Global Reinsurance asked almost 300 CEOs what are the looming issues for the reinsurance sector

At the Battle of Hastings in 1066, King Harold of England ordered his army to form a shield wall on Caldbec Hill along the Sentlache Ridge, a few miles north of Hastings on England's south coast. Positioned below the ridge, some two hundred metres away, was the army of William Duke of Normandy. The shield wall stretched almost a mile, forming a formidable barrier of hundreds of interlocking shields, each held in place by battle-hardened soldiers. However, the success of the shield wall depended upon the ability of each member to maintain his place within the line. Discipline was paramount if the wall was to be effective.

Initial skirmishes saw the wall hold fast. The soldiers held their positions, the wall was not breached and William's forces retreated. However, rather than maintaining the wall, some soldiers chose to chase the retreating army and broke the line. Seeing the men break rank, William used the speed of his cavalry to cut them off from the safety of their wall and hack them down. William took full advantage of this lack of discipline and staged mock retreats the length of the shield wall, pulling it down bit by bit, as section after section failed to hold the line and gave chase to the apparently fleeing soldiers. In no time at all, the wall was in disarray and William's forces were able to breach it.

Just as Harold called upon his troops to form a shield wall, so the reinsurance industry is being called upon to form its own solid defence. With clear signs on the horizon of an approaching soft market, the rallying cry has gone out to underwriters to grip their shields, keep resolve on their rates and maintain underwriting discipline. The ability of the market to stand firm is reliant upon each member maintaining its position. However, should one section break free and seek to chase the market down, the wall could disintegrate and once again the reinsurance sector could fall back into a gloom of underpriced cover and flabby terms and conditions.

Underwriting discipline

Commenting on the 2003/4 renewals season in the Benfield report, 'Holding the Line', Grahame Chilton, Group Chief Executive, said: "The question for 2004 is: Will underwriters continue to hold the line? There is substantial new capacity. A few players seem willing to pursue growth aggressively. Except for a few difficult casualty lines, there is no shortfall in capacity. And catastrophe losses have been low."

Regulators and rating agencies are demanding that the reinsurance industry maintain pricing discipline in the current environment. But with ample capacity available across most lines and some signs of competition in certain sectors already emerging, how likely is it that the industry will heed these demands?

Last January's renewals suggested that the market had succeeded in maintaining a degree of underwriting discipline, with pricing for cover on many lines remaining relatively stable. Despite such apparent price discipline, the reinsurance industry is still showing definite signs of softening, with property rates, having reached their peak in early 2003, the first to slack off - although the price drop has not fallen as far as some commentators had predicted, with premiums reductions averaging approximately 3-5%.

Other lines such as hull and aviation have taken a similar route. While premium rates on some lines continue to rise, particularly on the casualty side, most of these increases have slowed dramatically, even on lines such as Directors' & Officers' liability and medical malpractice. It seems unlikely that these sectors will soften in the near future, although if the US did introduce long-awaited tort reform measures, liability rates could be put under severe pressure.

In conjunction with the relative price stability, it would also appear that underwriters have been able to maintain terms and conditions. Dwight R Evans, Chairman & CEO of Arch Reinsurance Ltd, said: "This year terms and conditions in the reinsurance market have been reasonably stable. This is helping to moderate the competitive environment in the insurance industry."

Joseph Taranto, CEO of Everest Re, speaking at the Standard & Poor's (S&P) Annual Insurance Conference in New York earlier this year, said that he believed that by maintaining discipline, businesses can still achieve a "very good return in this market", but explained that in order to do this the underwriter must be "willing to walk away from poorly priced business."

However, as Ron Pressman, Chairman, President and CEO, GE Insurance Solutions (formerly GE ERC), pointed out, underwriting discipline is only one weapon of the armoury to be wielded if the sector is to establish a stable financial position. "It's pretty clear what reinsurers have to do to sustain their performance over time, through the cycle," he said. "And certainly disciplined underwriting is a part of it. But so are controlling expenses and executing on a solid investment strategy and reserving accurately, etc."

