Global reinsurers suffered their greatest ever loss from catastrophes in 2005, yet the industry in the US realised almost $1.9bn in net income and increased policyholders' surplus by $5.8bn over 2004.

Such compelling success invites envious competitors, sensing rising prices and quick, fat profits.

Catastrophe bonds, a competitor that was relatively ignored for more than a decade, are now being aggressively courted for their potentially rich returns. New reinsurance companies popped up in Bermuda, additional capital flowed into existing ones, and billions from the trillion-dollar capital markets, especially hedge funds, created more of the newest entries to risk transfer - sidecars and swaps.

These fresh additions to the reinsurance market will have to shoulder their way into the already well-established alternative risk transfer (ART) operations - captives, self-retention, risk retention groups, self insurance groups and loss control. These ART entities already represent an estimated one third of reinsurance equivalent premiums, according to Conning Research.

Modern businesses structure their risk financing so as to maximise value in terms of cost, variability of results, and the avoidance of catastrophic losses, according to Mark Jablonowski, an analyst at Conning Research & Consulting. "While insurance is, and always has been, a very efficient risk treatment option, alternatives do exist," he said. "Risk managers carefully weigh the costs and benefits of each alternative when structuring optimal risk financing programmes."

"Today's alternative market consists primarily of self-insured retentions, often supported by captives," he continued. "Yet retention alternatives are near or at their peak; they are maturing, stabilising and will not invade further into the role of traditional insurers and reinsurers. Risk managers are recognising that retaining too much risk is not good, that insurance has value. At the same time, a new wave of alternatives are emerging and focusing on capacity rather than price and competing more directly with traditional insurance and reinsurance."

Fewer reinsurers

Making entry somewhat easier for these new competitors is the reduced number of reinsurers writing business. Just since 1998, reinsurers and reinsurance affiliates operating in the US, as listed on the Reinsurance Association of America's (RAA) quarterly underwriting report, declined from 38 to 26 in 2005. Among the companies exiting the reinsurance sphere have been AXA and General Electric most recently, preceded by Aviva, CNA, Gerling, Hartford, R&SA, St Paul, and Zurich Financial Services. Yet gross premiums written for the RAA groups swelled from $19.4bn in 1998 to $40.2bn in 2005, more than a 100% increase. The gross written premiums per reinsurer/affiliate in 1998 of $0.5bn rocketed to an astounding $1.6bn in 2005, a three-fold increase.

Given that the reinsurance sector is becoming highly fractured, its future may well contain strong warnings of pending operating and financial disasters. Instead, the outlook appears to be surprising upbeat. Standard & Poor's has declared it is maintaining its stable outlook on the global reinsurance sector. Still, the rating agency rates the "industry risk of property/casualty reinsurers as high in absolute terms and significantly higher than that of either life re/insurers or property/casualty primary insurers based on issues such as low client loyalty; better financial strength not resulting in better pricing; exposure to unpredictable risks; and low barriers to entry and resulting pricing cyclicality."

It also noted that a substantial tightening of reinsurance and retrocession capacity for property/catastrophe risk has made "it difficult for primary companies and reinsurers to be reliant on reinsurance and retrocessional coverage to renew their protection programmes."

Fitch Ratings has maintained its stable rating outlook on the reinsurance sector, despite concerns that over the next 12 to 24 months the industry faces a number of key challenges, particularly cycle management. Although 2005's cat losses saw positive premium rate development in 2006, Fitch continues to believe that reinsurance pricing is cyclical due to the ease with which capital can enter and leave the market. Subject to a return to high catastrophe experience in 2006, Fitch expects that reinsurers will experience moderate premium rate reductions in 2007, but see their cycle management strategies truly tested in 2008.

"Reinsurers are modelling their exposures to more severe and frequent catastrophic events," said Mark Rouck, senior director in Fitch's insurance group, "and cedants are retaining more risk due to the price of reinsurance capacity. Additionally, reinsurers have trended away from proportional reinsurance covers towards excess-of-loss protection where they have more control over pricing and coverage."

Moody's Investors Service has maintained its stable rating outlook on the global reinsurance industry, despite record losses from hurricanes in 2005. Moody's noted that most reinsurers have sound balance sheets and good earnings momentum, absent catastrophes. These strengths are tempered by the inherent volatility of catastrophe-related business, the current pricing pressure on casualty lines of business, and the ease with which capital flows into and out of the market. The rating agency found that reinsurance market conditions vary sharply across business lines. Whereas catastrophe coverage is costly and scarce, casualty lines are subject to persistent competition and downward pressure on rates.

Hedge funds leaping

There has been much speculation, some of it ignited by the secretiveness of the transactions, concerning hedge funds leaping with their billion-dollar boots into the reinsurance arena. David Friedland, president, Magnum US Investments, and president, Hedge Fund Association, commented that hedge funds are very innovative and are always exploring new ways to generate consistent returns. "Whether that is hard money, lending, reinsurance, buying up life policies, or other 'new' strategies," he said, "the goal is always to try and generate consistent, positive returns and open up capacity with a new strategy." How long these high-flying, restless firms will stay with sidecars and reinsurers if another 2005-like storm season comes along, with losses approaching triple digits, remains an unanswered quandary.

