Mark Rouck looks at the rating trends and key issues in the US reinsurance sector

Fitch believes that there is a series of factors currently having a favourable impact on the US reinsurance sector. The sector's reserve position, while still deficient, has improved, investment yields are likely heading higher accompanied by favourable macro credit trends, and absent large catastrophe losses, we believe the sector will continue to generate underwriting profits for the next 12-18 months. However, we also believe that the underwriting cycle is alive and well and is already rearing its ugly head in various lines. Fitch believes that the depth and duration of the next inevitable soft market, along with market participants' actions in response to market conditions, are the key factors that will determine the sector's financial stability going forward.

Ratings stabilised

From the beginning of 2002 until today, Fitch's rating actions on reinsurers included 17 downgrades, 25 affirmations and no upgrades (see Table 1).

Fitch now believes that its universe of reinsurance ratings has stabilised, and it expects to make comparatively few changes to reinsurers' ratings in the near-term. In addition, Fitch expects that the number of rating upgrades and downgrades it makes will more closely approximate one another than they have in the recent past. Reflecting these expectations, Fitch changed its rating outlook for the global reinsurance sector to 'stable' from 'negative' on 27 July 2004. Prior to the change, Fitch had maintained a negative rating outlook on the sector since 2001.

A key consideration in Fitch's change in outlook is the belief that company-specific reserve deficiencies are now better incorporated into its ratings.

Although this doesn't represent improving fundamentals for the sector, other considerations that are more closely related to the sector's fundamental health have improved and contributed to Fitch's decision to change its rating outlook on the sector.

Reserve profile improves

The single most important factor contributing to Fitch's revised outlook is our belief that the industry's reserve deficiency, though still material, is declining and that adverse reserve development over the next 12-18 months will be lower in magnitude than that experienced in 2003. Fitch also notes that, as seen in Table 2, the sector experienced significantly less adverse reserve development in 2003 than it did in 2002.

We expect such future adverse reserve development to affect a more limited number of reinsurers, and, given the sector's recent strong capital formation, to be manageable from a capital perspective.

Fitch cites two primary reasons for the improvement in the reinsurance sector's reserve profile. First is a reduction in the US property/casualty sector's deficient reserve position, which was a key factor behind Fitch's July 2004 decision. Fitch's projected industry-wide deficiency, the vast majority of which is from the commercial lines sector, has declined moderately to $44bn-62bn at year-end 2003 compared to a range of $46bn-77bn at year-end 2002.

Second, reinsurers and cedants re-underwrote large portions of their books of business in recent years, which when coupled with the significant rate increases implemented during the 2001-2003 hard market, results in comparatively little risk that adverse development for accident years 2001-2003 will exceed Fitch's current expectations. Accident year 2001-2003 loss ratios incorporated into Fitch's current range of projected reserve deficiencies are 95%, 79% and 73% respectively.

Premium rates still adequate

The revision in Fitch's rating outlook also reflects its belief that market conditions will continue to support adequate profitability and returns on capital. Premium rate increases have moderated and in some lines rate decreases have become the norm. However, we believe that after several years of strong increases, premium rates are moderating from a technically adequate level that is still able to produce an underwriting profit.

Market conditions have clearly evolved over the last 12 to 18 months.

Starting in 2001 when the reinsurance sector emerged from the soft market, essentially all segments of the sector were able to implement rate increases and to tighten terms and conditions. In mid-2003 the ability to implement rate increases in property lines began to fade while rate increases in casualty lines were still the norm. By the second quarter of 2004, rate decreases in property lines became standard and casualty premium rate trends were flat-to-down.

Fitch views the near-term market as much more of a 'risk selector's' market, since the ability to maintain rate adequacy and hard-fought terms and conditions tightening depends on the reinsurer's specific characteristics and the class of business being written.

Fitch's decision to change its rating outlook on the global reinsurance sector also reflects its expectation of a higher interest rate environment as global economic growth accelerates. Fitch believes that this environment will foster continued improvements in bond portfolio credit quality and higher bond portfolio yields on new cash flows. From a rating perspective, we believe that these conditions will more than offset interest rate-driven declines in bond values, especially since most reinsurers follow a buy and hold investment strategy. While Fitch believes that this return to a more 'typical' interest rate environment will ultimately increase pressure on the sector's premium rates and terms and conditions, it believes that this specific pressure is unlikely to materialise in the near-term.

Absent a large natural catastrophe, Fitch projects the sector's 2004 combined ratio in a range of 95-98% as earnings will continue to benefit from strong premium rate increases and re-underwriting implemented during the hard market of 2001-2003. Fitch expects the sector's combined ratio to bottom-out within the next twelve months as the earnings benefit from the hard market runs off and the impact of the more moderate rate environment takes effect. Fitch anticipates that growth in the US reinsurance sector's net premiums written will be modest in 2004 reflecting the impact of flattening - or in some cases declining - premium rates.

Fitch's financial forecast for the US reinsurance sector for 2004 along with historical financial data is shown in Table 3 above, which incorporates actual and projected data for US-domiciled reinsurers under US statutory accounting principles.

