Major forces are pushing forward change in the German insurance market which will affect their future demand for reinsurance. Lee Coppack reports.

The planned merger of the large German mutuals, HDI and HUK-Coburg, announced on 5 May 1999, a tax bill of DM 8.75 billion from the German government and deteriorating results and stagnant growth in the main property/casualty classes are expected to accelerate the pace of change in this giant of European insurance.

The end result of these powerful forces is difficult to predict. Certainly, further consolidation, especially among medium sized insurers, is widely forecast, but as we have seen elsewhere, once there is sufficient momentum in the process of change, the market continues evolving into ways that may not have been obvious from the start.

The most likely effect on major German reinsurers generally will be a continuing reduction in their reliance on their home market as a source of reinsurance business, particularly traditional quota share treaties. At the same time, demand may well increase for sophisticated products, balance sheet protection techniques by cedants and technical expertise, all of which tend to be more expensive to produce than traditional business. Insurers will probably also look to reinsurers to absorb increasing amounts of volatility.

As the chairman of Munich Re's board of management, Dr Hans-Jürgen Schinzler, comments: “Consolidation generally takes away reinsurance premium, as insurers are bigger. However, since they are accepting larger shares in increasing risks, they need very specific reinsurance services and capabilities and enormous strength from their reinsurers. Reinsurers have become bigger as they have adapted to this environment, but smaller and medium sized insurers are still there, and if anything, they need reinsurance more, because they are relying on the expertise of their reinsurer, particularly for technical and industrial risks.”This spring in the face of clearly deteriorating motor results, the largest motor insurers, led by Allianz had announced plans to increase rates at least on new business. However, the merger of HUK-Coburg and HDI seems more likely to increase, rather than decrease, competition in this market, because the combined group will be Germany's third largest primary insurance group and a significant rival to Allianz in motor insurance. Also, since both are mutuals, they are not subject to the same return on equity pressures as quoted companies.

The tax bill results from a government requirement that insurance and reinsurance companies release what are regarded as excess loss reserves and discount the balance. Dieter Lüer of the Munich law firm Heuking Kühn Lüer Heussen Wojtek explains what effect this is likely to have: “Redefining loss reserves for tax purposes has several effects: loss reserves built up under the previous system exceed those admitted under the new rules, thus increasing the taxable profit. Insurers will consequently be faced with a considerable cash draw, which will make it difficult to show a reasonable result in the forthcoming commercial balance sheets. The long-term consequence of this will be general financial stress and a fall in investment income.” (For a more detailed explanation of the tax changes, see the article by Dieter Lüer on page 21).

The combined pressure of the current rating environment and tax changes which will deprive many companies of a cushion of generous reserves is likely to result in fewer but better capitalised insurers, whose approach to reinsurance purchase may change, believes Karl Mayr, a member of the board of management of ERC Frankona.

Says Dr Mayr: “The purchase so far has been insurance risk driven. It has not been cfo minded, but underwriting minded.” In future, there is likely to be more demand for more balance sheet protection products, finite risk, alternative and even capital market products.Arno Junke, a member of the management team in the German department of Cologne Re, likewise sees a number of ways that reinsurers can help their clients with tailor made solutions to the effect of having to restate and discount their reserves.

In the longer term, he believes that some insurance companies in Germany will deliberately downsize, leaving classes where they cannot get sufficient spread and mass of business to make the risks worthwhile. Already, a couple of companies have withdrawn from industrial fire business for these reasons.This aspect of market consolidation could provide some antidote to reductions in reinsurance purchase by larger and stronger insurers, because in doing so they will look for co-operation with their reinsurers. Says Dr Junke: “As reinsurers, we see business opportunities in advising and helping medium sized and smaller players get their maths right and come in with a strategy from which they can profit.”

Stagnant non-life business
The German insurance association, Gesamtverband der Deutschen Versicherungswirtschaft (GDV) reports that in 1998 non-life business suffered a decline in turnover of 1.9% to DM 93.2 billion ($50.9 billion), following a fall of 1% in 1997.

Motor, which is by far the largest non-life class of insurance in Germany, is also extremely important to Germany's reinsurers through quota share treaties and also on excess of loss contracts, particularly for personal injury. Direct motor premiums last year fell 4.2% in 1998 to approximately DM 38.9 billion after a 4.4% drop in 1997 or a total fall of 8.4% in two years, despite an increase in the number of vehicles insured. (For statistics from the GDV, see pages 10, 12.)Despite lower claims frequency, the steady erosion of the premiums base is having an effect. Werner Mutz in charge of German business at Gerling Global Re, is frank about the state of the motor market: “It is a disaster, “ he says. “The results have been worse than in 1997.”

