Global Reinsurance has conducted a survey of reinsurance CEOs to gauge the current strength of the market and to consider the sector's future direction. By Nigel Allen.
It would seem a fairly safe bet to assume that an industry built on the ability to predict the likelihood of a particular event and to estimate the financial impact of such an event should be able to more accurately than most forecast its own destiny. This was supported by the concluding remarks of the Global Reinsurance CEO Review 2001: "Whether they be global giants or local companies, they are all expecting growth in the near future. Nevertheless, they are aware of the challenges facing them…" However, after the battering which the sector has taken in the last two years, some would say that all bets are off. Encompassing this two-year span, the findings of this year's review reveal just how risky reinsurance can be.
In order to compile the information which follows, a number of CEOs in the reinsurance sector were asked to complete a comprehensive questionnaire. Questions were divided into four main categories relating to individual information, a company overview, financial statistics and factors affecting their business. Every respondent was guaranteed anonymity. However, a number of interviews were carried out 'on the record' with individuals to discuss the general findings of the review. All currencies referred to have been converted into US dollars.
Despite the delicate nature of the question, all of the CEOs answered the question relating to their age. Respondents were representative of a fairly broad age range, with 50% aged between 40 and 50, 38% falling into the '51 to 60' age category and 12% willing to admit that they were over 60. However, this fairly even spread was not reflected in the responses to the question on the number of years employed in the reinsurance sector. The survey revealed a marked degree of polarisation in terms of experience, with almost two-thirds of CEOs having amassed over 20 years of experience in the industry, of which approximately 30% had over 30 years. In contrast, 24% of respondents had only been working in the sector for five years or less.
Additional information was sought as to the backgrounds of those CEOs who had not cut their teeth on reinsurance. In total, approximately 40% of respondents had been brought up within the walls of the reinsurance industry. Of those who had previously worked outside the reinsurance industry, only one CEO had not entered the sector through the insurance door, having previously been an accountant. Unfortunately, these results do appear to support the theory that the reinsurance sector is guilty of keeping within its own ranks and reveals a distinct lack of cross-pollination with other financial sectors and of new blood entering the sector.
Unsurprisingly, there were few parts of the globe which the review did not reach, with responses coming from Bermuda, Europe, the Far East and the US. Break it down further still and the review's coverage encompassed approximately 135 cities. While less than one-fifth of companies were headquartered in the US, over two-thirds of those surveyed had offices located in the US, with half of those in New York. Both the UK and Bermuda were well represented, with approximately half of respondents reporting offices in London and Hamilton. Other European locations included Munich, Zurich and Milan, while 40% of companies had offices in Dublin and 35% had a presence in Paris. The review also showed that many had a strong presence in Asia, with approximately one-third having offices in Singapore and a quarter reporting offices in Beijing and Kuala Lumpur. Over one-quarter of respondents also had a base in Sydney. Other office locations included: Bahrain, Beirut, Buenos Aries, Calcutta, Guernsey, Mexico City, Tel Aviv, Toronto and Tokyo.
While the responses clearly showed the immense global presence of the reinsurance industry, what they also revealed was the incredible degree of polarisation between the reach of individual companies. The number of office locations ranged from one to 89, with 50% of companies having five offices or less, 70% having fewer than 15 offices and 15% having over 70 offices. As one would expect, this is mirrored in the number of company employees, although not to as great a degree, with 63% of companies employing less than 250 staff, while 25% employed more than 749. While it is perhaps difficult to reach any steadfast conclusions at such an early stage in the analysis if the results, the reinsurance sector clearly seems to lack a concept of a 'middle ground'. The companies surveyed appear to fall into two categories; those which specialise and those which globalise.
