Reinsurers need steady nerves and underwriting discipline in order to face an impending economic downturn, says Maria Kielmas
It is like waiting for the monsoon to break. Predictions of global economic turmoil emerge almost daily from government agencies and business sectors. Trouble is on the way, but not yet, the forecasters say. Despite economic and financial imbalances throughout the world - such as the US current account deficit and growing government and personal debt everywhere - on top of persistently high oil prices and threats of revived inflation, let alone terrorism, the industrialised economies seem to be muddling through. It won't last though, say the Cassandras. The reinsurance industry is generally acknowledged to be at the end of its latest cycle. So if turbulent economic times lie ahead, how will the reinsurers cope?
"The uncertainty in the global economic outlook underlies the need for the reinsurance industry to stick to risk-adequate pricing independent from the cycle," says Clemens Muth, executive manager for economic research at Munich Re. "Investment returns are no alternative to solid underwriting profits," he adds.
The expectation of high, or even adequate investment returns, especially after the hedge fund bonanza year of 2004, as well as the lack of sufficient other investment opportunities, has persuaded institutional investors to snap up riskier corporate and emerging market bonds. These investors received an unwelcome wake-up call in May when Standard & Poor's downgraded two of the world's largest issuers of corporate debt - General Motors and Ford Motor Company - to junk status. Caught unawares, many investors ditched their riskier bonds causing some turmoil in the credit markets. The result was that many investment banks reported falls in fixed-income trading revenues of anything between 20% in the case of Goldman Sachs to 77% in the case of Bank of America. Credit analysts predicted more downgrades of corporate debt in the months ahead.
But this is no reason for insurers and reinsurers to panic, thinks Chris Waterman, senior director at the European Insurance Group, Fitch Ratings. "Clearly there is credit risk exposure in insurance companies' investment portfolios. But typically insurance companies don't take on a significant asset exposure," he says, adding that the investment policy is usually to go for high-rated government debt.
Clemens Muth concurs. "Default rates as reported by the rating agencies are still at very low levels. There is some increase expected but most observers expect this increase to be moderate," he says. Citing what he termed Munich Re's very conservative investment policy, Muth noted that at the end of 2004 more than 86% of the fixed income securities the company had invested in were in the "AA" or "AAA" category, while over 94% were in the "A", "AA" or "AAA" category. Furthermore, he said reinsurers are little or not at all involved in the credit derivatives market.
Chris Waterman notes that although some reinsurers had been badly hurt by credit derivative losses some three years ago, now their credit default exposure has gone and is going down. Insurers' and reinsurers' investments are typically limited in these instruments and even then, they are mainly in the higher tranches, he adds. As far as the US market is concerned, there have been no significant losses in the portfolio of US reinsurers, says Allan Richmond, insurance analyst at T Rowe Price.
There are a bewildering number of debt and derivatives-related deals on the capital markets. Financial institutions and intermediaries have found they can make big money, and even choose the levels of risk they can tolerate, in the structured credit market. At the centre are collaterised debt obligations (CDOs). These are packages of loans, bonds and other debt instruments, which can be divided up into separate tranches according to their default risk exposure. The after-effects of the Ford and General Motors downgrades hit the riskiest CDO tranches in May this year. But the lower perceived risk tranches rallied, prompting many investors to believe that the car manufacturers' problems were just isolated cases.
Amazingly, nobody seems to know the size of the CDO market worldwide. JP Morgan estimated in a recent research note that the CDO issue by July this year could have been about $127bn. This contrasts greatly with the figure from the Bank of International Settlement (BIS) - the central bankers' central bank - which estimated the total CDO issue for 2004 alone at $838bn. Chicago-based structured credit consultant Janet Tavakoli estimated that this year the CDO issue could also reach $800bn.
Credit exposure still there
Notions that insurers and reinsurers had their credit market woes behind them were dispelled when it became apparent that companies such as Royal & SunAlliance (RSA) and France's Scor were still in the process of unwinding their positions and it remained unclear how large the ultimate losses would be. RSA first acknowledged its CDO losses last year when it published its 2003 annual report. At that time the company said it had lost £50m and warned that the losses could swell to £165m depending on the performance of "underlying debt obligations". The company claims it has reduced its exposure by some two-thirds. Scor, for its part, revealed that it had hedged CDO losses of up to $2.5bn with investment bank Goldman Sachs, paying the bank EUR45m for the service.