The problem, explains Mr Mutz, is not competition from foreign companies as some feared when the market was deregulated on 1 July 1994, but the fight for market share among German insurers who took rebating to such an irrational level that it has resulted in a new word: “rabatitise”, meaning to give rebates for virtually anything and everything.

“If insurance companies do not realise that original premiums have to increase, then we have to encourage them to do so,” by which he means that reinsurers will look for reductions in commissions on quota share treaties on renewal at the end of this year. “If we can get commissions down by about 2% to around 13%-14%, this would help a lot.”

More unusually, Mr Mutz comments on the deterioration of the results for motor personal injury where, although frequency has fallen from around 117/1,000 10 years ago to below 80/1,000, severity has risen in line with the experience of other markets. With motor liability premiums of about DM 23.8 billion and a technical loss of around DM 4 billion, this class produced a combined ratio of 117%. The price, however, of excess of loss reinsurance for losses in excess of DM 2 billion has fallen to a quarter of what it was, according to Mr Mutz, and because of the long tail nature of personal injury claims, it is one where the government's requirement for discounting of technical reserves will pinch the most.

Achim Neukirchen, head of German market business at Bavarian Re says that his company now has much better analytical tools to predict the underwriting results of ceding companies. Depending on those figures, he says: “We will decrease commissions. If they are bad, we will be prepared to cancel the treaty. It depends on the whole relationship.”

Mr Neukirchen is even prepared to say that Bavarian Re has not renewed a treaty two or three times in the last two years and has decreased commissions in the same number of cases. It is rare, he explains, because the business was profitable until 1997, but Bavarian Re is prepared to act where the results have deteriorated, if the cedant is “not reinsurance minded”.

Other classes
The next major problem, says Mr Neukirchen, is industrial fire, where although it is a smaller class of business, the situation is even worse than motor. According to the GDV, premiums in this class fell 22% to DM 2.6 billion, after a drop of 14.5% in 1997. Claims expenditure, however, rose 27.0% due to a drastic increase in severe claims, which will affect reinsurers.

Increased deductibles, captives and self-insurance, says Mr Neukirchen, are probably only responsible for about DM 300 million of the premium fall. Prospects for immediate change are not good: “As far as 1999 is concerned,” he says, “it is the same situation as last year. We have to face another year of a loss ratio of more than 100%.”

A relatively benign claims environment has been a major factor spurring competition in the German market, but a study from Munich Re's geoscience research group has warned that this should not be regarded as normal. “Historically the country has been hit again and again by significant natural catastrophes and losses from extreme weather events in Germany have been increasing.”

The group found that between 1970 and 1998, there were 459 natural hazard loss events in Germany, of which 65% were windstorms. Floods are in second place and other extreme weather events third. Windstorm losses totalled DM 20 billion, of which DM 8 billion was insured, which represented 75% of total losses and no less than 86% of the insured losses.

The series of winter storms in 1990 caused economic losses of DM 7 billion and insured losses of DM 3.5 billion, and today, overall losses of up to DM 10 billion can be expected from exceptionally severe windstorms. Hailstorms affect smaller areas but the potential for destruction is high. The Munich hailstorm of July 1984 generated economic losses of roughly DM 3 billion, of which about half was insured. Losses may exceed DM 5 billion if a conurbation is hit directly. Looking at flood loss potentials, the geosciences group has calculated that an extreme event in the catchment area of the River Rhine could produce economic losses of DM 20 billion, and loss potentials from storm surge scenarios are even more drastic. Economic damage in this spring's floods in Bavaria is thought to be at least DM 2.1 billion, but Munich Re spokesman Rainer Küppers indicates that fewer than 10% of German insurance contracts currently have coverage for flood damage.

Future growth
Unfortunately, the one area of business which is buoyant for insurers in Germany, life and health business, is “stagnant” as far as reinsurers are concerned, Tauno Jäkel, account executive life and health at Bavarian Re, says. He explains that growth in these classes over the last year or two has been mainly in unit linked and annuity products, partly as a result of concern over future state pension levels, but the structure is such that the only risk insurers are prepared to pass to the reinsurers is the longevity risk. Since reinsurers also have to deposit their reserves with the cedant at a minimum interest rate, Dr Jäkel regards this with a certain ambivalence. “While this risk is admittedly difficult to reinsure, it represents an excellent chance for professional reinsurers to demonstrate their creativity.”