Market share

As the cycle begins to soften, with falling premium rates across a number of lines, reinsurers are being called upon to refrain from competing for market share and maintain their focus on underwriting profitability. Key to counteracting the downturn in the cycle is a reinsurer's ability to limit its exposure to those lines which have peaked. Britt Newhouse, President of Guy Carpenter North America, said earlier this year: "A lot of money has been made recently. The problem is that the people who made it don't stop writing the business when they should."

As Ron Pressman explained: "In the final analysis, the true winners will be the companies that can weather the underwriting cycle and not expose themselves to the kind of challenges we all experienced as a result of the underwriting decisions made in the late 1990s."

It would appear that reinsurers have little choice but to bite the bullet on this one. Despite many companies reporting record profits in 2003 and maintaining similar income levels in the first half of 2004, a proportion of these profits have flowed into the myriad long-tail-related fissures undermining the balance sheets of many in the sector. Few believe that the industry has amassed sufficient capital to allow it to weather a similar soft market to that witnessed in the latter part of the 1990s. Furthermore, such profits have been achieved in an environment devoid of major catastrophes.

According to S&P in its 'Industry Report Card: Global Reinsurance', some reinsurers have already shown signs of avoiding or backing away from particular lines. "The rhetoric is encouraging," said Stephen Searby, a credit analyst at S&P. "It is also critical in order to avoid a repeat of the severe damage done to reinsurers' financial strength in the last soft cycle." He further commented: "The reductions in exposure will be combined with the underlying price reductions and are therefore likely to result in a material decline in premium volumes over the next few years. This will not be unwelcome, however, if it stems from a sensible risk management policy and should not generally be a concern for investors."

Commenting on the move by reinsurers to back away from difficult lines and to focus on those sectors which remain sturdy in terms of rates and terms and conditions, Arch Re's Dwight Evans said: "Reinsurers have shown a greater willingness to diversify their books of business, especially in areas which have shown the greatest improvement in terms and conditions." Although, he warned, "only time will tell if they can handle this business effectively. It's a question of execution and discipline."

However, by backing away from particular lines and looking to reduce overall premium volumes, reinsurers are flying in the face of demands from cedants, shareholders and intermediaries to maintain underwriting volumes. "When your volumes are dropping, it's very hard to tell your shareholders that's a good thing, that they should be excited you're doing less business," said Mr Taranto. "Having said that, it beats the alternative of writing more business and later having to pay for it."

Shareholder demands

The impact of shareholder demands could prove a major factor in the ability of reinsurers to manage the cycle going forward, as they seek increased returns on their capital. In Aon's annual reinsurance renewal report and outlook 2004, 'Reinsurance at the crossroads?', Colin Bryan, Chairman of Reinsurance, said that reinsurers faced two significant challenges.

"They must convince shareholders that they are worth investing in, despite their flaccid returns at the peak of the market. And they have to convince large clients it is a good idea to keep transferring risks to progressively weaker companies." The views of the investment houses on the investment potential of the sector are mixed. While some investment managers have reduced the investment grade on reinsurance stock, others have cited these stocks as being attractive, due to the relatively weak performance of the sector in relation to the insurance industry. Merrill Lynch recently cited the underperformance of European reinsurers as grounds for investment, commenting that it believed that such stock would see strong upside potential in 2004.

"Any business that is cyclical is a concern for investors," said Neil D Eckert, Chief Executive Officer of Brit Insurance, explaining that the international re/insurance market "is not loved by the stock markets." The problem, he added, is that the stock and reinsurance markets always seem to be out of sync with each other. "In 1995, at the peak of the last cycle, the stock market had people trading at a big discount. By 1998, when insurance conditions were not profitable, the stock market was trading at a peak." Mr Eckert believes there is one thing, however, which would see the return of the investor to the market. "Only when we are churning out lots of dividends will investors once again jump on the bandwagon."

Rating roundup

On 27 July, Fitch Ratings revised its outlook to stable from negative.