The dilemma faced by insurers, reinsurers and other investors in CDOs is whether to wind them down or hedge them. Hanging on to them may not be a good idea. If the credit cycle turns over the next year or so, as many of the market's expert watchers predict, insurers', reinsurers' and other CDO investors' positions will be even more fragile given the lack of liquidity in the CDO market in the first place, even from tranches rated at "AAA". And the lack of transparency in this market adds to the nervousness. CDO issuers have been known to substitute the various bonds and loans that work as the CDO's collateral, essentially dumping under-performing assets on unsuspecting investors.
Prospects for growth
Contradictory reports abound of investors' appetite for, or disenchantment with, such exotic debt instruments. But industry economists remain optimistic about prospects for growth, at least over the next year or so. In an April study, the Economic Research Division of Allianz said it believes the strong pace of expansion in the global economy will continue throughout this year and next. But the period of low interest rates is coming to an end. Allianz says this is to a certain extent a result of rising US inflation and the US Federal Reserve Bank's policy of tightening. European interest rates, Allianz believes, will also rise but this increase will be less marked than in the US.
The prospect of higher interest rates in the US should benefit that country's property and casualty market, thinks Allan Richmond. Interest rate increases of about 1% per year over the next couple of years will improve the company's investment returns. A Swiss Re study of the US property and casualty outlook noted that the sector's invested assets grew by a strong 17%, while investment yield declined to 4.4%; the lowest level in the last 30 years. Swiss Re thinks that investment results will continue to grow in 2005, driven by asset growth. But the focus on underwriting remains critical. The focus on underwriting was the main driver of improved profitability with return on equity projected at 10.7% in 2005 compared with 9.7% in 2004.
Global economic risks are marring this picture. "Geopolitical risks and global imbalances such as the huge US current account deficit remain risks for the world economy too in 2006," says Munich Re's Clemens Muth. The US current account deficit is expected to exceed $800bn this year. This has been largely financed by Asian central banks and investors that have been buying US Treasury bonds in an effort to halt any rise in their own currencies. As a result, US interest rates, instead of rising to adjust the economic imbalance caused by the deficit, have remained low. Imports of cheap Asian, in particular Chinese, consumer goods have helped keep inflation low. As long as this continues, a painful adjustment can be kept at bay, economists think. But then it is necessary to factor in world oil prices.
In common with other business sectors, insurers and reinsurers on either side of the Atlantic view the world oil price as the single largest threat to the global economy over the next two years. For some this risk is rated even higher than terrorism. The last year and a half of high oil prices are expected to act as a drag on economic growth as well as eventually stoking inflation as they work their way through national economies. Even if today's financial wizardry in the capital markets manages to avoid 1970s type stagflation (the combination of stagnant or negative growth and rising inflation) both consumer spending power and business profits are likely to suffer. So with such a cloudy scenario ahead, how will insurers and reinsurers continue with their underwriting discipline?
"In the upcoming renewals the primary insurance and reinsurance industry should avoid a return to cyclicality," says Muth. "I am confident that the reinsurance industry has learnt its lessons from the past soft cycle. Greater internal and external transparency, better steering tools and new management teams make me confident." Fitch's Chris Waterman isn't so sure. "A lot of companies are talking about cycle management strategies. I'm very sceptical. If all companies were successful, we wouldn't have a cycle," he says.
This has been Fitch's view for some time. In its mid-year 2004 "Global Reinsurance Outlook", Fitch commented that given premium rate pressure, risk selection would once again separate reinsurance market winners from reinsurance market losers. The company now believes that some reinsurers will succeed in implementing cycle management strategies. Those willing to maintain underwriting profitability at the expense of market share are more likely to succeed. But in the absence of catastrophe-related losses, this market discipline is likely to decline and inadequate pricing will eventually return. Fitch believes that excess capacity, strong recent underwriting year results and a reduction in reported adverse reserve developments will inevitably result in continued pressure on rates.
Clemens Muth thinks that the reinsurance industry should avoid the trap of once more subsidising other sectors of the economy with low or not risk-adequate rates. But as central bankers - such as the Bank of England and the US Federal Reserve - express increased concern about the levels of personal debt while at the same time economy indicators forecast trouble ahead, those debt-ridden end-consumers may risk adequate rates and choose a cheaper option. If underwriting discipline erodes and investment yields remain low, the outlook for some reinsurers is certainly cloudy. This balancing act between riskier investment options and less profitable underwriting mirrors that of the global economy.
Maria Kielmas is a freelance journalist.