With the dual impact of the credit crunch and softening market on balance sheets, Helen Yates asks how reinsurers can best navigate their way out of this challenging environment.

As the first half results trickled in it became clear that the excellent performance of the previous two years was coming to an end for reinsurance companies.

Balance sheets remained in good shape, but the combined impact of the global credit crunch and a softening cycle is beginning to test companies’ resolve.

An active hurricane season, which is still far from over, is creating further pressure. In previous soft cycles, investment returns would have helped counterbalance poor underwriting results. Not so in 2008.

For non-life reinsurance the first half results showed a slight drop in income on both sides of the balance sheet. Net written premiums went down by 1.9% to an overall $37.86bn, compared to $38.6bn in the first half of 2007. Shareholders’ equity dropped 3.8% to $264.3bn from $274.7bn the previous year.

At the same time, a larger number of moderate catastrophe losses saw the combined ratio climb to 92.2% from 89.6% in H1 2007. Analysts were quick to point out this was still a good performance.

With a higher proportion of their investment portfolios in equities, European reinsurers are more exposed to investment volatility. North American reinsurers have higher underwriting volatility as a result of their exposure to catastrophes.

Beneath the overall figures there were clear winners and losers. “It has been interesting to watch,” said Endurance CEO Kenneth LeStrange. “Most market participants have been conservative and yet even very secure types of investment have suffered from a lot of volatility.

I don’t sense many organisations are going to suffer true credit losses – although those with credit default swaps have been punished.”

AIG is the most famous sufferer at the hands of credit default swaps (CDS). But other insurers have also been afflicted. Swiss Re’s investment portfolio saw a further $320m writedown as profits halved to $580m from $1bn in Q2 2007.

As it revealed its first half results, XL Capital announced it had reached an agreement to eliminate any payment obligations to bond insurer SCA. Its exposures to the bond insurance sector have been well documented. In Q2, as well as a charge of $82.4m arising from guarantee and reinsurance agreements with SCA, XL saw profits drop to $237.9m compared to $544.5m in Q2 2007.

Munich Re saw its first half results drop 35% as it revealed a EUROS 2bn loss of investment income.

Berkshire Hathaway, Tokio Marine, Catlin, Max Capital and Lancashire all saw net income fall. Amid the gloom there were some surprises. Defying the challenging environment, Ace saw profits rise 15%, while Aspen, Hiscox, Flagstone and Validus also posted positive results. “Profits are likely to decrease in the next 12 to 18 months as a result of the soft market conditions and reduced investment income, but this is not outside of expectations at this point in the cycle,” said Fitch’s North America and Bermuda analyst Mark Rouck.

Despite a few winners, reinsurer profits are under pressure. AM Best points to softening rates and dwindling investment returns as key drivers. “With both property and casualty rates softening again, current reserving isn’t likely to be sustainable or reliable for boosting earnings in future years,” warns its report.

“Meanwhile, the weakening global economy and turmoil in the equity and capital markets have added to the pressure on reinsurers.” With investment income under pressure, there is less of a margin for error on the underwriting side, it warns.

Reinsurance heavyweights Swiss Re and Munich Re both backed up this assessment in their press briefings at the Rendez-Vous in Monte Carlo last month. “Due to the global capital markets environment, the price for risk is rising and capital costs have gone up sharply,” commented Swiss Re executive board member Michel Lies.

“The insurance market should take account of this.” Munich Re agreed: “A drop in investment income in the past months has led to shortfalls in profit and lower equity capital in the insurance industry. Munich Re anticipates that this will have a positive impact on the cycle and accelerate a turnaround in the trend.”

Healthy balance sheets

Despite the challenging environment, balance sheets remain in good shape after two years of record profits and low catastrophe loss activity. “The levels of capital are high by historical standards – there aren’t too many companies suffering,” said Ian Dilks, a partner at PricewaterhouseCoopers.

“Most reinsurers are not exposed to the more exotic instruments.”

Because they take risk on the underwriting side of their balance sheets, most reinsurance companies are conservative investors. As Fitch said, high asset quality has mitigated the impact of capital market turmoil.