With the record losses left by the hurricanes of 2005, rates for catastrophe coverage along the Gulf of Mexico have increased an average 76% for US states and 129% in Mexico, according to Guy Carpenter & Company, compared with a 2% increase for the rest of the world.

This rate hike has heightened the interest of hedge funds directly into the reinsurance business, but also the draw down of capacity in the retrocessional market has left a significant gap in that specialised market. "The lack of retrocessional protection has materially hampered the reinsurer's capacity to underwrite primary insurance companies," said Standard & Poor's credit analyst Steven Ader. "This, in turn, has significantly hampered the underwriting capacity of the primary insurer." Hedge funds have funded sidecars and catastrophe bonds to cash in on the dwindling capital of the retrocessionaires, especially on risk along the Gulf coast of the US.

The RAA reported that new or existing reinsurers have raised $23bn in capital over that of last year, with $7.3bn coming from hedge funds and private equity firms. Another $3.6bn in funding has come from sidecars.

Cat bond climb

The growth of catastrophe bonds since Katrina in 2005 has been extraordinary. Developed following the devastation of Hurricanes Andrew and Iniki in 1992, and further expanded by the Northridge earthquake in 1994, these bonds helped bridge the capacity gap between reinsurers and insurers by providing a means for them to tap into the capital markets to diversify their risks geographically. Starting out modestly, catastrophe securitisation averaged about $1bn per year from 1999 to 2002.

According to a study by Guy Carpenter, starting in 2005 there was unprecedented growth within the catastrophe bond market, largely driven by the urgent need to find capacity to cover US hurricane activity. The catastrophe bond market recorded a total of $1.99bn in 2005, a 74% increase over the $1.14bn in 2004 and 15% higher than the previous record of $1.73bn in 2003.

Aon Capital Markets observed that between November 2005 to June 2006, 24 bonds representing $3bn were issued, far exceeding the total amount in the previous 12 months. The size of the bonds ranged from $15m to $950m. Munich Re issued a total of five bonds for $223.4m and Swiss Re's three totalled $1.1bn. The perils covered by catastrophe bonds, according to Aon's accounting, run from 28% multi-peril and 15% US earthquake to 13% mortality and 8% casualty.

"While it is too early to estimate the future issuance of catastrophe bonds, this year's increase in market activity appears to be drawing more potential issuers and investors to the sector, providing further risk transfer options for the insurance and corporate markets," said Rick Clinton, president of EQECAT, which conducts risk analysis for catastrophe bond transactions. The bonds focused on a range of perils: European winter storm, North Atlantic hurricane, Gulf of Mexico hurricane, Pacific Northwest earthquake, California earthquake, Japan earthquake, Australia tropical cyclone, and Australia earthquake.

Just one loss

In more than a decade of issuing catastrophe bonds there was no total loss on any one bond until Katrina came roaring along. It is expected that a $190m-bond will be a complete loss for investors in KAMP Re 2005 Ltd. However, one loss will have little negative influence on the growth of the catastrophe bond market. While there was some confusion at first about how to structure and market these bonds, the procedures have become well-defined and the legal and accounting issues have been resolved for the most part. Furthermore, these bonds fit easily into a company's risk management portfolio, coupled with traditional reinsurance and a selection of other ART offerings.

Greg Hagood, principal and co-owner of Bermudian-based Nephila Capital said, "There is more demand for bonds now because the reinsurance market is more distressed post-Katrina and the retro market is shrinking dramatically. Thus catastrophe bonds are providing an additional source of capacity to the traditional market."

While Nephila Capital is structured as a hedge fund manager, its sole purpose is to manage funds dedicated to catastrophe reinsurance exposures. "We have been managing money for institutional investors in this format since 1998," Hagood said. "In the early days of our funds, we focused mainly on catastrophe bonds, but from 1999 onwards we have also been a market for industry loss warranty contracts, reinsurance and some retrocessional business," he said.

To the extent that these substitutes fill in where traditional insurance and reinsurance is unable or unwilling to provide coverage, "they may provide a symbiotic supplement to traditional insurance and reinsurance," said Conning's Jablonowski. "However, the potential clearly exists that these supplements will grow to replace many functions that the traditional insurance market now serves. Insurers and reinsurers will need to recognise their place in this changing market for risk protection, and adjust strategy accordingly."

In the longer term, insurers and reinsurers will be caught in a continuing squeeze for market share between both ends of the risk spectrum. "Forward-thinking insurers and reinsurers," he said, "will develop areas that can support captive markets and the increasing market for capacity alternatives."


- EQECAT sees rise in cat bond activity in 2006

- Cayman Islands becoming cat securitisation centre

- Aon underwrites Pacific Northwest earthquake cat bond.