Europe is still seen as a somewhat difficult market, and analysts are concerned this might be having a detrimental effect on European reinsurers, says Lindsey Rogerson.

European reinsurance companies could be forgiven for feeling unloved and out in the cold right now. There are few words of encouragement from analysts, and even when the words are not completely damning, so many caveats are attached that any fund manager reading their reports and briefing notes would think long and hard before investing.

Brian Shea and Christian Dinesen, insurance analysts at Merrill Lynch, are concerned about European reinsurers continued inability to produce returns, pointing out that history repeatedly shows that they lose more money in the bad years than they make in the good ones: "Given the challenges faced by the industry, it should not come as a surprise that returns have historically been inadequate. Over the last ten years (roughly the life of one cycle), we put the average ROE (return on equity) at 5-8% for Munich Re and Swiss Re. Hannover Re stands out with better returns and Converium with worse. All this begs the question: Can reinsurers earn an adequate return on an "AA" level of capital? We are doubtful."

In fact the pair are actually quite scathing about the abilities of European-based reinsurers to rise to the challenge and amend business practices. They want to see reinsurers rely less on investment returns and instead demand that all business lines underwrite profitably, and make greater use of securitisation. Until they see that they will continue to advise clients against buying either stocks or bonds from European reinsurers.

They explained: "Until we become convinced that the sector has more decisively overcome its challenges, we recommend structural under-weight investment stances on the European reinsurers in both the credit and equity world. This does not necessarily mean that interesting trading opportunities will never arise. At present, however, in terms of catalysts and valuation we do not see such an opportunity."

Merrill Lynch's view is sharply at odds with that expressed by the European reinsurers. Indeed, at its first quarter renewals briefing Munich Re said that its treaty renewals in reinsurance were strictly geared towards profitability. This strict approach to profit-orientated prudent underwriting does seem to have borne fruit in the first three months of 2006 at least: Munich Re reporting a 41.7% year-on-year leap in profits.

However Shea and Dinesen believe that any rise in premiums on hurricane-affected US lines will be short-lived, which would have serious knock-on consequences for ongoing profitability: "Much of the support for reinsurers in the capital, particularly equity, market appears to be the assumption that further catastrophes can be financed by future premium increases. Undoubtedly premiums will continue to go up at 1 July 2006 renewals, where many US treaties are negotiated. However, we think this may be the end of premium increases and for some larger reinsurers, more premium increases may no longer be possible."

Merrill is not alone in questioning European reinsurers ability to deliver the vintage year predicted at Hannover Re. Benfield is also sceptical. While the broker group admits that a quiet first quarter 2006 in terms of claims has allowed reinsurer to at least get off to a profitable start, it still feels that even if the revised catastrophe models, which are now up and running for the US Gulf Coast, help improve profitably and reduce losses, the European players are still exposed to other weather-related risks.

Lewis Phillips and David Flandro, authors of Benfield's European Quarterly review, said: "The European reinsurers remain exposed to other weather related risks closer to home, such as flooding which has been a feature of recent summers, as well as windstorm around the year-end. The recent tragic events in Indonesia also serve as a reminder that every day is earthquake season. Finally, the spectre of US casualty reserve strengthening from the soft 1997-2001 years has not yet been entirely eliminated. All in all, the prospect of record profits in 2006 is by no means certain."

This uncertainty is reflected in the ratings and outlooks currently offered for the European reinsurers. The table (see figure 1) looks very pessimistic with only one "positive" - AM Best for SCOR. In fact it is difficult to find anyone being particularly positive about European reinsurers.

Hiscox Insurance Portfolio recently bought shares in Munich Re but it is a "tiny" position - around 2% - and in all the HIP fund has only 6% of its assets invested in Europe, compared to 54% in the US, 24% in UK and 14% in Bermuda.

Nick Martin, investment analyst on the fund, explains that the decision to buy Munich was one of valuation rather than any change in the funds negative European stance. He explains: "We felt it was at a valuation call and Alexander Foster (HIP fund manager) is a bit more positive on Germany as a whole. He thought corporate Germany was improving a to a degree. That and generally because of the improving reinsurance market, which Munich should benefit from. But fundamentally we are still very much against Europe because they are huge companies which are difficult to analyse."

Martin is more positive on the prospect of rate rises between now and the end of the year. Having always thought that the predictions bandied about after last year's hurricanes where too high, he says that anecdotal evidence from both the London market and a recent trip to Bermuda suggest that substantial rate hikes are now taking place: "There is definite evidence that some quite attractive pieces of business are on the books now," Martin continued. "I think it is going to be a steadily improving environment. Titbits of information from the 1 June and 1 July renewals are that the rate rises have been pretty massive and at the same time people's exposure has been going down a lot. Back-of-the-envelope companies have halved their exposure, so if they had a repeat of Katrina it would only really cost them half what it did last year, but they have got a lot of increases on the rates."

But this is not necessarily good news for the European reinsurers who, according to Martin, are still too heavily focused on retaining market share rather than writing profitable business. He explained: "I think the people at Munich Re and Swiss Re and others are just hell-bent on keeping their market share and they are happy to slash their rates to get it. There is no need to be doing that in this market and it is a source of incredible frustration that they often leave a lot on the table. They could increase their rates but I have been told by underwriters in London and Bermuda that they (the Europeans) really hold back some of the rate rises that could actually and should actually happen."

- Lindsey Rogerson is a freelance journalist.