With the industry set to remain saddled with a negative outlook for the foreseeable future, Nigel Allen assesses the reinsurance sector from the perspective of the rating agencies.
In the introduction to Standard & Poor's recent report, Global Reinsurance: Calmer waters ahead?, credit analyst Stephen Searby writes: "2002 has been described by some as the reinsurance industry's own `perfect storm' with its combination of significant adverse reserve development and the meltdown of the capital markets." Despite first half 2003 results recording substantial improvements across the board in terms of profitability, with rating agency Fitch reporting a 37% year-on-year increase in net premiums underwritten and a rise in earned premiums of some 25% based on the results of 25 leading reinsurers, it is clear that the industry still remains a risky prospect.
The slew of recent downgrades by all of the major rating agencies has been well documented, and it is of little surprise that the `AAA' rated reinsurer should be teetering on the brink of extinction. Standard and Poor's (S&P) rates only Berkshire Hathaway's reinsurance operation `AAA' due to its explicit external support, in common with fellow rater Moody's, while Fitch bestows the triple `A' accolade on Berkshire's General Re and National Indemnity. However, it would appear that the downgrading blitzkrieg which the agencies have launched on the sector during the last twelve months is beginning to run its course. "The shock downgrades, driven by shock results, are predominantly over," confirmed Mark Hewlett, Managing Director for European Insurance at Moody's Investor Services in London. "What you are seeing now is a potential for further downgrades. However, it should not be anywhere near the same magnitude as we have seen in the last twelve months."
While the negative outlook is an indication that downgrades are likely to outstrip upgrades in the next twelve to 18 months, on an individual company basis it should be noted that the number of reinsurers carrying a stable outlook far outweighs those with a negative tag by a factor of more than two to one. As Fitch points out, despite the toppling of many of the big reinsurance hitters from the AAA pedestal, most still retain very high financial strength ratings. However, it is their credit quality that is in doubt, and due to the disproportionate amount of capacity wrapped up in these mega reinsurers, this credit uncertainty is acting as a drag on the sector as a whole.
While the various reports and reviews cite a myriad reasons for the continued negative outlook, the lion's share of responsibility lies squarely with the issue of adverse reserve development on prior year business, stemming from chronic under-pricing, particularly in US casualty business during the soft market. Despite the marked improvement in operating results recorded in the first half of 2003, reserving deficiencies continue to dog the industry, particularly among the large reinsurers. According to S&P, Employers Reinsurance Corp bolstered its reserves by some $3bn; Munich Re's American Re-Insurance Co channelled $2bn into its reserves; and General Reinsurance Corp, a subsidiary of Berkshire Hathaway, strengthened its reserves to the tune of $1.4bn. Major reserve strengthening has also been reported by other reinsurers including Converium, SCOR and XL.
Fitch puts a $9.2bn tag on 2002 reserve strengthening levels, stating that had this not been required, the disappointing 110.7% combined ratio reported for the property and casualty sector in 2002 would have been a much healthier 99.1%. As it points out, such a drain on capital is far exceeding the benefits the industry has garnered from a low catastrophe experience in recent years and the "hardest premium rating environment experienced in years". Moody's specifically refers to the severe reserve hits which have been taken on casualty lines of business as a result of the dramatic rise in accident claims flowing from the US tort system and in particular on general liability, professional liability, medical malpractice, workers' compensation and, of course, asbestos-related claims.
While the agencies commend the reinsurance sector for acknowledging and acting upon reserving inadequacies, none believe that the recent capital injections will prove the panacea for such a serious ailment. While the requirement for extreme reserve strengthening is expected to decline in the future, reserve inadequacies yet to be unearthed by primary insurers in longer-tail business such as workers comp and excess liability are expected to affect reinsurers' reserves on a lagged basis, further compounding the continuing problems posed by asbestos, WTC, D&O et al. However, Stephen Searby was positive about the reserve situation. "I think there were a lot of reserving actions at the end of 2002, and I think, more importantly, current accident year profits are strong enough to absorb any further developments," he said. "While the big pain has been taken, we are not ruling out additional smaller pains, but it will not be a public pain, but rather a drag on profitability going forward."
