Can Bermuda reinsurers manage their excess capital successfully after two record-breaking years? If the market can get this right, it could just help to ease competitive pressures, explains Laline Carvalho.

Bermudian reinsurers enjoyed an exceptional year in 2007 – providing record-breaking operating results. Banking on two straight years of strong profitability, this market has been able to deliver operating returns to their shareholders not seen in over a decade. As profits continue to pile up, these reinsurers are also enjoying record capitalisation levels.

As we move further into 2008, however, there are concerns over softening market conditions across most lines of business and geographic regions. These are bringing into question global reinsurers’ ability to maintain strong, sustainable earnings. In addition, Bermuda has some specific issues which may impact the way reinsurers manage this glut of capital in coming years.

A combination of low catastrophe losses, adequately priced business, and favourable loss reserve emergence contributed to most Bermuda reinsurers posting strong combined ratios in 2007. The market, which includes companies writing both insurance and reinsurance and a number of players focusing on property writings, had strong underwriting results with an average combined ratio of 74% and ROE of 20% for the year. This led to record aggregate net earnings of $12bn posted by these companies in 2007.

Managing capital

The increased competition seen in the reinsurance sector of late is partially explained by increased risk retention by cedants. This is a reflection of strong business margins and very strong capitalisation currently enjoyed by the primary markets. Although this development is outside the control of reinsurers, there are other areas where the sector can influence competitive pressures.

One of the most important pertains to how the industry decides to manage its excess capital position. Currently, the majority of Bermuda and US reinsurers rated by Standard & Poor’s have their capital adequacy position well into the “AA” and “AAA” levels as measured by its capital adequacy model. In 2007 a large number of reinsurers – including a significant number of Bermuda-based companies – announced share buyback programmes, a trend that is continuing into 2008. So far, however, the amount of share repurchases have been significantly below what reinsurers have earned, so absolute capital is still growing.

After many years in which the sector mostly shunned the idea of acquisitions, these are coming back onto the agenda for a number of reinsurance management teams. The market only saw a few announcements over the past year, including SCOR’s bid for Converium, and the Validus and Ariel Re bids for two Lloyd’s syndicates: Talbot and Atrium, respectively.

The latter also exemplify a more recent trend among a number of Bermuda writers. This is to expand geographical reach outside their Bermuda operations as a means of gaining greater flexibility of product and client reach. Along these lines, Montpelier Re recently announced its intention to start a new Lloyd’s syndicate. Allied World has established a new company in the US to underwrite and expand some of the US-related reinsurance business it previously wrote out of its Bermuda operations. The ultimate success of these strategies – and how they will reshape the industry – will only be seen a few years down the road.

The returning of capital also seems set to continue. Bermuda shareholders’ equity jumped by a healthy 13% to $72bn as of 30 September 2007 (latest data available), compared with 30 December 2006. Like the rest of the industry, most players (see chart on page 32) are flush with capital at a time when profit opportunities are dwindling. Most of them have started buying back their shares, with more substantial buyback activity expected.

As of September 2007, this group bought back about $2.7bn of its shares, which constituted 3.7% of shareholders’ equity. On an aggregate basis, these Bermudian companies still have approximately $3.4bn (4.7% of shareholders’ equity as of 30 September 2007) under existing share repurchase authorisations.

S&P does not see any rating implications to the share buybacks that are underway provided that the risk-adjusted capital at these companies remains within expectations. M&A could be an alternative to share buybacks, as it provides a conduit for some of these players, particularly among the Class of 2005, to deploy surplus capital as we continue into a softening market. Nevertheless, widespread M&A activity across the reinsurance sector is not anticipated.

Economic pressure

On the macro-economic side, a few trends may also influence reinsurers on their thinking about capital. In particular, the current volatility in the capital markets as a result of subprime losses is expected to impact investment returns for the sector this year. In previous soft cycles, the ability of reinsurers to make up for underwriting losses with high investment returns was an important factor and the current situation may mean that a more conservative approach prevails.

Global reinsurers as a whole are expected to have limited exposure to subprime losses from their investment portfolio, given the generally high quality of their invested assets. With the exception of XL and Scottish Re, which have posted relatively large losses related to subprime, most other US and Bermuda reinsurers have reported relatively small losses in this area. However, most companies in the sector have recorded modest investment losses over the last six months related to declining values of securities held. This uncertain investment environment is expected to continue at least through the remainder of 2008.

At a turning point?

While the US reinsurance market has lost some of its lustre over the past decade, Bermuda has significantly increased its profile in the global reinsurance marketplace during the same period. With two classes of formation since 2001, the market has more than doubled its writings over the past decade, reaching aggregate net writings of approximately $46bn during 2007.

Taking advantage of a period in which US reinsurers were faced with operating losses and restructuring their businesses, the Class of 2001 players quickly established themselves in a wide range of products in the insurance and reinsurance markets around the world, and particularly in the US. Today these are very large companies in their own right with large premium volume and capital bases. Although Class of 2005 competitors have a narrower scope with greater focus on property writings, most of them are also fairly large-sized companies with capital in excess of $1bn.

A number of factors may impact the amount of capital flowing into Bermuda in coming years. Among the key advantages Bermuda has been able to offer over the US (and other domiciles) is its tax-free status as well as the speed with which companies are able to set up operations. While these advantages are still attractive, evolving market forces are likely to make investors consider other potential domiciles for future formations beyond just Bermuda. Among these are the increasing attractiveness of domiciles such as Ireland, Switzerland and Dubai in offering access to high-quality human capital and access to other markets such as Europe and the Middle East.

With the increased usage of non-traditional capital sources, such as insurance-linked securities and sidecars, it is likely that a significant proportion of new capital entering the reinsurance industry in future years will take this form.

Companies operating in Bermuda face a number of challenges. How far pricing falls over the next six to 12 months will have a direct impact on potential profit margins. It is certain to provide some clues as to whether sustainable cross-cycle earnings are truly achievable by this sector.

As investors continue to focus on the bottom line, whether to return capital and how much to return is expected to be a key part of Bermuda management teams’ decision-making process. Pricing continues to deteriorate in both insurance and reinsurance lines. Mergers and acquisitions are likely to be an attractive option for some players and a modest amount of M&A activity in the global reinsurance sector is expected over the near tem. Over the medium term, the increasing appeal of other tax-advantage domiciles as well as the increased use of non-traditional forms of capital is likely to make it difficult for Bermuda to sustain growth rates at the levels seen by the island over the past six years.

S&P maintains a stable outlook on the global reinsurance sector, but will continue to monitor premium rate deterioration and terms and conditions over coming months. Depending on how significant this deterioration is over the next 12 months, the outlook on some reinsurers may be changed to negative by year-end 2008 and some companies in the sector could be downgraded in 2009.

This is reflective of the fact that current ratings are based on the expectation that reinsurers will be able to achieve better cross-cycle earnings this time around, and that future soft cycles will be shorter and shallower than seen in previous decades. The upcoming June and July 2008 renewals, as well as the 1 January 2009 renewal season should offer significant clues as to whether underwriting discipline will ultimately prevail.

Laline Carvalho is a director at Standard & Poor’s.