Once upon a time there were high hopes that Sydney would emerge as a global reinsurance centre. In the mid-1990s, to be precise, the Australian capital market was only too happy to support local start-up reinsurance and catastrophe risk companies which were eager to take advantage of the expanding Asian markets and play a major role in the global reinsurance market. Today, it's a very different story. The last couple of years have seen a dramatic turnaround for Australian reinsurers writing international business. Reinsurance Australia Corporation (ReAC) and GIO Re are now in run-off, following on from the collapse of New Cap Re early in 1999. Now a shadow of its former self, any visions Australia's reinsurance industry may have harboured have proved the stuff of fairytales.

Some have called it the “great reinsurance crisis,” others the “reinsurance debacle.” Whatever the moniker, the fact remains that Australia's domestic reinsurance industry has well and truly flopped, reinforced by last month's announcement that NRMA has put its reinsurance business into run-off. Australia's current involvement in the global reinsurance market will be restricted for the time being to niche books written by such players as QBE's global operations, based in London. For all the fuss about the power of modern telecommunications, reinsurance remains a largely loquacious, handshake-based business.

There was more to the recent troubles than mere geography, of course. Much more. Timing was a major factor. Aggressively pursuing business in a brutally soft global market was never advisable, and an unprecedented year of natural catastrophes in 1999 (both in Australia1 and worldwide) exacerbated matters. Other potent portents run to a list: lack of competitive strength; adverse selection and inappropriate risk management; uncommitted capital; and the Sydney broker syndrome.

As Ian Thompson of Standard & Poor's in Melbourne explains, at a time of abundant capacity, “Australian reinsurers failed to develop any redeeming competitive strengths and, as such, were destined to occupy a low position on the food chain. To achieve the volume to cover costs, Australian reinsurers accepted poor quality business in the hope of establishing a franchise or niche and, over time, improving the quality of business sourced.” A strategy which only has a hope of working at times of low loss frequency, it was doomed to failure. Risk management practices also left a lot to be desired due to inadequate retrocessional protection, weak underwriting, and loose control and monitoring of aggregates. Meanwhile, the lack of major sponsors or long-term committed shareholders resulted in a failure to achieve credible financial strength ratings, further limiting access to ‘tasty' premiums. Remarks Mr Thompson: “Australian reinsurers comprised naive, opportunistic shareholders with shallow pockets that lacked the resolve to build a reinsurance enterprise.”

In the midst of all this, Sydney-based brokers didn't help. Managing risks and building a franchise from geographically distant Australia have proven difficult and brokers have generally been restricted to transacting low quality international business. “This may well be a function of adverse selection targeting the Australian market, as well as the Sydney-based brokers' poor access to high quality business,” observes Mr Thompson.

Various factors contributed to the demise of Australia's domestic reinsurance market, but the simplest sum-up would be “too young, too soon and too high a frequency and severity of losses.”

Blow-by-blow accounts

First down was New Cap Re, once the shooting star of Australian reinsurance. A subsidiary of Bermudian reinsurance firm, New Cap Reinsurance Corporation Holdings Ltd, the company began underwriting in 1997. It took very little time for the writing to hit the wall. Operations were suspended in April 1999, following several severe catastrophe losses (including hurricanes Mitch and Georges and the Swissair accident), the intervention of the Bermudian regulator in the parent company when its reserves dipped below the statutory minimum, and the suspension of trading in the holding company's equity. A voluntary administrator was appointed, reflecting the severe losses incurred in 1998 (estimated at US$140m, according to Moody's, leaving only US$50m of capital) in addition to the negative cashflow implications of regulatory intervention at the parent company (New Cap Re Australia benefited from an inter-group quota-share with its parent). Creditors of New Cap Re voted in September 1999 to liquidate the company, which has left various US and London market practitioners with burnt fingers and an antipathy towards Australia. A tad unfair some might say, considering the international markets cruelly took advantage of Australia, but that's the reinsurance business for you.