While this assumption is to a degree borne out by the responses to the question concerning the lines of reinsurance business written, which ranged from a focus on particular lines such as life & annuity, property or casualty to those writing all lines of business, the degree of polarisation is not as great. This is not, however, surprising as 'diversification' seems to be an industry buzzword, with the dangers of having all your policies in one basket apparent to all, and in particular the rating agencies which continually cite a well-diversified portfolio when highlighting factors for affirming or upgrading financial strength ratings.
Total revenues for 2002 ranged from $76m to $44.5bn compared to a range of $66m to $40.2bn for the previous year. The review revealed an increase on average of 28.4% year on year. This figure excludes percentage rises for new start-ups which did not report a full year of operations in 2001. Only one respondent recorded a decline in total revenue in 2002.
Respondents were asked to state the main contributory factor behind the change in total revenue. While many listed organic growth, more specific responses highlighted factors such as: growth in particular lines of business; rises in premium rates, an increase in earned premiums; greater demand; improved pricing, and term and conditions; investment income; lower combined ratios; greater retention; changing from proportional to non-proportional retrocession; and capitalising on the hardening of the market.
When asked to forecast the percentage change in revenue for 2003 compared to 2002, approximately one-third of CEOs chose not to respond. Of those who did, almost all were confident that total revenue would continue to rise, although the predicted increase was down slightly on that recorded for 2001/2002, with an average forecast of 27.2%. Of those who predicted a decline in total revenue, the contributing factors were listed as either downsizing or restructuring.
Factors for anticipated growth differed slightly from those given for growth in 2002. Responses once again listed organic growth, greater demand, rate rises, increases in earned premiums and the state of the reinsurance sector, with particular reference to the demise of Gerling Global Re. However, other factors included were: increased opportunities in the European market; growth in investment income; new business lines; risk adequate pricing; currency fluctuations and strong growth in financial reinsurance.
In terms of the volume of gross reinsurance premiums written, this ranged from $76m to $28.3bn in 2002 compared to $61m to $24.7bn for 2001, with an average increase of 35.9% year on year. The results for net reinsurance premiums written produced a similar spread, with figures for 2002 ranging from $44m to $24.8bn, compared to $44m to $20.8bn for 2001, and representing an average increase of 45.2%. However, when asked to predict the percentage change in net reinsurance premiums written for 2003, while still predicting an increase, most believed that this would be considerably lower than in the previous two years, with one respondent anticipating a drop of 60% in premiums written. Despite this, the average remained a positive one, with a rise of 21.5% expected.
Almost all of the companies polled reported improved loss ratios in 2002 compared to 2001, with an average improvement of approximately 24%. Some respondents reported horrendous loss ratios for 2001, one in particular rising to 194%. However, a look at the lines of reinsurance business written and one can quickly see that all of those companies recording high loss ratios were involved in writing property catastrophe lines. While the average loss ratio for 2001 was 96.7%, 2002 has shown an improvement of approximately 24% to 72.1%. Predictions for 2003 are much more muted, with a 3.6% improvement anticipated.
That loss ratios should have dropped by almost a quarter highlights the increasing dependence reinsurers are placing upon that core function of their business - underwriting. With a combination of continued weakness in global investment markets, with poor returns on European equity investments and equally poor returns on US corporate and government bonds, and the need to bolster inadequate reserves, many reinsurers have had the capital rug pulled from under their feet. Not able to rely on external sources of capital, reinsurers are increasingly dependent upon their ability to generate income internally. Reinsurers are also becoming much more selective in terms of clients, with a high degree of risk aversion in relation to more problematic lines and ever greater amounts of information being demanded on the portfolio which is to be protected. Steven Hitchcock, Deputy Managing Director at Heath Lambert, said: "The ability to obtain huge investment returns is severely diminished, so we are back to pure underwriting rather than cashflow underwriting." A more disciplined approach to underwriting is now required to re-establish a solid capital platform. "Now the reinsurance sector has to show that it can create capital through solid economic performance, through underwriting and through a disciplined approach to balance sheet management," added Dirk Lohmann, CEO of Converium Ltd.