The rating agency stated that it expected a slowdown in rating movement, with the number of downgrades going forward set to more closely follow upgrades. Favourable market conditions, according to Fitch, would continue to maintain acceptable levels of profitability and returns on capital, and while premium rate increases were down markedly on those witnessed during 2001-2003, this slackening of pace is occurring from "a technically adequate level" and will still allow for an underwriting profit to be made.

Central to the rating agency's decision to revise its outlook was the belief that over the next 18 to 24 months the reinsurance industry would see a decline in the amount of adverse reserve developments compared to 2003. While fully expecting reserve deficiencies to arise, particularly in relation to the US property/casualty sector, Fitch said that its deficiency range for this sector had declined slightly to $44bn-62bn, from $46bn-77bn. Coupled with efforts to re-underwrite books of recent business and the marked increase in rates witnessed between 2001-2003, this placed the sector on a more stable footing. However, only one week before Fitch's pronouncement, Converium had announced that its reserves for 1997-2001 were deficient to the tune of $384.7m due to problems relating to US E&O, D&O and umbrella business. Converium CEO Dirk Lohman bemoaned the situation as a "US casualty reserving saga."

As Ron Pressman explained, the sector remains focused on how ratings changes can impact their financial security, and the ongoing "reserving saga" is serving to heighten this focus. "Just when it seemed reinsurers had answered many of the salient questions," he said, "the recent reserving disclosures by prominent companies put the issue back on the agenda. The concern is whether the period of reserve strengthening driven by the soft market from 1997-2001 is over." In April this year, S&P revised its reserving criteria for global reinsurers and some non-US insurance groups writing casualty business. Rob Jones, a credit analyst at S&P, said of the decision: "The analysis of loss reserves is often the most challenging component in evaluating an insurer's balance sheet strength. Analysing the current balance sheet is, in turn, an important component in determining the overall rating." Under the revised criteria, reinsurers will be expected to complete a loss-reserving spreadsheet model for each particular casualty line.

The compiled results will then be compared with available third-party actuarial analysis.

Add to this the recent increase in the use of contractual rating triggers, and a company's financial strength rating could become "the be all and the end all" for those reinsurers which are downgraded beyond certain threshold levels. Such clauses, if triggered, can either force a reinsurer to provide increased collateral for potential liabilities or result in the termination of a contract. A company already in financial dire straits can ill afford an outflow of capital resulting from contract terminations, and as a result could be sucked into a ratings black hole. The danger is that they will create a 'credit cliff' - a concern for reinsurers and rating agencies alike. Neil Eckert described the use of such triggers as "a very retrograde step", stating that the onus should be on the buyer to ensure that they "shop widely". "If you spread your reinsurance risk," he said, "you should be able to mitigate the effects of a reinsurer downgrade."

Spreading risk

A further incentive for cedants to spread their risk across a number of reinsurers is the issue of 'willingness to pay'. There is growing concern about and a growing gap between the amounts of reinsurance recoverables being reported by cedants and the amounts being reported by reinsurers.

Commenting on the findings, a report by Conning Research and Consulting Inc, released in July and entitled 'Reinsurance Recoverables: Mind the Gap', Clint Harris, Vice President at Conning Research, said: "While there are filing data issues that distort the net gap calculation, we estimate that it was between $14bn and $24bn in 2003. The increasing recoverable values expose the industry's increasing dependence on a financially healthy reinsurance sector." Stephen Christiansen, Director of Research at Conning Research added: "Our study found that as recoverables have grown, so has the gap between cedant and reinsurer expectations. The rate of recoverables growth slowed from its 29% high in 2001 to 6% in 2003, yet the aggregate recoverable gap continued to grow at a 22% rate in 2003." According to Benfield in its report 'Holding the Line', a study of 2,600 life insurers, the sum of reinsurance recoverables they expected to collect from reinsurers had risen 57% between 1996 and 2002, from $120bn to $188bn. Clearly, under such circumstances reinsurers' credit quality is vital.

