Japanese insurers burned their fingers in international reinsurance markets in previous years, but Takashi Oka says now is a good time to look outside Japan for properly priced cessions.
Generating profits through international reinsurance business is not easy. Losing money is much easier, as many Japanese companies have proved. In the past, some have lost vast sums by assuming risk from insurers outside Japan.
Historically, many Japanese companies were involved in the exchange of proportional reinsurance treaties based on the profitability of annual results. This reciprocal business with international companies was a way of achieving improved portfolio spread, and it worked well when companies had similar results. However, adjusting terms and premium volumes was frequently a tough exercise, and thus the exchange of proportional treaties came to an end in the early 1990s. The value of the practice was lost when companies realised that finding quality business to match their own results was getting increasingly difficult.
One kind of treaty that was thought to be of good quality was the quota share reinsurance of marine syndicates at Lloyd's. However, in time they proved to be exactly the reverse, due to the incidental non-marine exposure that was covered by many of these treaties, risk which included US liability exposure to asbestos, seepage and pollution. In addition, many Asian companies gave their pens away to underwriting agents back in the 1980s. It was an easy way to increase their premium income, but horrendous claims followed. The lesson was learned the hard way.
Domestic market share
The global market hardened following hurricane Andrew in 1992, and new capital flooded into Bermuda. The trend for Japanese managers, however, was to avoid expanding on the reinsurance side. In the wake of traumas suffered through past losses, they remained relatively modest in the international reinsurance arena. Instead, the prevailing management goal of the period was to increase domestic market share. Japan is the world's second-largest non-life insurance market, and for many years it was a regulated market with tariffs. This environment meant that, prior to liberalisation, the main target of Japanese insurance companies was the huge and profitable domestic market, which was growing steadily alongside the Japanese economy. Thus, inevitably, the appetite for international reinsurance business was small.
Liberalisation began in Japan when the new Insurance Business Law was introduced in April 1996. It was followed, in November that year, by the announcement of the Japanese `Big Bang' plan for the financial sector. The fundamental changes that resulted from deregulation and liberalisation presented new challenges for insurers, and accelerated the restructuring of the business model. The domestic market became highly competitive, while, in the background, the Japanese economy was slowing down, suffering from a state of stagnation.
To maintain healthy organic growth, and to pursue efficiency and cost reduction, mergers and tie-ups became the market's fashionable trend. A series of business combinations have been completed in the Japanese non-life sector since 2001, and virtually all the top 15 non-life insurance companies have established alliances. As the size of the companies and the pressure to improve profitability and capital efficiency grow, companies tend to take greater retention of risks.
At the same time, deregulation and liberalisation meant more freedom to manage the business, which was considered to be a good opportunity for business expansion. For example, Tokio Marine Global Re (TMGRe) was established in December 1996 in Dublin, as a group retention facility. However, in October 1999 TMGRe was re-launched as an open-market reinsurer, to accept third party business, as well as retaining more of the group's business. The company was placed at the core of Tokio Marine's international reinsurance strategy. A branch in Labuan, Malaysia, and offices in Kuala Lumpur and Mexico City were opened, and clients' agreement was obtained to transfer business previously written by Tokio Marine, Tokyo, to the new offices.
By opening these offices, the company secured a marketing advantage and was able to provide more focused and client-orientated services. Meanwhile the profit margin of reinsurance underwriting was narrowing, due to the soft market conditions. Reductions in operational costs were necessary. One rationale for the business transfers was that the resultant reduction in administrative work in Japan, which has the highest labour costs in the world, would enhance the company's competitiveness by minimising operational costs.
In March 2000 Tokio Millennium Re was established in Bermuda. Its primary objectives are to diversify geographically the group's current risk portfolio and to develop alternative risk transfer mechanisms outside the scope of the parent's current risk portfolio. Tokio Marine's catastrophe aggregation is concentrated in Japan, while catastrophe exposure in the US and Europe is minimal, Thus, Tokio Millennium Re pursues risk swaps. They are a viable method of achieving a better portfolio spread, through ceding a bloc of Japanese property catastrophe risk in exchange for assuming an equivalent value bloc of catastrophe risks from elsewhere. The ability to assess and model the risks properly is most important. The intent of such deals, to reduce capital costs by maintaining net premiums, is effective because there is no need to pay additional reinsurance costs.
Into the upswing
The worldwide reinsurance market was already hardening in early 2000, following the European windstorms Lothar and Martin in December 1999. However, September 11, which affected virtually all lines of business on a scale never before expected, thrust the market into real turmoil. It accelerated the process of upward adjustment of rating levels and tightening of contract terms and conditions.
After a decade in a soft market environment, the cycle has finally turned around. Rates have increased sharply, while terms and conditions have been altered to make exposures more manageable. The retrocession market has contracted, pushing the cost of such protection too high in many eyes, so reinsurers are writing more business on a gross basis. The market paradigm has changed dramatically, presenting new business opportunities.
However, not all the news is good. The financial position of many re/insurance companies deteriorated after September 11, and their security ratings were downgraded. Meanwhile concerns over re/insurer security heightened. Having a strong financial security rating plays a vital role in achieving recognition as a decent player in the international market. Moreover, the flight to quality is a positive move towards a healthier industry.
New capital has been introduced to the reinsurance market in a positive way - it is being supplied and managed not by naïve capacity providers, but by reinsurance professionals. Another positive factor is that nowadays boards of directors are taking tighter control, and transparency has become a requirement for underwriting in all organisations. The use of rating models is widespread, so trigger points for reinsurance losses are more obvious, and underwriters cannot accept business if they are unable to justify such a decision. Thus, the volatility of rating levels driven by factors of supply and demand should be minimised.
Many existing reinsurers have also increased their capacity. The idea is to take advantage of the current market situation, but capital providers demand high returns - a situation that is not helped by the current low interest rate environment. In previous cycles, new capacity progressively led to a softening market. This time the outlook is different. The January 2002 renewal proved that in addition to terms such as the exclusion of terrorism, pricing levels are a key factor for placements. Business offers could not attract sufficient support if the terms were inadequate. But once prices offered were high enough to surpass the trigger threshold, placements were often oversubscribed, showing that this time, new capital will not necessarily lead to a renewed soft market. Instead companies - including Japanese companies - have adopted the goal of increasing the value of their reinsurance businesses and maximising return on capital.
By Takashi Oka
Takashi Oka is chief executive officer of Tokio Marine Global Re Ltd.