Reinsurance prices dropped across the board at the 1 January renewals. Helen Yates asks what could prevent prices going into freefall. Have underwriters learned the lessons of the past?

Excess capital, competition and risk retention have taken their toll. Reinsurance prices fell significantly at the 1 January renewals. The 1/1 renewals is when 90% of all reinsurance contracts are renewed and therefore it is the best time of the year to judge whether reinsurance pricing is going up or down. And it’s going down. The hard market created by Hurricane Katrina in 2005 – the world’s most expensive natural catastrophe ever – has begun to turn.

According to Guy Carpenter, rates were down by an average of 9% across all lines. “Conditions appear to be the direct result of excess supply, fuelled by strong profits and low losses,” said the reinsurance broker in its renewals report. This was more down to luck than design, it warned. While 2007 saw plenty of natural catastrophes, the industry was spared any major losses due to a fortuitous combination of near misses and low reinsured values in the regions affected.

Benfield also saw fit to highlight the ever-present threat from catastrophes. “Despite another relatively benign year for major catastrophe losses,” it says in its renewals report, “the longer term escalation in size and frequency looks set to continue given predictions on climate change.” Indeed, 2007 saw two major flooding events in the UK, the worst wildfires on record in the US (which cost Allstate over $450m in Q4), several intense hurricanes in the North Atlantic and even a cyclone in Oman, among numerous other events. The renewals came late as buyers held out longer in the hope of getting a better deal. Willis says the delay was also due to uncertainty owing to the lack of consistency across lines and markets. “There’s a lot more variability – a major difference between the best and worst renewals,” notes Aspen CEO Chris O’Kane in his renewals roundup.

But on most lines, price decreases were not as dramatic as buyers had hoped. “Reinsurance rates haven’t softened as much as they were headlined to do so,” says James Skinner, active underwriter at Talbot Underwriting. “The lessons from the previous soft market have been learned. It’s a tight underwriting environment and models are being adhered to.” Bryon Ehrhart, chief executive officer of Aon Re Services and Aon Capital Markets agrees: “It is softening but it is softening with discipline on both sides of the transaction. I haven’t seen significant evidence of people doing things that don’t make sense economically.”

Not everyone believes underwriters maintained discipline. “There’s some really crazy stuff going on,” says O’Kane. Lines that fell dramatically include US property casualty (where rate reductions were in the region of 10% to 15% according to Willis). While most cedants and reinsurers were prepared for prices to slide by up to 15%, some held out for price drops of up to 20% – according to Guy Carpenter – which led to difficult negotiations and in a few cases, a reduction in signed lines. In Europe, property catastrophe prices decreased by a more modest 5% and 7.5%, as the impact of Windstorm Kyrill and UK summer flooding served to hold up prices in those sectors affected by loss experience.

Supply and demand

Marine prices appear to have softened only modestly. Further reserve strengthening from hurricanes Katrina, Rita and Wilma helped to prop rates up, explains Willis, although reductions began to appear in the fourth quarter of 2007. The consensus is that rates went down by five to ten percent across marine lines. Following intense price competition among primary marine underwriters in 2007, many cedants looked to “share the pain” with their reinsurers, according to Benfield. They were disappointed.

Traditional retrocession has softened modestly (by five to ten percent, according to Willis) and capacity has returned to the industry. With the exception of Kyrill in January 2007, non-marine retro was not affected by any of the smaller scale loss activity last year. This, combined with a relatively benign Atlantic hurricane season, resulted in price softening, says Benfield. “Less restrictive cover and more moderate retrocession pricing will potentially create the environment for increased purchasing during 2008,” the broker predicts.

Along with traditional retro programmes, collateralised retrocession capacity continued to feature at the 1/1 renewals in the form of renewed sidecars and industry loss warranties (ILWs). While the pricing of ILWs fell dramatically – by up to 25% for US wind and 35% for US earthquake – volumes traded continued to increase. The renewals for retro occurred particularly late, according to Chris Klein, global head of business intelligence at Guy Carpenter. “This is quite often a symptom of excess supply where buyers hold out to see if they can get a better deal,” he explains.

