsurers as return on revenue (ROR), defined as pretax operating income divided by total revenue, excluding capital gains, declined to 13.8% in 1998 from 15.1% the preceding year, in line with the 14.1% past five year average ROR. The decline in operating results is largely attributable to higher frequency and severity of losses and incremental cost of Year 2000 (Y2K) readiness. The largest decline in ROR's emanated from smaller reinsurers, (capital less than $500 million) who have less financial flexibility to offset pricing pressures with expense efficiencies.
The 1998 combined ratio for reinsurers domiciled in the US was 102.4, a 5.1 point deterioration from last year. Most notable were property losses from Hurricane Georges with losses of approximately $3.5 billion in the US and Caribbean, a hailstorm in Minnesota in mid-May 1998 with losses in excess of $1 billion and an ice storm in Canada and northern US initiating week-long power failures in Quebec and Ontario that produced losses in excess of $1 billion.
In reviewing US catastrophe losses for the US property/ casualty market (compiled by Insurance Services Office and adjusted for inflation),1997 was the second lightest property cat year over the last 10 years. Nevertheless, levels experienced in 1998 were significant as they exceeded the ten year mean by 30%.Contributing to the industry's increased loss ratio were losses produced by “carved-out” workers' compensation exposures. Surfacing most notoriously in February 1999 with Cologne Re's posting of $275 million in reserves for estimated losses generated by the Unicover program, the full industry impact is still unknown. When these risks were ceded into the property/casualty reinsurance market, it was at rates far below the levels normally associated with the risk profile. The impact on any one reinsurer is still too early to estimate until losses begin to materialize. The appropriateness of the transactions is being contested as evidenced by two lawsuits: Fairfax Financial Holding's recent lawsuit against the agent, Sterling Cooke Brown Holdings Ltd and Allianz Life Insurance Company of North America's lawsuit against Sun Life, Phoenix Home, and their authorized agent, reinsurance intermediary AON.
Flat reserve levels raise a question over the adequacy of loss reserves for the property/casualty reinsurance industry. The level of technical reserves (defined as outstanding loss and loss adjustment reserves and unearned premium reserves) relative to earned premiums has remained around 2.4 times over the last three years. In light of softening premium rates and expanded terms and conditions, the amount of risk assumed for any given premium dollar has increased with no measurable increase in loss reserves.
Net investment income grew 2.4% in 1998 to $4.6 billion from $4.5 billion the preceding year. Total assets grew by 4% in 1998, where invested assets are a significant component. This larger investment base, predominantly fixed maturities, generated good returns and remained free of major write-offs related to underperforming securities. Low interest rates have negatively impacted companies' ability to invest new cash flows from operations at attractive yields. The lower volume of premium writings together with the lower yield on new money will place a strain on companies that seek to maintain comparable profit levels. Reinsurance recoveries on paid losses reached $1.3 billion in 1998 with 27% related to accounts due in excess of 120 days. The percentage of non-current reinsurance recoverables, in light of increasing reinsurance utilization, may become a matter of concern if the increase is related to credit risks and not timing patterns.
Pre-tax operating income, excluding capital gains (losses), decreased 8.3% in 1998 to $3.4 billion largely as a result of lacklustre underwriting and investment returns.
Statutory surplus increased a modest 3.9% in 1998 to $63 billion from $60 billion in 1997, the lowest percentage increase in the 1990s. Underwriting losses and lower re-investable rates for decreasing premium volumes undermined the generally stable investment returns. Capitalization remains very strong for all reinsurers in the secure range of Standard & Poor's financial strength ratings. The withdrawal of capital has begun with some of the largest reinsurers, such as General Re and Employers Re pulling back from lower performing programs and smaller players like Vesta, USF Re and Chartwell, selling out to larger players.
Standard & Poor's believes the combination of weak pricing and less rigorous reserve levels is likely to include further combined ratio deterioration of at least a couple of points in 1999 and prospectively further deterioration in 2000 which could lead to rating downgrades as the level of capital adequacy declines. It is far too early to predict a hardening of rates across other lines or for rosy forecasts for earnings, which will remain under pressure from the combined burdens of weak demand and excess capacity. Given current market conditions, 1999 and 2000 will be very challenging years for the US reinsurance industry.
Grace M. Osborne is a director in Standard & Poor's Insurance Ratings. She is responsible for the evaluation of financial strength and debt ratings for several property/casualty reinsurers, life reinsurers and specialty insurers predominantly in the US, and Bermuda.
Ms Osborne joined Standard & Poor's after 13 years in various financial reporting and planning roles in both the life and property/casualty industry. She also worked for Peat, Marwick, Mitchell (predecessor to KPMG Peat Marwick) on its New York office audit staff.