Conventionally, capacity is a measure of the volume that a specific vessel or container is able to hold. More figuratively, it describes a combination of ability and endurance: "His capacity for work is unmatched." In reinsurance, capacity has similar meanings. It refers to a specific measure, usually the amount of risk a single reinsurer can bear, either in aggregate, or for an individual risk of a specific type (known also as `line size').
Alas, it is common for reinsurers to overestimate their capacity, as events have recently demonstrated, and subsequently to burst from the pressure. This occurs when a reinsurers' risk appetite is greater than his capacity, akin to the problem which occurs when one's eyes are bigger than one's stomach.
Ability and endurance
As in conventional language, so too in more figurative reinsurance-speak can capacity refer to a combination of ability and endurance. The combination comprises a supply of underwriting capital that is granted to an underwriter, and sometimes is sufficient to change the fortunes of entire markets, either downward ("he has the capacity to ruin the hard market for everyone" ) or, more rarely, toward profits ("without that cheap capacity from Fortress Re, aviation insurers actually have to underwrite").
One of the apparent dilemmas of the insurance sector is that for every dollar by which international capacity falls, forcing prices up through the constriction of reinsurance supply, one or more dollars eventually materialises to replace it. In the brief period that occurs before all the capacity is back in the game (known as the `hard market'), everyone blindly believes that the capacity will not come back, and optimistically tells shareholders that "this time it is different". However, even as the wounded withdraw their capacity, the unblemished launch IPOs and convertible debenture issues and primary rights offerings, which inevitably replace the capacity lost through the losses.
A common derivative of capacity is overcapacity, which refers to an excess of reinsurance supply over demand. However, the state of overcapacity may not actually be possible. It is simply a product of the misallocation of capital to specific areas of insurance, which is temporary, or of a complete imbalance of supply and demand in the insurance sector as a whole. Rather then measuring available capacity against global risk, it is generally considered relative to global premium. This was illustrated in the years leading up to September 11: overcapacity was widely identified by pundits who believed they knew all possible permutations of future events, but when the largest catastrophe loss ever actually bore down upon re/insurers' balance sheets, all of that capital came in rather useful.
In fact, if anything, it was shown that there had been a shortage of capacity, despite commentators' endless droning (suddenly halted) to the contrary. Insurers and reinsurers simply had not charged enough for its use. In other words, there was more capacity than global premium volume was willing to service at ROEs satisfactory to analysts and ratings agents. The amount of capacity relative to global risk was, however, proven to be inadequate, and as a result governments around the world have been forced to provide additional capacity (in the form of backstop guarantees) to allow the insurance of commercial property and airlines to continue.
The myth of overcapacity has been illuminated, although it is unlikely to have been banished. As sure as those who claim that the soft market will never return are wrong, the fiction of overcapacity will return, as prices again fall below economic levels. It is a certainty almost by definition. The effect is illustrated in a recent announcement by Allied World Assurance Co, which states: "In response to the continued contraction of capacity for excess casualty coverage," said insurer is to immediately "double from $25m to $50m" its capacity for such risks. Perhaps this illustrates that capacity is like energy: it can never be destroyed.