ReAC didn't do too badly following its creation in 1993. It enjoyed several years of profit before succumbing to a relentless string of losses. The company showed the first signs of ill health when it reported an after-tax loss of A$116m for the first six months to 30 June 1999, compared to a A$33m profit for the same period the previous year. In typical PR speak, ReAC shrugged off the news as “disappointing”, blaming the double whammy of high losses and continued soft premium conditions. However, it soon became apparent there was more to the company's problems when a recovery plan was put in place which reduced the risk profiles and improved the quality of the underwriting. Any hopes that ReAC could go forward with a much smaller, less volatile book of business were quashed by early 2000. The company was forced to suspend operations as the full extent of the latest losses incurred made their fatal mark. According to Moody's, the losses finally disclosed in respect of 1999 indicated that ReAC's net loss for the year was A$467m (including abnormal cost of A$93m), leaving the company with net assets of only A$53m. The company had been technically in breach of the Australian regulator APRA's2 solvency margin requirement (specifically 15% of claims reserves) at the end of 1999. APRA stepped in and ReAC is now in the run-off zone.

GIO Australia Holdings has rarely been out of the headlines for the last couple of years. When AMP, the Australian/UK life and pensions giant, made a hostile takeover bid for GIO in late 1998, the ensuing war was the most vicious in corporate Australian history. GIO fought a hard, expensive battle (it cost A$26m to defend the AMP bid) but the giant won. AMP secured control in January 1999, snaffling 57% of GIO's equity. The aim of the move was a ‘get out or get bigger' strategy for AMP's poorly- performing general insurance operation. However, having failed to properly investigate GIO's reinsurance business, AMP undoubtedly rues the day it ever set eyes on it. The company first disclosed potential problems emerging from its reinsurance business in May 1999 when it announced a profits warning. Keen to ensure full control was maintained, and to try and stem the obvious emerging losses, AMP launched a bid for the remainder of GIO equity three months later, which was completed in December.

As Simon Harris, vp/senior analyst at Moody's, explains: “Although GIO had ceased writing or renewing reinsurance business in August 1999, on full acquisition AMP began an aggressive policy cancellation programme, designed to limit exposure on unexpired business and to firmly place the business in run-off. However, by this stage, GIO had already reported a loss of A$761m for the 12 months to June 1999, followed by reserve strengthenings of A$180m in November 1999 and an estimate of A$175m for additional losses since June 1999.” The dismal performance of GIO Re during 1999 wiped out the profits accumulated by the company since it started trading in 1986. As with the other troubled Australian reinsurers, the usual suspects played their part in such disastrous loss experience. GIO's board freely admitted that poor management discipline was a major factor with too much risk retention (around 80% was retained) and not enough risk assessment. GIO Re had tried to address this problem through a restructuring process and failed.

GIO's reinsurance business was never a core part of the AMP/GIO proposition, but it will certainly never be forgotten by AMP. The after-effects of the GIO transaction (analysts prefer to call it the “GIO disaster”) have included a mercurial share price and a board indulging in musical chairs, the most notable player being George Trumbull, the departed American former CEO. The transaction cost AMP close to A$2bn on paper, a pretty significant smack in the teeth. Admittedly this was set against tax losses and cost savings in excess of A$150m to be wrung from the merger of AMP General Insurance and GIO, in addition to the ongoing building of the general insurance business. However, rumours abound that it's only a matter of time before AMP itself becomes a target. Famed US investor Warren Buffett has already gone on record appraising AMP as an excellent business and perhaps by implication a potential acquisition, so who knows what might happen. Only time will tell.

Things can only get better

There is no doubt that Australia's reputation as a reinsurance market has been somewhat tainted by recent events. Nevertheless, several strong players remain, most notably QBE whose approach of acquiring and building niches under the auspices of a strict central risk management has proven successful. Aside from QBE, the current Australian reinsurance market essentially comprises branch and subsidiary operations of all the major reinsurance groups. In terms of the available workforce, the sound regulatory system and proximity to the largely untapped Asian markets, the market still enjoys plenty of potential. And, as Mr Thompson points out, “the Australian market will remain a substantial buyer of reinsurance protection, in that it is one of the largest and most sophisticated insurance markets in the Asia/Pacific region.”