The US reinsurance sector's performance is not entirely reflective of that of the broader reinsurance sector. Table 4 (page 54) includes US GAAP-basis operating performance data for 14 reinsurers, most of which are Bermuda-based. In comparison to the data in Table 3, the data in Table 4 generally show higher rates of return on capital and higher premium growth rates. This reflects differences between US statutory accounting principles and US GAAP. It also reflects the relative immaturity and corresponding lack of legacy reserve issues faced by the reinsurers formed in the wake of 9/11 that are included in Table 4.

Going forward

Fitch believes that the key issues impacting the US reinsurance sector going forward include the following:

- The depth and duration of the next soft market. According to an article written by Guy Carpenter in 2002, the last commercial lines soft market started in 1988 and continued for twelve years. In contrast, the average soft market in the US lasts 7.4 years. Although these references are focussed on the primary market, Fitch believes they can be used to draw inferences on the reinsurance market.

Our rating outlook is intended to look through 'normal' soft markets so that we don't move our rating outlook in response to normal cyclical conditions. If, however, we see evidence that the next soft market is destined to be longer and more severe than usual, we will likely revisit our rating outlook. Such evidence would include severe and prolonged premium rate decreases, loss cost assumptions that are inconsistent with medical and other inflationary trends, and accident year loss ratios that appear inconsistent with historic results and current conditions.

- Management's response to changes in the sector's position in the underwriting cycle. Many market observers have opined that the next soft market's duration will be mitigated by managements' increasing sophistication and reliance on financial modeling to help avoid the perils of under-pricing their products. We remain unconvinced. We believe that there are few, if any, management teams that wittingly under-priced their product in the last soft market and that management largely believed that it was walking on the right side of the fine line between maintaining adequacy and maintaining market share, while competitors were acting 'irrationally'. This line of behaviour is likely to occur again in the future given the inherent challenges in pricing reinsurance.

- Shareholder expectations will continue to provide near-term positive pressure on the reinsurance sector. However, we expect this pressure to fade over time. Foremost among these expectations is the assumption that reinsurers will follow the 'right' strategy, namely refusing to pursue market share and top-line growth at the expense of bottom-line profitability.

With many reinsurers warning of pressure on premium rates during their second quarter earnings calls and memories of the pain inflicted by the last soft market still fresh in shareholders' minds, we anticipate that shareholders will be very sceptical about market share and top-line growth stories. However, we also believe that market participants' and observers' memories are fleeting and absent significant catastrophe-related losses, we expect the discipline imposed on the market by these conditions and memories to fade over time.

Longer term, we expect shareholder expectations to continue to be the key factor balancing the reinsurance sector's capital flows. Historically, capital has flowed into the sector when rates of return were perceived to be high and has flowed out of the sector when rates of return were perceived to be low. We see nothing on the horizon to suggest the future will be any different. We believe that returns on capital will peak within the next twelve months and note that many shareholders, perhaps sensing that rates of return are peaking, have begun questioning reinsurers about implementing or increasing dividends and or share repurchase programs.

- The cost of letters of credit (LOC), the most common form of collateral provided by alien reinsurers to their US-domiciled cedants, will increase.

A key factor underlying this trend is heightened demand for LOCs used to collateralise reinsurance recoverables due from life reinsurers. This heightened demand will result from primary life insurers ceding portions of their Regulation XXX reserving requirements and alien reinsurers collateralising the resulting recoverables.

In addition, Fitch believes that banks will increase fees charged to provide LOCs as they implement Basel II regulations requiring them to hold more capital to support LOC obligations. Furthermore, Fitch believes that bank consolidation is likely to continue to reduce the supply of LOC providers, further pressuring LOC fees.

Trends impacting LOCs and other forms of collateral will continue to be important as primary insurers continue to be acutely concerned about the credit quality of the reinsurance industry from both an ability to pay and willingness to pay perspective. As seen in Table 5, US-domiciled insurers' credit exposure to reinsurers remains very large, approximating one half of their surplus at year-end 2003. On a positive note, US-domiciled insurers' reinsurance recoverables grew at a much smaller rate in 2003 than they had in recent years, which in combination with overall strong surplus formation resulted in the industry's ratio of reinsurance recoverables to surplus declining by over ten percentage points.

- Replacing the Terrorism Risk Insurance Act (TRIA). TRIA, which shifted a large portion of terrorism risk from the insurance sector to the US taxpayer, will expire in 2005. If replacement legislation is not enacted upon TRIA's sunset, Fitch believes that most insurers and reinsurers will revert to excluding terrorism risk from coverage, while others that believe they have expertise underwriting terrorism risks will pursue such business.

We believe that the ability to effectively price and underwrite terrorism risk remains largely unproven and thus represents a potential exposure to the insurance industry. We also believe that TRIA's sunset could result in a certain amount of disruption to the industry and that it would adversely impact the overall economy.

- We don't know what we don't know. The 9/11 Commission recently opined that one of the reasons the US government and its agencies failed to anticipate the attacks of 9/11 was "a lack of imagination". The same can be said for the reinsurance industry. Industry observers (including rating agencies) constantly test their imaginations by asking themselves, what could go wrong that I haven't thought about? Almost by definition, this is a test that we are bound to fail.