Expense ratios remained relatively stable over the two years, ranging from 49.75% to 6% for 2001 and from 43.8% to 5% for 2002, with an average improvement of 1%, which is not particularly surprising as the need to control costs is now paramount. While one-third of respondents declined to predict a change for 2003, of those who did a slight improvement was anticipated, with ratios to improve by on average 0.4%.
For approximately 30% of companies polled, their books of business were 100% non-life premiums. In 2001, the non-life/life premium split ranged from 69% to 95.93% in favour of non-life premiums. The bias towards non-life premiums increased marginally in 2002, which produced a range of 73% to 98%, with an average increase in non-life premiums of 2.4%. Of those who forecast non-life/life premium levels for 2003, while the anticipated change was slight, it was still a push towards increased non-life premiums levels, with a predicted rise of 0.8%.
Levels for treaty and facultative premiums unsurprisingly followed a similar pattern to those for life/non-life premiums. One-third of respondents reported a 100% reliance on treaty premiums. Of the remainder, the 2001 figures for treaty premiums ranged from 67% to 99%, while those for 2002 ranged from 66% to 99%. No respondents predicted any significant change to their levels of treaty premiums in 2003.
Once the financial health of the companies polled had been established, the attention of the survey turned towards the impact of the state of the reinsurance marketplace on their business.
The first question asked respondents to list the three main factors contributing to growth in their business. While many cited an increase in their customer base and expansion into new classes of business, by far and away the greatest contributing factor was that of rising premium rates. The reinsurance sector recorded dramatic rate hikes across the board in 2002 and while rates have begun to level off in some lines in 2003, such as property catastrophe and aviation, rates for professional liability lines such as D&O and E&O have not. As premiums in such sectors continue to rise at an alarming rate, the pressure on insurers to bear greater risk retentions grows, and some commentators have suggested that reinsurers might be in danger of "pricing themselves out of the market" should rises continue at such a pace.
"There is what we call a 'choke price'," explained James Bryce, President and CEO of IPCRe, "that point at which the client says 'I'm not going to buy it'. And that is a real danger. For classes such as property catastrophe this is not so much a fear. However, for some other classes, for example D&O and E&O - the professional indemnity lines - there does come a point where, if it is hard and companies are unrealistic, you could force a client into a captive or self-insured retention." However, Mr Lohmann of Converium questioned whether the present strength of insurers' balance sheets could support such a move. "There will be, once companies are able to absorb more risk and retain more risk, a tendency towards increased retention, but that is going to be a long-term process. Right now, I would say that the status of the balance sheets of most insurance companies is still relatively weak, either because they have inadequate reserves for their prior years in asbestos or because of erosion of assets… Both of these factors have hindered their ability to retain more and so they are still buying."
With some reinsurers pulling out of lines considered more trouble than they are worth and reducing their presence in others, the way has been left open for companies to step into the breach. This is reflected in the number of respondents who reported expansion into new business lines as key to business growth. The London market in particular has been able to exploit these gaps due to the unique diversification of capacity it affords. Bermuda has also rallied, with the 'Class of 2001' a response to the depleted market capacity occurring in the immediate aftermath of September 11.
While many respondents referred to increases in their customer base as assisting growth, some respondents also cited an increase in the size of relationships with select customers. By referring to 'select' customers, this would appear to support the idea that many reinsurance underwriters are becoming increasingly selective in what business they write and are keen to hand-pick those clients who have in place adequate risk management strategies, limiting their risk exposures and helping to guarantee continued improvement in their combined ratios, perhaps the only effective means of combating poor investment returns.
Other factors contributing to business growth included: increasing shares in existing programmes; the impact of financial strength ratings; and an improved capital base.
Counterbalancing these factors, CEOs were asked to list the biggest constraints to future business growth. About 70% of respondents cited both shortage of capacity and increased competition as main constraints. As already mentioned, significant withdrawals from a number of lines following the tragedy of September 11 and the corporate debacles of Enron, WorldCom et al resulted in a mass shortage of capacity and speeded up what was already seen as a hardening market.