The old adage, "Make hay while the sun shines" is reflected in the renewed levels of profitability reported by most reinsurers, stemming from the dramatic rate hikes which have populated the current hard market, with price rises of between 50% and 300% on most lines, particularly property cat and D&O. But as the sun begins to rise later in the day, questions are being asked about whether the amounts of capital reaped during the hard cycle harvest will be sufficient to see many through the coming soft market.
While Fitch expects moderate rate increases to continue over the next twelve to 18 months as reinsurers strive to further strengthen damaged balance sheets, the market is already beginning to show signs of softening on lines of business such as property cat and aviation, due to increased capacity. The scales are once again tipping in favour of the buyers and brokers, who are calling for reductions in rates, particularly in the light of two fairly benign loss years. However, as AM Best points out, "investors' demands for substantial returns for the extra risk on their capital will continue to exert strong pressure on the industry to maintain price discipline".
A further factor which may help shift the balance in favour of the reinsurer in terms of pricing control is an increasing tendency towards seeking more `opportunistic' non-proportional business at the expense of the `relationship-based' underwriting of proportional business, according to S&P's. While such lines of business have indicated stronger levels of profitability reflected in a tendency to carry lower combined ratios, by moving away from a focus on maintaining historical relationships it could also afford the reinsurer a greater degree of influence over the pricing of the business.
Last year saw a sharp contrast between the fortunes of the newer, more specialised entrants to the reinsurance sector and those of their more established counterparts. According to Fitch, "The larger reinsurers have not taken advantage of these opportunities in recent years, as evidenced by their at best average profitability relative to the market, and the well below average profitability of such firms as Employers Re and Munich Re." S&P estimated the average combined ratio for Munich Re, Swiss Re, ERC and General Re, for 2000 to 2002 to be 127%, in comparison to 108% for Bermuda-based reinsurers over the same period, leading it to question whether the traditional reinsurance model founded on global diversification coupled with financial clout was still appropriate.
Not hindered by the legacy issues currently hampering the profitability of their larger cousins, the unencumbered balance sheets of the new start-ups have proved attractive to investors, with Bermuda-based carriers raising approximately $9bn of new capital since September 11. They have also benefited from adopting the aforementioned more `opportunistic' approach to writing business, rather than carrying out business on a relationship basis. Their limited size is an advantage in allowing them to flit quickly between business lines in search of profits. However, Moody's believes that bigger can still be better, providing competitive advantage as a result of greater service and technical expectations on the part of the cedant, coupled with the enhanced pricing power which results from having a larger share of capacity.
While the new Bermuda-based carriers have achieved outstanding levels of profitability, and despite initial focus on specific lines have managed to diversify in a relatively short space of time, Fitch is concerned that "it may ultimately prove to be their undoing if they are unable to properly select and price risks when the window of opportunity closes and the reinsurance market softens." Moody's also raises concerns over the levels of commitment in terms of capital providers, estimating that of the capital which has entered Bermuda, approximately half has come from financial investors, who typically seek short-term returns on their investments, with a number already having exited the sector via IPOs.
All the rating agencies commended the industry as a whole for its renewed focus on core underwriting activities. Many reinsurers have set about re-underwriting their portfolios and exiting those lines of business which have failed to perform sufficiently. The implementation of more sophisticated modeling systems has also enabled more adequate pricing control, while stricter terms and conditions have facilitated a reduction in risk exposure. While in many respects imposed by the removal of the investment market safety net in the form of previously high returns on portfolios, such measures hold the sector in good stead as the soft market looms. The reinsurance industry is striving to counterbalance the deficiencies resulting from the previous soft market, the demise of the investment markets and the continued efforts to plug reserving holes, with improved pricing, tighter terms and conditions, and a focus on strict underwriting discipline. However, the market would appear to be conspiring against it. "At a time when underwriting margins are improving" explained Mark Hewlett, "the pendulum has swung the other way because there has to be greater reserving - financial markets still aren't stable. And just at that point when you might be able to balance it, what is happening? Trading conditions are well off the top, the competition is returning and returns are sliding."
For further commentary on the views of market practitioners on rating agencies, and the responses of the rating agencies to the state of the reinsurance market, tune in to GRTV from the Rendez-Vous de Septembre, at www.globalreinsurance.tv , Day Two (03:40-05:38; 14:02-25:49; 34:20-45:32).
Nigel Allen is the Assistant Editor of Global Reinsurance.