In the cedants' search for acceptable credit, many are continuing to turn to the post-9/11 start-ups in Bermuda. Well-capitalised and generally lacking the drag of long-tail liabilities and the threat of reserve strengthening, most of the companies launched in 2001/2002 have witnessed phenomenal growth, with a number of Bermuda's shining lights reporting gross written premium increases in 2003 of over 100% on the previous year.

However, concerns have been raised from a number of corners regarding the ability of Bermuda's reinsurance youngsters to deal with the approaching soft market. One issue is the question of whether the 'Class of 2001' working from a fairly robust capital base may be in a strong enough position to look at reducing rates and chasing market share. If, as some commentators fear, Bermuda proves to be the first to break rank in the reinsurance shield wall, then it is highly likely that other markets will be forced to follow suit. Tom Upton, a credit analyst at S&P, commenting on the potential impact that Bermuda's reinsurers could have on pricing, in its report 'US Reinsurance Midyear Outlook 2004: An Outcast in the Global Market', said: "All of us would stand around and hold our breath, to see who would be first to let go. As soon as the first one let go, everybody let go. That's what worries me as I look at this Bermuda market. When somebody cuts loose on terms and conditions or really starts competing on price, what happens then?"

Donald Thorpe, Senior Director at Fitch Ratings, commenting in the report, 'The Bermuda Class of 2001: Still riding the wave', said of the new reinsurers: "Their timing was excellent and these companies have benefited from the distractions created by legacy issues within more mature competitors.

Conversely, they have only experienced the very best of times - the hard part of the pricing cycle combined with a relatively low catastrophe loss environment." However, many of the newcomers relied heavily upon attracting experienced market practitioners into their ranks, so it is perhaps somewhat unfair that accusations of inexperience are being levelled at the market.

Mr Thorpe also raised concerns about a trend towards branching out into new lines of business, citing the example of property writers moving into casualty lines to make up for declines in rates in their original lines.

"This diversification into traditionally more challenging market segments creates more concerns whether required underwriting expertise is in place across all business segments." According to S&P, some of Bermuda's newer participants are also looking to take on increasing amounts of primary insurance business.

A timely reminder

Much of this diversification is a reaction to the fall in returns in property writers' core markets, but the unpredictable nature of catastrophe business - and the possible consequential market reaction - needs always to be kept in mind. "Hurricane Charley is a timely reminder that losses are still out there," said Brit's Neil Eckert, "... it would have served to concentrate the mind." Initially put at between $10bn and $25bn, insured loss estimates from Charley are now expected to be in the range of $5bn to $10bn, making it the second largest hurricane loss in US history, but substantially lower than 1992's Hurricane Andrew. This time, the market got off lightly. Charley, despite making landfall as a category four hurricane with windspeeds of 145mph, had an extremely narrow band of damage winds, a factor which drastically reduced the economic and insured losses from the event. With a number of re/insurers currently releasing their loss estimates from Charley, individually ranging from $6m to $200m, it is clear that the brunt of the losses will be borne by the Bermuda market - the traditional property catastrophe market since the 'Cat Pack' formed in the wake of Hurricane Andrew.

As the soft market begins to take hold, in certain ways Charley could not have been better timed. It will hopefully have served to blow away any cobwebs that may have settled on a market which has been catastrophe-free for a relatively long period of time, and if nothing else will certainly help stabilise any decline in property cat rates. Whether the industry's underwriting shield wall proves a barrier to the approaching soft market, or simply a windbreak for the next hurricane, it is imperative that it is erected and that it be held.

In order to compile the information contained in the following tables, some 300 CEOs in the reinsurance sector were asked to complete a comprehensive questionnaire. Every respondent was guaranteed anonymity.

Respondents were asked to comment on four key issues:

- the biggest factors contributing to growth in the reinsurance sector;

- the biggest constraints to their company's future business growth;

- the three biggest challenges they faced in their position as CEO; and

- the most threatening market issues facing their company at present.

Global Reinsurance would like to take this opportunity to thank all of those who took of their time to provide this information.