Globally, the Australian property/casualty insurance market ranks as the tenth largest, with direct gross written premiums of A$14.5bn in 1998. Like so many other markets, consolidation is very much the name of the game. Aside from the AMP/GIO deal, major moves in the last couple of years have included: and

  • the merger of Commercial Union and NZI into CGU Insurance Group following the global merger of UK-based Commercial Union plc and General Accident plc;

  • the friendly takeover of FAI by HIH, the combined operations of which amount to around A$2.6bn in premium income. HIH recently announced a five-year joint venture agreement with Allianz Australia Insurance involving both companies' retail general insurance businesses;

  • the establishment by QBE and Mercantile Mutual of a joint venture company to manage broker-generated general insurance portfolios and reduce the cost of doing business;

  • the friendly merger of the non-life operations of NRMA and RACV, resulting in a combined premium income of A$1.65bn, followed by the not-so-friendly recent NRMA demutualisation/flotation which saw various directors vociferously campaigning against the move. With a war chest close to A$2bn, the company is now eyeing potential acquisitions as it seeks to diversify from its roots as a New South Wales personal lines insurer to become a national multi-liner.

    With a ferociously competitive general insurance market putting pressure on margins, it's hardly surprising that the drive for size and economies of scale is a prominent feature of such activity. Generating a greater geographic spread of risk and product diversity, and accessing new or more efficient distribution avenues and a wider customer base have also played their part. In addition, many observers believe that the fear of becoming a target in a consolidating market has pushed several insurers into friendly mergers.

    All this activity has meant that the Australian insurance sector is becoming increasingly concentrated. The top five groups currently represent around 50% of the market and the top ten a whopping 90%. Those vying for the remaining 10% may find business uneconomic if they lack a competitive niche. The general consensus is that consolidation will continue, but not at the pace of recent years. At the upper end of the market, many of the serious acquisition targets have been taken. However, Rhys B Withers, managing director of Munich Reinsurance Company of Australasia Limited (MRA) takes a different line: “In view of the relatively small number of independent risk takers left in the marketplace it is hard to imagine further consolidation. It is, however, conceivable that unless companies achieve improved returns on equity, some overseas-owned companies may withdraw from the market as a result of decisions of their parent companies.”

    Operating environment

    Australia's direct insurance market has risen in real terms in recent years, as the economy has prospered. The GDP has expanded by an average of 4% per annum over the last ten years. The property/casualty sector continues to be dominated by personal lines – together, motor and household account for 55% of direct written premiums. Other major classes include commercial fire insurance and employer's liability/workers' compensation. For most lines, profitability has deteriorated over the last few years; APRA reported an overall loss of A$2bn for direct insurers for the year to 31 December, 1999. After the allocation of investment revenue, this resulted in a net loss of A$595m. The total combined ratio came to 123%, with liability lines particularly poor – professional indemnity (146%), public and product liability (168%), and employer's liability (160%). More recent results reported by APRA for the year to June 2000 (which include both direct and reinsurance firms) include an underwriting loss of A$2.2bn. This represents an 18.3% improvement on the previous year, where reinsurance losses associated with the Sydney hailstorm affected the June 1999 quarter results. As Michael Vine, also in the Standard & Poor's Melbourne office, explains: “The operating environment has been difficult, especially in commercial lines, with strong competition fuelled by surplus capacity and soft reinsurance rates, and claims adversely impacted by a series of natural disasters and deterioration in various liability lines.” He adds that costs associated with Y2K readiness and transitional provisions for the introduction of the 10% goods and services tax (GST) have also left their mark.

    Mr Withers observes that since the early 1990s, “the direct market has undergone severe pricing stress to the extent that many direct companies in Australia are now largely unprofitable in terms of modern expectations of return on equity. The whole region is particularly prone to natural catastrophe exposures and the direct market has shown little, if any, ability to accumulate funds against future losses, other than through reinsurance continuity.”

