Clifford Rich explores the secrets of Bermuda's success
First, and perhaps most important, the development of the Bermuda market should be viewed in an historical context. While Bermuda has been an accepted home for captive insurance companies for many years - it is, in fact, the world's leading domicile for captive insurers - the formation of ACE and XL in the mid-1980s initially put Bermuda on the insurance map. Still, it was not until Hurricane Andrew in 1992 that solid inroads into the mainstream reinsurance market were made. Following this, the now famous Class of 2001 start-ups entered the market in the wake of the terrorist attacks of September 11. The common thread at these three points in history is that of simple economics. With the promise of high returns, capital flowed into the market during times of great 'dislocation' to meet industry demand for capacity.
In the mid 1980s, it was the North American excess liability crisis that drove the creation of ACE and XL, while major catastrophic events were a factor in the next two waves of company start-ups. The companies established in Hurricane Andrew's aftermath filled the void resulting from both the depletion of industry capital as well as the increased demand for catastrophe capacity from wary primary carriers, which began to use more conservative assumptions in enhanced catastrophe models. Little elaboration is needed to understand the reasons behind the most recent spate of company formations following September 11, other than to note that the industry's very ability to survive an event of such enormous proportions was in question.
Compared to other industries, the re/insurance business is remarkable in terms of the relative speed with which capital can enter the 'system' in response to market conditions, whether it's a single line of business, as was largely the case with Hurricane Andrew, or a more wide-ranging dislocation as resulted from the September 11 terrorist attacks. Some $4bn in initial investment capital flowed into the Bermuda market post-Hurricane Andrew, while another $8.2bn funded the most recent round of start-ups.
Given that the greatest development in the Bermuda market has been seen at times of enormous industry need, the fact that it is relatively easy to create an insurance or reinsurance company in Bermuda cannot be overlooked as a major contributor to the market's development over the years. A new company can be established in Bermuda in a few weeks or less, while it can take significantly longer elsewhere. Indeed, it can take almost a year just to change a company's name in all of its admitted states in the US. The ability to enter the market quickly, particularly at times of stress, is an important advantage.
The rating agencies also played a vital role in the relatively rapid acceptance of Bermuda company formations at crucial junctures. In many cases, the usual three to five-year waiting period for an initial rating was waived and marketplace acceptable ratings were accorded based on generous capital bases, business plans and strong management. No doubt there was also pressure on the rating agencies from ceding companies which wanted to have an assessment of the financial strength of the new and well-capitalised market participants in order to protect their own ratings from the effect of using unrated reinsurers. Once ratings were assigned, the road to market acceptance was reasonably assured, at least in the short-term.
A 'friendly' neighbourhood
One distinct advantage to a Bermuda domicile is the island's favourable tax policy. There is no income tax, capital gains tax, value added tax, sales tax, use or wealth tax. There are, however, real estate taxes, annual government fees, payroll taxes and a consumption tax on all imported goods of at least 22.5%. In addition, for US-sourced business, there is an excise tax of 1% of the gross premiums written. With the US corporate tax rate averaging 35% of income, this decidedly pro-business stance on taxes makes Bermuda extremely attractive. However, given the generally poor results posted by US companies over the past few years, the Bermuda tax advantage has not been a major factor in terms of relative profitability. As US companies continue to recover and are subject to corporate income taxes, the Bermuda tax advantage may be more readily apparent.
It's also a fact that Bermuda is more relaxed in terms of ongoing regulatory oversight and the related bureaucratic hurdles compared to onshore locations.
While a friendly regulatory environment may be a plus, the desire to circumvent the oversight of more highly regulated jurisdictions does not appear to be the driving force behind decisions to domicile in Bermuda. As part of their long-term strategies, many insurance groups have decided to maintain companies in both their target markets and Bermuda. As a result, the issue is more one of time-to-market, and the regulatory argument may not be as strong as some profess over the long haul.
