European reinsurers have been turning to debt

The past two years have witnessed a material improvement in the risk-adjusted capital of Europe's reinsurers. This partial restoration reflects capital injections (both equity and debt) as well as a reduction of their risk profile, particularly via a shift to lower-risk invested assets and reduced reserve volatility. It also reflects improved earnings following the recent hard environment and a greater focus on underwriting discipline.

AM Best's Capital Risk-Adjusted Ratio (BCAR) compares our view of required capital to available capital for rated companies. At the end of 2001 (after capital had taken the impact for the World Trade Center), this ratio was at 166%. By the end of 2002, following both investment losses and insurance losses (in particular adverse development on US casualty), the number had declined sharply to 128%. By the end of 2003, however, this ratio was partially restored to 152% (see figure 1).

The successful capital raising by some companies has demonstrated that there is still a degree of appetite among investors for reinsurance paper.

Some substantial equity issues have been well supported by institutional investors, such as Munich Re's EUR4bn, SCOR's EUR750m and Hannover Re's EUR413m.

However, both the limit to available equity capital and the desire of reinsurers' management to increase return on equity capital employed means a significant part of the capital raising has been in the form of debt.

This increase in debt usage, combined with the increased exposure of capital to reinsurance recoverables, is an observed trend in the structure of European reinsurers' capital. As figure 2 shows, at the end of 2001, reinsurance receivables represented more then twice the debt capital held by Europe's major reinsurers, and were equal to nearly two-thirds of the equity capital.

That is no great surprise in the immediate aftermath of a large catastrophe loss such as WTC. However, by the end of 2002, reinsurance receivables remained at the same very high level and, in fact, slightly higher as a proportion of total equity. This reflected the fact that, notwithstanding the recoverables being paid on the shorter tail parts of the WTC loss, the emerging adverse development problem on US casualty, especially for the 1997-2001 accident years, continued to increase to the level of recoverables.

Moreover, this increased recoverable leverage has occurred at a time of a growing trend for reinsurance disputes and as the creditworthiness of reinsurers overall has reduced.

In response to this, during 2003 AM Best has witnessed active attempts by European reinsurers to manage down this asset risk. By the end of 2003, reinsurance recoverables represented less than half of total equity and less than one-quarter of the sum of equity debt.

Debt levels themselves, however, have slowly moved in the opposite direction since 1999, reaching in 2003 a peak of 23% of the total of debt equity and receivables. That is almost exactly the same scale as receivables themselves.

Capital Adequacy

Prospectively for 2004, AM Best expects that risk-adjusted capital adequacy will essentially stabilise and perhaps improve marginally. But this apparently benign picture does have some risk associated with it. Firstly, rising interest rates could depress bond values. Bond exposure has increased relative to equity exposure in the last couple of years as Europe's major reinsurers have sought to reduce their overall asset risk. While this can be seen as a prudent response to the problems faced in 2001 and 2002 of underwriting and equity losses hitting at the same time, the interest rate risk embedded in even highly creditworthy bond portfolios suggests that a material move in interest rates could expose reinsurers to substantive realised or unrealised bond portfolio loss.

Secondly, the ongoing risk of adverse loss development of prior years remains. In July, Swiss reinsurer Converium AG recognised losses on its 1997-2001 US casualty book well above its own declared expectations from just a few months before. While, at the time of filing, no other European reinsurer has felt the need for this kind of reserve adjustment in 2004, the potential for this clearly remains, not least because of the tendency for this to come as a surprise to managements themselves. Underlining this is the concern that, as many commentators have already noted, there appears to be some disconnect between the higher degree of reserving for US casualty in primary insurance markets and the lower reserve levels in reinsurance markets. It is very difficult to know accurately whether this difference is a justifiable distinction based on the nature of reinsurance contracts or the different information seen by primary insurers and reinsurers at this stage of loss development. A final trend which could add pressure to the apparent stability of risk-adjusted capitalisation is the increasing global participation by reinsurers in casualty business. At the anticipated speed of this trend, it is unlikely to have an overall material effect in 2004, but it will trigger increased risk charges, especially reserve risk, which could cause risk-adjusted capital levels to reduce somewhat.

As the soft market begins to really develop, the greater challenge is how reinsurers will manage to maintain the balance between return on capital employed to shareholders and creditworthiness. At some level there must be a dynamic tension between creditworthiness and maximising return on capital employed. Clearly, all other things being equal, for every pound, dollar or euro of additional capital employed for the same amount of business, there is a reduction in that return. That said, there is clearly some common ground. Credit analysts look for a sufficient return on capital employed to support ongoing capital commitment; they believe that the willingness of shareholders to continue to capitalise a reinsurance company is a function of their belief in future returns. Equally, investors do not want to see reinsurers run on too thin a capital basis, as too much bankruptcy risk undermines most equity investment returns models. In purely logical economic terms, this would lead to a natural balance between capital adequacy and return maximisation. But, of course, reinsurance is a cyclical business, and all of the factors driving cycles conspire to mean that competition pushes prices down. This has already emerged in property and other shorter-tail classes such as business interruption.

So how do reinsurers go about managing the balance of shareholder return and creditworthiness into the soft market? The logical, and often highlighted, thing to do would be to reduce premium volume and capital employed together, thus focusing underwriting on the more profitable parts of the softening market while maximising returns on capital. But while returning capital to shareholders in line with premium volume reduction makes sense in this specific context, it presents a fundamental challenge for managing risk-adjusted capital overall.

While net written premiums and shareholders' funds are reduced in lock-step, the loss reserve risk and the asset risk as a proportion of the shareholders' funds increase materially. Hence, the overall risk profile of the insurer is substantially weakened. This is the direct, and inevitable, consequence of the run-off of a business with any degree of tail. Historical reserves from a time of higher volumes of business will not reduce at the same rate as drastic cuts in current premiums. Therefore, the assets covering the reserves will not reduce at that rate either. Moreover, even without reserve and asset risk charges, the idea of reducing current premiums and capital together is not a panacea. It is likely that the impact of the softer market overall will mean that, even on the reduced premium income, the underwriting profitability is reduced unless more premium risk is taken to compensate. This would, of course, also worsen the premium component of the total risk profile. In addition, premium as a measure of risk in a soft market understates the actual risk and in a reduced book with a shrinking balance sheet, diversification asset, reserve and current premium are all likely to deteriorate.

In some respects, the increased use of debt by European reinsurers in recent years provides a potential response to this challenge. To the extent that hard market underwriting is being supported by debt capital, there is obviously the opportunity to pay back debt as opposed to equity as part of the process of reducing the balance sheet.

Finally, an additional wild card in the game of how Europe's reinsurers will address the softening market is the link between balance sheet pressure and price discipline. The continued concern about adverse loss development and the need to find a way to sufficiently service shareholder capital that enough can be retained to manage asset and reserves risk through the soft market is, in itself, a fundamental pressure to minimise rate reductions and hence minimise the soft market itself. That is to say the major providers of reinsurance capacity around the world may simply not have the ability to cut prices sufficiently to cause a long and deep soft market. Add to that the global investment environment which, even with rising interest rates, still means that the underwriting must be the dominant source of reinsurers' profits, a pricing discipline not seen in the last two decades should be present this time.

But the early signs are not that promising. Property reinsurance is clearly softening at a material rate, as are other short-tail and casualty lines.

While apparently much more robust, it seems far from clear that the absolute levels of casualty pricing even today are as attractive as they should be.