    Meanwhile, the market has other ‘local' anomalies to contend with. Personal lines are largely a state matter, with different states operating different schemes. Workers' compensation is a particular bugbear, with the class remaining stubbornly in the hands of government in a number of states despite substantial unfunded liability problems in the area. The prospect of politically unfavourable price hikes and union pressure to remain in public hands has apparently outweighed common business sense. However, following an escalating deficit within the scheme (A$2bn at the last count) the New South Wales government (the largest state in terms of population) was planning to fully privatise its workers' compensation scheme last October but has postponed indefinitely. The Insurance Council of Australia (ICA) has stated its displeasure by describing the decision as “extremely disappointing.” NRMA chief executive Eric Dodd, the newly-elected president of the ICA, has promised to address this area during his term of office.

    More bad news has come courtesy of the new Labour government in Victoria which has moved to restore the rights of seriously injured workers to sue for damages under common law. The change will be retrospective, dating from 20 October 1999, when the government was elected.

    Motor has its own peculiarities. Divided into non-compulsory for vehicle theft and damage and compulsory for third party injury and damage, the states enjoy a monopoly on the provision of third party insurance, although New South Wales, Australian Capital Territory (ACT) and Queensland allow private insurers to underwrite the schemes, allowing consumers to decide who to buy their statutory cover from. Recent analysis has shown that in many cases, compulsory third party (CTP) rates charged by insurers are far below what is required to achieve anything resembling a profit. As Moody's explains, “following privatisation of the New South Wales CTP scheme, average premiums charged by insurers fell by 43% over two years, as many players sought to achieve a sizeable share of this large market. Although rates need actuarial certification before application, this drive for market share and the level of future claims uncertainty in this business may have led to the use of somewhat optimistic assumptions. In New South Wales, recent legislative action to place a ‘cap' on third party injury payments may, however, improve future profitability.”

    The states' monopoly of CTP provision is now under review by the Australian Productivity Commission.

    The GST introduced last July has led to significant one-off charges to insurers in addition to major costs incurred as a result of information technology (IT) changes for the tax. Despite the short-term pain, analysts contend that the introduction of GST should be largely cost-neutral to insurers; the tax payable on services provided (that is, claims paid, repairs, etc) will rise as a result but an imputation system will allow insurers to offset this using tax received on premiums. Andrew Reeves, a senior manager with KPMG, argues that although GST applies to general insurance, it is the reinsurers which will face the most complex implementation issues. “The ‘detached' nature of reinsurance means that reinsurers are, at least to a degree, reliant on brokers and insurance companies for their understanding and valuation of the impact of the legislation. The resultant ‘information lag' places reinsurers in an unenviable position as the legislation requires a full, immediate understanding of the underlying nature of the original insurance, in order to apply the tax.

    “The fact that other reinsurers in other parts of the globe faced similar issues when GST was introduced provides little immediate comfort to Australian reinsurers, who are still trying to come to grips with the full impact of the complex GST rules.”

    Cautiously optimistic

    Taking all of the above into consideration, is there any hope for the Australian insurance market? The general consensus is that there is, and this time there are no dissenters. The old chestnut “cautiously optimistic” comes up every time the subject of the market's future is broached. Mr Withers, for one, is happy to report that the market “is currently characterised by strong rating improvements.” Daniel R Nikles, CEO of Winterthur International Insurance Co in Sydney is equally upbeat. Speaking as a niche player in the field of multinational corporate business, he points out that although his sector was under tremendous pressure until the second part of 2000, in line with the rest of the non-life insurance market, the current renewal season has witnessed a hardening market and “an opportunity to reward well-managed accounts with a good performance while being able to demand appropriate pricing for others.”

    He concludes that the generally hardening market is good news for those insurers with a healthy book. “It has been a while since such a statement could be made in our industry in Australia.”

    On the subject of statements, it is perhaps symptomatic of difficult times that few players are willing to offer any insight into recent market experience. There are 104 private sector general insurers and 26 reinsurers currently licensed in Australia and a substantial cross section was contacted during the research for this article. Mr Withers and Mr Nikles were the only players kind enough to offer their observations.

