Will the speedy responses of US regulators and re/insurers alike to question marks over finite reinsurance be enough to stave off a decline in investor confidence? asks Lindsey Rogerson
The turmoil in the US re/insurance sector resulting from the on-going investigations into so-called finite reinsurance products and broker commissions shows no sign of abating. Bristol West and Genworth Financial are just the latest companies to receive subpoenas requesting information about their use of finite instruments. And the controversy is spreading. Already German and UK authorities have issued their own requests for information, while rumours abound that the Irish authorities are considering similar action. But what does it all mean to investment analysts and fund managers?
Warren Buffet, legendary investment guru and founder of Berkshire Hathaway, refused to answer shareholder questions about its subsidiary General Re, at the group's annual meeting, recently, because investigations were still ongoing. However one industry analyst said that he believed institutional investors, at least, would respond favourably to the swift action taken at General Re. In May, the reinsurer pulled the plug on a consulting contract it had with Ronald Ferguson, its former chief executive officer, citing the fact that he failed to answer questions from US regulators.
The analyst, who did not want to be named, said: "The investigations are definitely having an influence on sentiment, but markets tend to take a good view of a new broom coming in."
American International Group may be hoping for a similarly favourable upturn in analyst opinion if a report in the Wall Street Journal that it intends to force out six executives - chief executive officer Maurice "Hank" Greenberg and chief financial officer Howard Smith have already gone - turns out to be founded. (Mr Greenberg has since resigned from the AIG board)
As to the eventual reach of investigations, market commentators seem split. Citigroup Smith Barney said in a recent analyst note that, "the essence of every insurance transaction is the assumption of volatility from some entity that doesn't want it in exchange for a premium. Viewed in this context, all insurance and reinsurance products are on some level 'earnings smoothing' products."
Smith Barney said it was not raising the point to excuse or mitigate any wrong doing that may or may not turn out to have gone on, but rather to highlight the vast potential for further investigation, should the authorities decide to adopt the broadest possible horizon.
However the opinion is not universally held. One analyst who recently visited the US told Global Reinsurance, "The view in the US is that the use of these instruments was not wide spread and so most reinsures should be insulated from the fallout."
Already a number of insurers have said they will not be using such finite instruments again. Bristol West has just one such contract outstanding. And last month's call by the National Association of Insurance Commissioners (NAIC), the regulatory body for US insurers, for more in depth disclosure of the nature of reinsurance contracts, should further help to shore up investor confidence that the industry has cleaned house.
However, there is near consensus that the fallout for brokers will be a lot worse. There is wide-spread concern that brokers, some of whom are faced with the loss of a large segment of their income, after forswearing contingent commission agreements, will recover. Many commentators doubt whether they will be able to recover at all in the short term.
Smith Barney said, "The brokers face the task of retooling their business models, as a highly profitable revenue stream has now been taken away." Adding that Marsh & McLennan appeared particularly vulnerable as it made some $845m in contingent commissions in it most recent accounts.
Looking beyond the current investigations the general investment fundamental still make many US reinsurers attractive. Hiscox's Insurance fund holds Transatlantic, which in May announced it was increasing its quarterly dividend by 20%. Dividends have been increasing in fashion ever since the technology bubble went pop at the turn of the century, and so the increase by Transatlantic will be welcome.
However this must be set against the dramatic decline - 10% -15% - in first quarter premium volume for 2005, highlighted by Morgan Stanley in a recent note, a trend which it attributes to primary insurers simply deciding not to place out business to reinsurers.
Another development being closely watched by investors is that of the restructuring of reinsurance programmes, a rethink already underway before the Boxing Day tsunami. Benfield said that third quarter storms in the US had convinced many insurers to review the structure of their reinsurance programmes. (See chart). Traditionally, reinsurance contracts have been written to protect for the severity not frequency of adverse whether events such as hurricanes and tornados.
However, Benfield claimed this was now under review after several consecutive years of insurers having to pay out on claims, but not having recourse to their reinsurers. It believes insurers will increasingly look to provide price frequency into any reinsurance contract.
Strong underwriting at certain US casualty reinsurers has also been winning plaudits in some quarters. Benfield singled out XL Re America's assertion that in a low interest environment underwriting profits were mandated.
Smith Barney also likes XL, but plumps for ACE Limited as its top pick for 2005. It feels that both are positioned well, in underwriting and investment terms, to perform well in the next few years.
The majority of reinsurance programmes, as illustrated by the 'current' example in Chart 2, are structured on the basis of severity not frequency (a very large single event rather than a series of serious, but smaller losses). The US hurricane losses exposed of current reinsurance programmes, which were structured to protect against a large single event. Primary insurers therefore retained a large proportion of the losses as each hurricane was not large enough to attach to the higher layers.
Chart 2 shows two possible reinsurance programme structures which would factor a level of frequency risk into pricing and offer insurers a higher level of protection. 'Proposed 1' illustrates a step down retention structure, allowing insurers to apply losses in size order. This would allow the largest losses to be absorbed by the largest retentions. The main benefit of this structure is it reduces net losses in a multiple loss scenario. The second of the proposed reinsurance structures (Proposed 2) illustrates a graduated retention programme, whereby the retention over a fixed loss layer would decrease per occurrence. It provides the same retention for the first loss as the current programme but decreases at a gradual rate for all subsequent losses.