Capital market appetite for insurance products continued to grow in 2007. “That trend will definitely continue,” says Ehrhart. “We saw a 55%-57% increase of volume in the catastrophe bond market last year and we’re looking for another year over and above 2007 as reinsurance prices soften.” While some sidecars were wound down, many were renewed for 2008. “For the first time in reinsurance history we really have a substantial amount of flexible capacity in the market,” says Swiss Re’s chief economic Thomas Hess. “So there is more overall control with respect to capacity. This not only limits the upside, it also limits the downside.”

“For the first time in reinsurance history we really have a substantial amount of flexible capacity in the market

Swiss Re's chief economist Thomas Hess

For most experts it is clear what has led to pressure on reinsurance prices. “More capital and less demand means lower prices,” sums up Aon’s Ehrhart. For Hess it is the combination of a well capitalised and solvent reinsurance industry, low catastrophe activity, more reinsurance capacity – both traditional and alternative – and primary insurers increasing their retentions.

Risk retention has continued despite softening reinsurance prices. “We saw clients taking business out of the market and that’s really a reflection on a couple of years of good results and some very robust book value growth,” notes Validus chief underwriting officer Conan Ward. “People’s risk appetites have gone up and at the same time you’ve had growth of reinsurance capacity, which leads to softening.”

Greater risk retention was a theme throughout 2007. It suggests reinsurance pricing stayed relatively robust, argues Benfield. According to O’Kane, the continuing differential between pricing in primary insurance and reinsurance is one reason for increased retentions. “The fallout from this differential will be interesting to watch,” he says. “Will insurers retain more or reinsurers become less disciplined?”

Increased retentions are a reflection of the fact that primary insurers cannot grow their business in such a competitive environment, explains Hess. “Many primary companies are overcapitalised and so they think they can carry more retention. This can be a dangerous thing for companies to do because they may increase their risk as a result,” he adds.

Conditions may be competitive in primary insurance, but they have become increasingly cutthroat in reinsurance. The rating agencies continued to favour a diversified business model in 2007 (having lost favour with the monoline – all eggs in one basket – model after Hurricane Katrina). This push to diversify into new sectors and new markets has led to increased competition and a healthy appetite for strategic mergers and acquisitions.

Worsification worries

In fact, diversification has become the justification for many M&A deals. In by far the biggest transaction of last year, Scor described the Converium deal as an “optimal diversification”. Diversification was also named as a reason for the Argonaut-PXRE merger. Ward expects that M&A activity to continue. “The monoline business model isn’t very popular with either shareholders or the rating agencies so I’m sure there will be some action there,” he explains.

“As the market softens, doubts still linger about ‘diversification for diversification’s sake’ as the focus shifts to underwriting acumen as the key differentiator in a downturn,” says Benfield in its renewals report. The concern is that in their bid to enter new sectors some reinsurers may be tempted to lower rates in order to gain all-important market share.

In 2007, Bermuda players demonstrated their interest in Lloyd’s through a number of new syndicates or mergers (including Validus’ buyout of Talbot, Ariel’s acquisition of Atrium and Montpelier Re’s new Syndicate 5151 – see table 1). Fears that competition for market share could be pushing down rates is rejected by Talbot’s Skinner. “Newcomers into the market entered with a disciplined approach to underwriting,” he says. Ward insists Validus is looking for long-term growth and has moved away from anything opportunistic. “From a growth standpoint in the reinsurance businesses we tend to look more like an older line player in terms of how we’ll handle 1/1,” he says. “The low hanging fruit for us has pretty much gone.”