    Mr Vine, meanwhile, echoes other analysts when he pronounces a positive outlook for the general insurance industry, following an improvement in industry fundamentals brought about by shareholders demanding stronger underwriting practices and improved returns. “The resulting increase in premium rates and the cost benefits from consolidation are expected to boost profitability in 2001. Anecdotal evidence suggests that in the renewal period for June 2000, there was a 20% increase in commercial lines premium rates in property classes, and a more than 20% increase in liability classes, with strict underwriting controls exercised.”

    He goes on to point out that “subsidiaries have renewed their focus on operating efficiency and profitability to justify the use of capital in a mature, and, in some cases, remote market. While competition for market share continues, it is expected that premium rates will continue to harden and profitability improve. However, companies positioned in the middle of the market without an apparent niche or expense efficiencies will continue to find trading difficult. The current support from higher-rated local and foreign parents also may be reassessed in light of changes in strategic direction or the failure of general insurance operations to meet required return hurdles.”

    Industry resolve

    Firming up local results will be a high priority, then, in order that international parents feel confident about remaining in Australia. A strengthening regulatory structure will also fortify the industry over the long term, albeit posing yet another challenge for the market. APRA recently announced proposed changes to regulatory requirements which will boost the market's solvency position. Australia's supervisor has made it clear that it will ensure the recent reinsurance troubles never darken the country's doorstep again, but this should not be mistaken as a negative indictment of current regulation. Australian regulatory and accounting treatment of property/casualty business is relatively sound by international comparison. Some would go so far as to say the country is a world leader in imposing tough standards for its financial institutions. With the exception of New Cap Re, no policyholders have experienced any losses as a result of recent events.

    The proposed reforms are expected to be introduced over the next couple of years following extensive market consultation. Analysts are, not surprisingly, all for this development. Remarks Mr Harris: “The principle concerns in reforming the existing solvency standards have been that they are not risk reflective, do not reflect the link between asset and liability mix, and that they do not cater for inconsistencies within reported liability values. APRA's reforms therefore propose significant alterations to the current position, with insurers being able to prove solvency either through a default formulaic risk-based solvency approach (with a harmonisation – possibly including mandatory actuarial advice – of statutory liability evaluation), or through an APRA-approved internal capital model.”

    While such moves should help to underpin sounder reserving and pricing, the economic position of the players will not transform overnight. It will take some time before the market's capital strength sees serious improvement, either the result of market-wide improved risk assessment or through the withdrawal of smaller, modestly capitalised companies unable to cope with a more stringent regulatory environment

    One thing is for certain, however. Despite its idiosyncrasies, the Australian market offers plenty of potential. Dreams of becoming a global reinsurance centre may have bitten the dust, but Australia is emerging as an important centre for global finance. As the gateway to the Asia/Pacific region, and with time zone, language and educational advantages, the country offers a unique competitive edge. Moreover, although the Australian general insurance industry has a reputation as an innovator in product development, the use of alternative risk transfer methods has yet to take hold. As Mr Nikles puts it: “Until very recently, alternative risk transfer techniques were more often discussed than practised. Market conditions in the past did not provide incentives to risk managers to go far beyond their comfort zone and traditional insurance placements prevailed. This might now change as the cost of insurance goes up.”

    Whatever the future holds for the Australian market, it will undoubtedly live up to the country's folk heroes, appropriately known as ‘battlers'.

    1. The A$1.5bn Sydney hailstorm of April 1999 was the largest single Australian loss. It fell to a large extent on local Australian reinsurers. Put in context, natural disasters in Australia have cost insurers A$2.75bn

    since 1993.

    2. The Australian Prudential Regulatory Authority (APRA) is the insurance industry's supervisory body. APRA regulates authorised companies according to the Insurance Companies Act 1973 (as amended) and is also the prudential regulator for life insurers, superannuation funds and banks. It came into existence on 1 July 1998, replacing the Insurance and Superannuation Commission.

    Valerie Denney is a freelance insurance journalist and a contributing editor to Global Reinsurance.