This year has seen a definitive hardening in rates for catastrophe property covers, according to a report from reinsurance broker Guy Carpenter.

Across the world, the property catastrophe market hardened in 2002, representing the third straight year of rate hikes after six years of soft market. As part of the hardening environment, clients have found themselves increasing differentiated - those with relatively low losses and better data have been receiving better terms and conditions than insureds with more impaired loss records.

A report issued in September by US reinsurance broker Guy Carpenter, called `The World Catastrophe Reinsurance Market: 2002', identified the events of September 11 last year as ones which "turned a firming catastrophe property reinsurance market into a classic hard market, with substantial price increases and significant capacity shortages."

The immediate effect of the World Trade Center (WTC) losses was a retraction of terrorism-related cover, though by the 2002 renewals the wholesale removal of terrorism cover had relented and it became available in certain circumstances. With a gaping hole still existing in the terrorism risk market, certain countries started investigating the possibility of setting up a terror cover pool, along similar lines to that established in the UK in the early to mid-1990s, following the Irish Republican Army (IRA) attacks on mainland UK. So far, France and Germany have followed the lead of Pool Reinsurance, creating pools for terror cover within their countries, and the US continues to consider such a system.

Across Europe, other countries have discussed the option about setting up a government-supported pool. Austria, Italy and Norway have all actively looked at the option, while Belgium has expressed an interest but commented that the Belgian market is probably too small and therefore a European-wide pool should be set up.

The WTC loss was not the only major factor affecting the market in the past year. The well-documented corporate scandals at Enron and WorldCom are expected to lead to some pretty serious directors' and officers' losses, as well as other liability losses. At the same time, re/insurers' balance sheets have been hit hard by the drop in the equity and bond markets. "And the new wave of asbestos claims is adding to the pressure," commented the report.

"It should also be noted that the insurance losses of September 11, 2001, did not occur in a vacuum," continued the report. "The long soft market, weak investment earnings, and substantial losses from catastrophes, particularly in 1999, had weakened the finances of reinsurers. Further, the ability of a number of smaller players to provide capacity to the market was limited by a lack of retrocessional cover, caused in part by the collapse in the late 1990s of the emerging Australian reinsurance market."

It is well documented that more than $20bn in new capital has entered the market since the WTC disaster, and much of this capacity flowed into Bermuda, traditionally a major hub for property catastrophe business. The inflow of new capital may have helped temper the rise in rates for property cat business, which this year are still below their 1993 peak. The Guy Carpenter report identifies several reasons for this:

l Hurricane Andrew in 1992 resulted in panic in the catastrophe market in 1993 and 1994, compounded by the Northridge earthquake in January 1994. Both events led to massive losses, and resulted in major increases in projected losses from large catastrophic events;

l at the time of hurricane Andrew, catastrophe modeling was a young science, with few benchmarks on cat pricing at rates generally set by the market's ability to bear. Nowadays, cat risks are modeled extensively and expected losses from natural hazards tend to be fairly stable from year to year; and

lpost-hurricane Andrew, the reinsurance sector continued to write property catastrophe business. By contrast, after September 11 it pulled most of the capacity previously available for terrorism covers.

ART option?

With the harder market inevitably comes the question of whether alternative risk transfer solutions such as catastrophe bonds will now have their day. Cat bond activity appeared to peak in 1998, but there has been a resurgence of interest of late. "In terms of transactions, it now appears, based on data reported so far this year, that activity in 2002 will be at a higher level than in 2001," commented the report. "These instruments, however, still constitute a relatively minor part of the overall catastrophe risk transfer market, though it should be considered that catastrophe bonds typically provide protection only for very low probability events ... As such, catastrophe bonds provide a realistic and important alternative for clients for low probability events. Should pricing of catastrophe bonds continue to become more competitive, an increase in the use of these instruments can be expected by insurance and reinsurance companies."

US spotlight

After years of soft market conditions in the US, a hard market is currently dominating the reinsurance business. The hardening had started for the penultimate renewals season, though at that point rate increases were more a factor of loss experience than capacity shortage. The last renewals season showed both significant price increases and tighter terms and conditions. According to Guy Carpenter, "Overall, restrictive occurrence limits were applied not only to natural disasters, as was previously standard practice, but to all perils. Reinstatements were further limited and are no longer free in most instances. Exclusions for terrorism, toxic mould, and cyber risk were selectively imposed. There was also a strong desire by reinsurers to remove many of the additional coverages that had been included through the soft cycle."

Inevitably, the WTC attacks sharply focused the market's attention onto terrorism coverage. Immediately after the loss, terrorism re/insurance was assessed to be unquantifiable and therefore uninsurable. "In the ensuing weeks leading up to the renewals of January 1, 2002, this position was ameliorated, and presently the degree to which cover is available varies by reinsurers, class of business, and terroritory." Quoted rates have varied widely, according to the report, and a Federal backstop is still a possibility, at least at time of writing.

The massive changes in insurance companies' underlying portfolios and terms and conditions have made it almost impossible to compare the change from year to year in any meaningful way. By analysing the placements of major US insurers, Guy Carpenter has attempted to surmount this problem, and in doing so has revealed that price increases have moved up almost across the board. During the course of 2002, average limits per programme shot up, reflecting insurers' concern at exposures to mega-catastrophes. According to the report, "While in general insurers sought higher limits, many programs were not completed, as cedants retained more risk at various layers. Their motivation was twofold: to hold the line on reinsurance costs and retain more net profitable business in a hard primary market." By contrast, average retentions - stable for several years - only nudged up slightly, reflecting cedants general satisfaction with their programme structures, "particularly where they view that a change, such as an increase in retention, could negatively impact their financial rating."

As the 2003 renewals season negotiations start taking place, there are still questions about whether prices will continue to rise, and terms and conditions continue to contract. Is the market continuing to harden or is it closer to reaching the top of the cycle? "At this point, industry opinion is divided," commented the report. "There are those who forecast the beginnings of a softer market, pointing to factors like the increased capital entering the industry, signs of price weakness at July 1 renewals, and the relatively low catastrophe loss record so far this year."

There are several factors which belie this particular viewpoint, however. Reinsurers are feeling financial stresses, including capital withdrawals from countries and lines of business. At the same time, the low interest rate environment and weak equity markets are resulting in low investment incomes, while claims inflation appears to be on the increase. These woes are further added to by claims for D&O and other liability covers from the recent accounting scandals in the US. "As we move toward the first wave of renewals in January 2003, we should gain greater clarity on market direction," concluded the report.