Retro pricing fell marginally at the 1 January renewals, but it’s not a buyers’ market yet. Mairi Mallon looks at the dynamics facing a market with its own unique set of rules.

“Unlike the rest of the market we might have a situation where there is reduced supply and increased demand and if that happens, prices could even go up,” predicted Richard Brindle, chief executive officer of Lancashire Insurance, ahead of the 1 January 2008 renewals. “So it will be interesting to see what happens. It is certainly not going to be a soft segment next year. But don’t tell anyone because we don’t want too many people stampeding into it.”

While the reinsurance market expects pricing to keep on slipping in 2008, there is one segment which could buck the trend – retrocession. With a continued shortage of capacity, few carriers offering the business and a number of sidecars being wound up; retro could see prices remaining somewhat stable.

At the time of going to press, the general agreement was that retro rates had softened by about five to twelve percent – nothing drastic – and those in the know say it still a very attractive class to write. According to Benfield, in its renewals report, “Whilst 2007 was another banner year for reinsurance results, the 2008 retrocession renewal season was always going to be a classic ‘squeeze’ period reflecting retrocession writers’ response to their clients’ future concerns about the economics of their reinsurance accounts.”

The reinsurers that currently offer retro include Lancashire, Everest Re, RenaissanceRe and Berkshire Hathaway. Then there are a handful of Bermudian sidecars including Advent Re (Validus), New Point Re (Harbor Point), Cyrus Re (XL) and Norton Re (Brit) providing collateralised cover. Some sidecars were retired in 2007, including Sirocco (Lancashire), Panther Re (Hiscox) and Blue Ocean Re (Montpelier Re), while others were renewed, such as Starbound II (RenaissanceRe) and Norton Re II. Cyrus Re II is another example, but with a capitalisation of $105m it is substantially smaller than its 2005 predecessor, which had capital of $525m.

Retro exodus

According to Chris Clark, chief executive officer of Willis Re Specialty, following the 2004/2005 season worldwide retro became virtually non-existent and programmes were segmented into pillars, typically US and non-US. “Pricing became very attractive with the subsequent flood of new capital to take advantage of the opportunity. With a shortage of UNL [ultimate net loss] capacity many of the new entrants sold ILWs [industry loss warranties] on an opportunistic basis,” he said.

“Following the 2004/2005 season worldwide retro became virtually non-existent and programmes were segmented into pillars, typically US and non-US

After Katrina, Rita and Wilma in 2005, the re-evaluation of capital requirements by rating agencies, plus the discovery of a number of correlating classes within companies, led to many exiting the market. GE Insurance Solutions, a large retro player, was bought up by Swiss Re, which did not continue with the line. Then PXRE had its own long list of woes and stopped writing the business. Other contenders, such as Brit Insurance also left – but sensing that good money could be made, it subsequently launched its own Bermudian sidecar to provide its own collateralised retro protection. Brit has a 19% share, alongside a number of other investors, in Norton Re, which currently underwrites property catastrophe retro cover.

“(Traditional retro) is not something we currently do here in London – it is something to invest in. We decided to exit retro after Katrina, Rita and Wilma and it was a decision about our risk appetite and our number of correlating classes that Brit actively currently underwrites on its balance sheet,” says John Turner, chief executive officer of Brit Insurance. “That, plus the change in dynamics the rating agencies were going to impose on companies. But, having said that, we still believe that it is a class of business that offers great opportunity in terms of profit. As a consequence, the way we approached it was, ‘Why not align a group of investors who have the same risk appetite as Brit, and effectively go into it as a joint venture?’ and we invested into this entity.”

A gun to the head

In 2007, with balance sheets getting stronger after record profits in 2006, buyers bought more strategically using a combination of reducing exposures, running higher retentions and retaining portions of the risk. “As the financial well-being of cedants continued to improve many dropped low risk transfer bottom layers,” says Willis Re’s Clark. “Worldwide capacity was still limited and US-exposed business remained highly priced. As demand reduced, ILW activity slowed and many of the new entrants came up with increasingly sophisticated and innovative alternative products.”

The reason retro was doing very well was simply there was an undersupply of capacity, explains Brindle. “Unlike most lines of business of late, there are still not many traditional offerers of UNL capacity out there. So big buyers, the large US reinsurers, can’t fill up their programmes with retro as they used to, and they are buying other products. They are buying cat bonds or they are self-insuring large chunks. So it is not a normal marketplace where you are competing against other carriers. You are competing against self-insurance and parametric products and so-forth.”

Despite retro being an attractive line of business, everyone agrees it is risky, takes a lot of capital and requires a large element of trust between brokers and underwriters. So there has been a great deal of caution in writing it. “We use retro on a pro-rata basis,” says Jim Bryce, chief executive officer of IPC Re. He described the use of retro as “surrogate capital” and stressed you need to know how to use it to get the benefit. He favoured companies that offered it long term, not opportunistic short-term providers, as an element of trust was needed.

“Despite retro being an attractive line of business, everyone agrees it is risky, takes a lot of capital and requires a large element of trust between brokers and underwriters

“You never want to give your sword to your enemy,” said Bryce. “You would only give this business to another reinsurer you trust. If you are a sensible player, there are buyer opportunities and seller opportunities.” He likened opportunistic sellers of retro as taking part in “rape and pillage” as they can charge what they like during the hardest part of a market. “You can always find capacity – it is just a question of terms and conditions,” adds Bryce. “They can sell it to you with a smile on their face and a gun to your head.”

Maintaining discipline

Brindle says that retro had been a big part of Lancashire’s business since it started (just under 15%) and that it has been a big winner for them. He says the retro market has changed for the better, and while risky, can be done well by the right people. “I think we saw the most disciplined and hard market anybody has ever seen for retro,” he explains. “The retro market was an extremely ill-disciplined market in the past, pricing was very volatile, and there was such a lack of transparency.” Because of this, providers ended up “getting absolutely hammered every time”, but in 2006 real discipline returned. Turner predicts 2007 will have been a good year for retro and that “naturally tends to generate a bit of excitement about the class”.

“Here is a piece of business that has potentially great returns in it,” he says. “We have not seen, yet, a huge flood of new capacity into the property catastrophe retro space. But I think there is a general expectation that if you are a buyer of property catastrophe retrocession you will get a better deal than you were able to get in 2008.” This doesn’t necessarily equate to significant price reductions, he adds, rather a slight broadening of cover or a smallish price decrease. “But there is not sufficient new capacity coming in that means that the supply demand dynamic is changing drastically.”

Another factor in the pricing of retro as the market moves into 2008 is the string of mid-size natural perils losses in 2007, which were big enough to get into the property cat market, but not big enough to impact the higher layers of retro. As a result, this has also kept demand up.

So with a limited supply and plenty of demand, a number of market-watchers continue to predict prices will hold up amid softening on other lines of business. This will prove a challenge, says Willis Re’s Clark. Capacity in 2008 is getting back to full strength and with pricing on primary business reducing, retro underwriters are under pressure to reduce prices and widen territorial cover. “But it is not yet a buyer’s market,” he adds.

Mairi Mallon is a freelance journalist.