Dr Jäkel says there is more interest for reinsurers in disability business, which is gradually becoming more sophisticated. Products are now starting to distinguish among different professions, where previously the only distinction was between manual and white collar jobs. It is in areas like this where reinsurers, with their much more extensive experience and sophisticated systems, can really add value to an insurer.

Growth by acquisition
Munich Re has publically stated it is not in a hurry for more acquisitions. Having reduced its proportion of reinsurance from Germany from more than half to around one-third with the acquisition in 1996 of American Re and in 1998 of Torino Ri in Italy, it has now built up its direct operation in Germany, ERGO, which helps to stabilise the more volatile reinsurance results. However, the company does continue to add to the reinsurance group: buying two Lloyd's managing agencies and setting up a service company in Poland.

At the time it announced provisional figures for 1998, Munich Re said: “In the present competitive environment, opportunities for organic growth in the classic reinsurance segments are limited.” Munich Re had, nevertheless, been able to extend its market position, but on balance it does not expect significant growth in reinsurance premium income.

There will be benefits for Hannover Re in the HDI-HUK-Coburg merger. Hannover Re senior vice president Roland Vogel says: “From a strategic perspective, we will be part of a bigger group and that is obviously good news.” Although the merger will increase business from Germany for Hannover Re, one of its long term goals, the immediate effect will not be material. HDI owns 75% of the shares of Hannover Re and cedes all its reinsurances to a subsidiary of Hannover Re, Eisen-und-Stahl (E&S). E&S writes almost all Hannover Re's German business. HUK-Coburg is one of its cedants and owns 6.4% of E&S.

Mr Vogel explains that since HUK-Coburg concentrates on personal lines, its reinsurance needs are more limited than those of HDI which writes major industrial risks. The merger, he explains, will probably increase Hannover Re's premiums by about DM 100 million, compared to an overall book of about DM 12 billion.Hannover Re, is pursuing its policy of differentiation and strategic diversification. It is, for example, one of six companies writing the first ever reinsurance of the Lloyd's central guarantee fund and the only German company to do so. One result - along with the effect of slightly reduced rates - has been that over two years, from 1997 to 1999, the amount of its business coming from Germany has fallen from 31% of its total premiums to only about 20%.

The company set out its view of its home market in the following way in its strategic principles and goals: “Our presence in our profitable home market is inadequate. On the other hand, this market is in the process of radical change of which we aim to take advantage through a repositioning of ourselves in the market with the goal of doubling our market share over the long term.”

Some change seems likely for Gerling Global Re. A number of possibilities are suggested for the future of the Gerling Group - but none is certain. At present the group is 70% owned by the Gerling family and 30% owned by Deutsche Bank but Deutsche Bank is uncomfortable with a holding of this size and would like to increase it or sell. Another possibility is some form of stock market float for the Deutsche Bank stake.

In the meantime, Gerling Global remains acquisition minded, board member Klaus Bultman indicates. In April 1999, the company announced the acquisition of the new and renewal business of TIG Re's North American division for an undisclosed price. Last year, it acquired the US company Constitution Re.

Cologne Re, however, this year is suffering the effects of diversification gone wrong. A venture into reinsurance and retrocession of US workers' compensation business written through a US managing agency for the company's US subsidiary, Cologne Re Life Reinsurance Company, has made a loss of $275 million pre-tax. Apart from its initial statement, the company has been reticent about the circumstances involved. Like its parent company, General Re, Cologne Re is now part of the Berkshire Hathaway Group.

The biggest challenge for ERC Frankona this year is putting together its existing operations in the London market with those of acquisitions, Eagle Star Re and Kemper Re (UK). Director Karl Mayr explains: “We are trying to bring the portfolios together and keep as much profitable business as possible.” Together they give ERC Frankona a very substantial presence in the London market with a diverse portfolio.
Thus, It seems likely that the conjunction of falling rates, reduced reserves and continuing competition will result in significant changes in the German insurance market both continuing and becoming more visible. The impact on reinsurers may not be as immediate. The classical model is that larger insurers buy less reinsurance of which non-proportional increases in importance, but while the market remains composed of German or German speaking companies, traditional relationships will continue to be important and abrupt cancellations of large quota share treaties are likely to be rare.

Over the longer term, however, there probably will be evolution with a reduction in demand for proportional treaties and more interest in tailor made programmes and balance sheet protection products. German reinsurers in their home market will, therefore, be asked for products which are both more expensive to produce and more volatile to carry. The trend toward diversification into less volatile lines of business and other parts of the world will continue.

Lee Coppack is co-editor of Global Reinsurance.