"Because of the tragedy of 9/11 hitting both reinsurance and insurance, both non-life and life, and virtually every class of business, everything was a record loss with the exception of surety," explained Mr Bryce. "And with the Enron debacle of fourth-quarter 2001, we got every class. That dislocation caused a new kind of cycle change. It was not like the 1980s, which was a casualty crisis. It was not like the early 1990s, which was a property catastrophe crisis. It was a severe dislocation against all classes. It was something that has never been seen before in the history of the industry."
However, Mr Lohmann refuted the claim that the reinsurance sector is currently lacking sufficient capacity. "I wouldn't say that there is a huge shortage of capacity globally right now. It may be a bit tight but it is not like we have an absolute dearth of capacity in reinsurance." Mr Bryce believed that capacity should only be considered on a sector-by-sector basis. "Today, in terms of property catastrophe, it is a very healthy market. There is enough capacity if you are willing to pay the right price." He went on to say: "If you look at the reinsurance industry, there are pockets where the industry is definitely hard. The limits of D&O are still sizeable, and for people who want to buy there is simply not enough capacity." However, Stephen Hitchcock painted a slightly healthier picture of the much maligned sector. "We are seeing capacity coming back into the more difficult classes, such as D&O and professional liability."
With more and more reinsurers focussing on fewer and fewer prime clients due to increasingly restrictive underwriting processes, it is to be expected that increasing competition should rank high in the list of constraining factors. It is also of note that, when asked for the most threatening market issues facing their companies, changes in the type/level of competition came out top, polling some 77% of CEO responses. The reinsurance sector has become a highly competitive and compacted environment, with a spate of M&As, consolidation and closures, and particularly that of Gerling Global Re since the last survey. "There seems to be a continuing polarisation," commented Mr Bryce, "where the strong are getting stronger and the weak are getting weaker. The companies in between are disappearing. And you will see a greater degree of polarisation with fewer numbers."
The problems of a shortage of skilled staff continue to dog CEOs, while developing and retaining potential leaders, and the ability to recruit or compete for quality staff ranked high in the responses to the biggest challenges facing respondents. The majority of industry practitioners agree the reinsurance talent pool is shallow and despite its recent battering, the investment banking sector would still appear to be a greater lure to financial practitioners.
While future growth was not considered to be affected by an inadequate infrastructure to support growth, approximately 50% of CEOs, when asked what they saw as the biggest challenges currently facing them, cited the ability to develop that infrastructure. There is a myriad of reasons which could be contributing to this problem, including insufficient time to devote to establishing an adequate growth strategy, shortage of skilled staff to carry out such a development, and a lack of potential acquisition targets. However, there is little doubt that capital restrictions are also a contributing factor, and the inability to reinvest capital into the company to bolster growth. In fact, respondents ranked making investment and capital allocation decisions just as problematic.
Capital is coming under severe pressure. The last 12 to 18 months, while they have been relatively free of major catastrophes, have seen many companies acknowledge inadequate reserves, with the resulting loss of capital to cover these shortfalls. Further capital is having to be set aside to meet the ever more stringent risk solvency requirements being established by both rating agencies and regulators. While new capital did enter the market following the events of September 11, this was insignificant in comparison to the amounts of capital exiting the sector, and on the whole this capital influx was channelled into Bermuda and the London market. As a result, reinsurers are now having to return to the tried and trusted methods of profitable underwriting to make a buck.
Reinsurers are finding themselves in an unenviable position of having to satisfy rating agency and regulator requirements on the one hand, and the demand for solid returns from investors on the other, at a time when potential capital sources are turning their gaze from the reinsurance sector. This is reflected in the responses of a number of CEOs who highlighted the difficulties of increasing or simply maintaining shareholder value.