David Priebe, chairman of global client development at Guy Carpenter, added: “The industry in general has emerged relatively unscathed from subprime issues. A few select companies have been affected but the industry as a whole has not been impacted. Where there has been an impact it has been on equity portfolios.”

The situation is very different to just a few years ago, when global recession following the dotcom boom left reinsurance companies in poor shape to cope with the losses of 9/11.

“There have been very good underwriting results over the past two to two-and-a-half years and balance sheets have been replenished,” explained Priebe.

“Companies have actively managed capital through share buybacks and other means.” He added that the quality of balance sheets, as well as the balance of portfolios, was much better today than in the past.

After the active storm seasons of 2004 and 2005 there was a feeling the industry had been caught out.

The losses from Katrina in particular – in excess of $40bn – had not been anticipated.

As a result, catastrophe models were recalibrated whilst the rating agencies increased their capital requirements. Companies reduced their exposures to peak catastrophe risk and actively worked to diversify portfolios. In just three years, the industry looks very different.

“The cat models have improved and there have been advances in data quality and data availability,” said Fitch’s Europe and Middle East analyst David Stephenson.

“There are signs that reinsurers are actively managing their portfolios.” Enterprise risk management has also risen up the reinsurance agenda, particularly since Solvency II has increased emphasis on risk management and capital adequacy.

“The general trend is the use of more sophisticated methods of managing the business,” observed Dilks.

Companies may be in better shape to cope with a softening market than in the past, but will they continue to manage capital efficiently? Despite AM

Best’s view that reserving was likely to suffer in the future, Stephenson said that adverse reserve development had reduced and capital was likely to remain at a strong level “because it is harder for them to rebuild it in this environment”.

Nevertheless, dwindling investment returns and falling prices (in the absence of a major cat loss), might prove difficult to sustain discipline long term.

Shorter cycle

So could the credit crunch drive rates up? In Monte Carlo, many reinsurers were emphasising the importance of instilling greater underwriting discipline.

“Investment returns should shorten the cycle,” agreed PwC partner Andrew Kail. “Absent a major catastrophe there will be a general malaise in rates but there will come a point where underwriters and reinsurers will not be prepared to rely on those rates.”

Of course underwriters always preach discipline. As Dilks put it: “I’ve never met an underwriter who has said ‘I’m going to undercut rates’.”

According to Fitch there are signs that discipline is being maintained, although Swiss Re’s Lies said that he was concerned about those chasing market share. “As long as we have naïve players we won’t react as quickly (to a hardening market).”

Another major concern for the industry is the 2008 hurricane season. While they were both earnings rather than capital events, Hurricanes Gustav and Ike point to an active season. At the time of writing, insured losses for Gustav were estimated at about $4bn-$10bn, while AIR Worldwide estimated Ike would cost between $8bn to $12bn onshore and $600m to $1.5bn offshore.

Should there be further losses, many are concerned about the industry’s ability to recapitalise in an illiquid market. After Katrina, the industry raised $30bn in just a few months. “A lot of capital that was attracted in 2006 and 2007 has already fallen away because the rates of return have

gone down,” said LeStrange. “The capacity was a shock absorber for the industry.”

What many reinsurance companies are now preparing for is the possibility that capital may be less easy to come by in 2009. LeStrange said that he believed that investors would prefer ILS.

“In today’s world, the need to recapitalise could be very challenging to execute. It could be very punishing to existing companies,” he warned. Another class of start-ups in Bermuda was also unlikely after a major loss, said PwC’s Dilks, “partly because Bermuda has run out of space – where do you put them? And if most companies are trading at a discount to book value there is a real risk putting money into start-ups.”

While balance sheets are healthy, the challenges as the industry moves into Q4 2008 are many and varied. Should the hurricane season pass with

moderate losses, there will be no need to recapitalise, said Kail. Should catastrophe claims be significant this year, the credit crunch could make it difficult to raise funds.

For now, at least, the industry is well capitalised and a disciplined approach looks to be on the agenda for most underwriters. In the run-up to the 1 January renewals, dwindling investment returns could be just the nudge they need to ensure that it stays that way.

Helen Yates is a freelance journalist.

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