The traffic hasn’t just been one-way. A number of London market players established or increased their presence in Bermuda in 2007. Hiscox, Kiln, Omega and Hardy all announced they were redomiciling to the low-tax jurisdiction. These were clearly financially-driven decisions as well as a bid to get closer to US catastrophe business. Other geographies have proved popular for reinsurance companies looking to pioneer new markets. Emerging markets such as China, India, South America and the Middle East have increasingly found themselves the focus of international reinsurers.

“If there were another very large event, the ability to raise new money could certainly be impacted

Another key trend in 2007 was the appetite of reinsurers for primary insurance. “We’re going to see increased M&A activity in 2008 and increased reinsurer appetite to write insurance,” predicts Ehrhart. Ironshore, Montpelier Re, Max Capital and Endurance all bought US specialty insurers last year. And most recently Axis launched Axis Insurance in the US. Some are questioning whether a downturn in the global economy could dampen the M&A fervour of 2007. “There may be a little bit of consolidation among reinsurers but we will not see an aggressive or offensive wave of large-scale M&A activity,” predicts Swiss Re’s Hess.

Cloud on the horizon

According to Benfield, the subprime crisis is a “potential cloud on the horizon” for reinsurers. The industry is likely to be exposed to the global “credit crunch” and subprime fallout in three key ways. The first is direct underwriting exposure, the second is asset exposure and the third is ability to access short-term funds, explains Klein.

In a report at the end of 2007, Guy Carpenter said it expected D&O claims to amount to $2bn – although recent reports have suggested this figure could go as high as $9bn. Mortgage and bond insurers are directly exposed to the fallout. The current woes facing this sector have already become a case study for the rating agencies and other opponents of the monoline business model.

At the time of going to press, XL had been downgraded by Fitch and AM Best after announcing expected losses of up to $1.7bn (primarily as a result of its exposures to credit insurer Security Capital Assurance). PartnerRe and RenRe had also written off their $200m investment in MBIA’s financial guarantee reinsurer Channel Re. There are very real concerns that the full impact of the credit crunch has yet to be felt – with a large number of corporate defaults yet to come. “We were directly impacted given the timing of our IPO,” says Validus’ Conan Ward. “The day before, some $3bn was pulled out of the debt market.”

As the full-year results begin to trickle in how many more reinsurers will reveal losses related to subprime investments is uncertain. “We will certainly be watching carefully when audited full year results come out to see if there have been any developments since the third quarter,” says Klein, although he adds that as a rule, insurance and reinsurance companies tend to be “pretty conservative on their investments”. So far, only Swiss Re has revealed major losses on its asset side, revealing a $1bn writedown as a result of two credit default swaps.

“If there were another very large event, the ability to raise new money could certainly be impacted,” warns Ward. With the credit crunch reducing liquidity in the global equity and debt markets, it is fair to assume that reinsurers could find it harder to raise new capital. Klein believes reinsurers currently have sufficient liquidity and facilities in place to cope in the event of a major industry loss.

“Hopefully reinsurers will maintain discipline and the industry will have learned lessons from the past,” says Thomas Hess. How far rates soften depends as much on underwriting discipline and the influence of capital market capacity as it does on whether there will be any major catastrophes in 2008.

“Expect more storms, expect bigger storms and expect storms where we haven’t seen them before,” said Chris O’Kane when he was asked how the industry should prepare for global warming. An active hurricane season in the North Atlantic in 2008 has already been predicted by Guy Carpenter’s scientists, but it will take something significant to reverse the softening trend, says Ehrhart. “We think a $25bn-$50bn event is the only thing that would stop the downward trend – that would make it level.”

Klein isn’t so sure. “A lot has been done to reduce aggregate exposures to these events. So say there was another $40bn-$50bn loss, it may not have such a profound impact.” Since Katrina and her sisters in 2005, catastrophe model revisions, rating agency requirements and a new focus on enterprise risk management have left their mark, believes Ward. “If Katrina happened today you would find companies a little less leveraged and a little more cognisant of what their ultimate downside could be,” he says.

Helen Yates is editor of Global Reinsurance.