While market conditions might seem ripe for M&A activity, which has certainly been on the increase over the last two years, only 18% of respondents saw managing M&A activity as a challenge. This may be because the M&A market has now run dry or as some have suggested, the returns that many predicted from strategic acquisitions have not been as great as expected.
Respondents ranked changes in the type and level of competition as the most threatening market issue, but almost 50% of respondents also highlighted the continued impact of fluctuations in the reinsurance cycle. Of those interviewed, all remarked upon the severity of the reinsurance cycles which the industry has experienced in recent years. "You will always get cycles in insurance and reinsurance," concluded Mr Hitchcock. "History will continue to repeat itself. The cycles may be shallower and shorter in duration, but there will always be cycles - partly because new capital arrives and competes with old capital." A key influence on the dampening of reinsurance cycle has been the rise of the model. "Prior to the broad acceptance of cat models in the US you had a fairly cyclical movement in pricing," explained Mr Lohmann. However, he added, following the impact of hurricane Andrew in 1992 and the Northridge quake in 1994, "it was no longer a question of do you model, but what model do you use?" He continued: "The use of more sophisticated tools, a greater acceptance of modeling, and not only in cat but in other areas, will help to dampen cycles, but I don't believe that we will ever be able to avoid cyclicality."
Difficulties still exist in purchasing retrocession cover, according to the survey. The retrocession market has suffered from a raft of downgrades, with a number of withdrawals from the sector. Unsurprisingly, retrocessionaires drove a hard bargain for cover in 2003 and many believe this will continue into 2004. The sector has also seen few new entrants, but while the reinsurance sector has witnessed a 'flight to quality', so too has the retrocession market. "The supply of retrocession remains very tight," confirmed Mr Lohmann. "There are players who want to dabble in it. The question is, do buyers want to avail of that capacity? When reinsurers buy retrocession they are acutely aware of the counterparty risk and performance risk, as far as credit quality is concerned." Rating agencies, however, while aware of the part played by retrocession in supporting the reinsurance sector, are wary of over-reliance. "One of the first questions that both of the ratings agencies which cover us asked after 9/11 was how much of this have you retroceded?" Mr Bryce explained. "When I said 'zero', you could literally hear the sigh of relief."
There is one issue which has been seen as both a challenge and a threat, both a contributor and a constraint to growth, and that is the rating. "Everyone needs a yardstick and the rating agency is that yardstick," said Mr Bryce, "both for the buyers of insurance and the lending institutions." However, the mass downgrading of the reinsurance sector in the last two years has caused a number of people to ask questions about the rating process itself. "The speed with which some companies go from 'AA' rating to insolvency gives us some concern as to what sort of a pointer these agencies provide," said Mr Hitchcock. Mr Lohmann suggested that there is a need for the rating process to place greater emphasis on qualitative elements. "In the re/insurance business probably two-thirds of the balance sheet and the same percentage of the profit and loss are based on estimates and those estimates can prove to be wrong over time. So you have to look at the qualitative elements as well." However, the rise of the rating may be waning, he believed. "In the past, the buyer would defer to the rating agency on the decision of who was going to be an acceptable counterparty. For this class of business it must be 'AA' or higher. If they take that position today, they are not going to find too many people they can talk to!" He continued: "Buyers of reinsurance are now asking themselves other questions. For example, is the capital that is behind my counterparty actually committed to reinsurance? The decision by buyers not to accept insurance companies as counterparties for reinsurance business - a division of an insurance company - is an indication of that."
The enforced return to a focus on underwriting profitability brought on by the virtual demise of all other forms of external, revenue-generating channels could well prove a godsend for the industry, redolent of the old saying, "What does not kill you can only make you stronger". By returning to its core competencies the reinsurance sector cannot help but profit in the long-term, and when capital markets once again become a viable source of revenue, the sector should be primed to exploit it.
By Nigel Allen
Nigel Allen is the Assistant Editor of Global Reinsurance.