Authorities in Bermuda have also focused more attention on the regulatory treatment of reinsurers (as opposed to primary insurers) than many other jurisdictions due to the rising importance of that sector to the Bermuda economy. The reinsurance industry is important to Bermuda and, as a result, it has established set capital thresholds, depending on source and type of business, that are specific to reinsurers. Much of the regulation was largely driven by the industry itself in order to maintain market order and credibility. Bermuda's regulations, however, remain less stringent than those of other jurisdictions and, arguably, could be somewhat less effective in protecting the interests of policyholders if tested.
A number of other factors have generally been credited with the movement of capital to Bermuda, making it one of the world's key reinsurance centres.
One often cited reason is the political stability of the island, a self-governing British Crown Colony since 1612 with an elected legislature and one of the oldest parliaments in the western hemisphere. There is also little unemployment, a highly literate population and currency stability since the value of the Bermudian dollar is pegged to the US dollar. Bermuda has also unquestionably developed into a first class business centre, with state-of-the-art communications systems, a sophisticated infrastructure and the added benefit of relatively convenient travel times to other financial centres.
Unencumbered by past sins
As a group, the Bermuda reinsurers are relatively unencumbered by poor underwriting decisions made long before the hard market that developed post-September 11. Any benefit the US companies may have seen as a result of the hard market was more than offset by severe adverse loss reserve development in each of the last four years, seriously impacting reported results. According to Guy Carpenter's analysis, for US reinsurers as a group, that development added an estimated 14 points to the reported combined ratio in 2003, 29.2 points in 2002, 19.6 points in 2001, and 5.9 points in 2000. Moreover, removing development from accident years 1995 and prior (which presumably would eliminate almost all development on older, intractable problems such as asbestos and environmental claims) did not materially improve that dismal record. The points added to the combined ratio after that adjustment were 12 points in 2003, 25.9 points in 2002, 19.4 points in 2001 and 10.8 points (an increase of almost five points) in 2000.
This plainly demonstrates that the adverse development over the four-year period just ended was overwhelmingly from the weak underwriting years of 1996 through 2001. While asbestos and environmental losses are still major legacy issues, it is clear that the US reinsurance industry has been preoccupied with correcting its more recent poor underwriting and reserving actions, a fact not lost on the rating agencies which maintain a negative outlook on the industry.
Some industry watchers and participants believe that the new Bermuda companies are 'opportunistic' and that many of those companies will not be around over the long-term. We certainly do not have a crystal ball, but there is little doubt that there will be a weeding out and some consolidation in the industry, as has been seen in past years with the disappearance of most of the super cat writers formed in 1993. However, it is important to note that those were very specialised companies principally filling a capacity void in the catastrophe market and that they merged into strong competitors, giving their clients continuous reinsurance partners.
Most of the remaining Bermuda-based groups are now playing a much more varied role in the market rather than just specialising in property cat, and have established operating companies in the US, either through purchase or new company formations. These groups offer multiline coverages on both a primary and assumed basis with the majority of the business produced by the US subsidiary ceded back to a sister Bermuda reinsurer.
Will the experience of the Bermuda carriers be dramatically different than that of their counterparts in the US over the long-term? Probably not, is the most likely answer. Over many years of experience, we have seen that the reinsurance industry is cyclical. Inevitably, an abundance of capital and fewer opportunities to deploy it at desired rates of return can invite less than optimal decisions. It is also very possible that some of the benefits that the Bermuda-based players currently enjoy will diminish over time. The slight advantage in underwriting expenses enjoyed - currently about 2.5 points by our estimate - could be reduced over time as infrastructure for claims handling and other back-end activities is required. The favourable regulatory and tax environment in place today could also change.
Regardless, the Bermuda carriers are well capitalised, well managed and most of them lack the legacy issues plaguing some US and non-US reinsurers.
We expect the Bermuda holding company structure, coupled with a significantly capitalised Bermuda operating company and operating companies in other key areas of the world, will have strong potential for success. Balancing the lack of a track record for many of these carriers, particularly with many of them participating in long-tail liability lines, makes choosing the right reinsurer an important task for ceding companies.