01/05 saw a decline in reinsurance spend, but will softening prices see this trend reversed? asks Sean Mooney
The reinsurance industry is now in the soft phase of the cycle.
As prices have fallen, so has the global reinsurance spend, as demand has not expanded to make up for the loss in price. Why not? Don't cedents recognise a bargain?
From our market perspective, we believe that demand has stayed constant on average because cedents have fixed concepts for their risk transfer program. They have decided on the level of protection they need and designed their purchase accordingly. If exposures do not change much from year to year, programs will be stable.
This program stability in recent years has been accentuated by the use of modelling, particularly in the natural hazard arena. As a general rule, model results for the same exposure base will not change from year to year. Furthermore, at present, while reinsurance pricing has been declining, reinsurers are not giving away their product. Reinsurer profitability remains high, as seen in financial reports for the first six months of 2005, while data shows the combined ratio of the top 10 global reinsurers was below 100 on average. Faced with pricing that they consider high, some cedents are choosing to retain more net, particularly in situations where they can use their own capital as a financial cushion.
This is not to say that all market participants are uniformly freezing their program structure, as some are availing of lower prices to buy up more limit. Other players with highly profitable primary books are keeping more net. And tactical players are staying on the sidelines, as they perceive the market as still too richly priced. However, the overall result is that demand has not offset the reduction in price, and overall spending has declined.
But this price inelasticity is hardly the full story in explaining cedent buying behaviour. Demand for reinsurance is a function of a complex set of factors, a number of which are external to the insurance and reinsurance industry. For the immediate future, we can expect the total reinsurance spend to decrease, with falling prices the major factor behind the decline.
Later in the cycle we can anticipate many other factors to play a role - some positive, some negative.
On the plus side for growth are increased fears of mega-catastrophe losses from natural and man-made perils. Hardly a season passes without more evidence of increased adverse natural phenomena, such as the record early tropical storm activity in the Atlantic this year, on top of 2004 - the year of the Indian Ocean Tsunami, Florida hurricanes and Japanese typhoons.
Adding to the pressure is the growing fear of terror. The London and Sharm el-Sheik bombings were a horrible reminder that the terror threat is alive and capable of delivering a heavy toll in both human and economic terms.
Demand for reinsurance and reinsurance protection can be expected to rise with the continued growth in the world's economy, powered in part by the spectacular take-offs in the world's most populated countries, China and India.
On the regulatory front, pressures on a global scale for risk-based capital requirements can be expected to lead to expanded demand for reinsurance protection. Finally, cedents outside the US have to be concerned with the potential for contagion from the American disease of litigiousness.
On the negative side, reductions in expenditure for reinsurance are likely to arise from consolidation. In recent years, consolidation in the primary market, notably in Japan, the UK and the US, has led to reduced demand for reinsurance, as larger entities tend to have reduced needs for risk transfer. Given the basic maturity of the primary insurance industry, consolidation can be expected to continue, as the "winners" increase their market share at the expense of the "losers," either by direct acquisition or through attrition. In addition, there is the continued shift from pro rata to excess of loss. This has the arithmetic impact of reducing reinsurance demand in terms of premiums.
Vertical shifts upwards in cedent programs, partly as a result of more in-depth risk management methodologies, can be expected to continue leading to lower spending on reinsurance, as higher layers of protection are lower priced. The reinsurance market also faces pressure from ART. While developments such as catastrophe bonds have not replaced a large segment of the reinsurance market, they may in the future. And we may experience other forms of innovative risk transfer, particularly as hedge funds, with their capital and their savvy, increasingly turn their attention to insurance markets.
The question then is how these and other factors will balance out? Our overall sense is that the pluses will outweigh the minuses and that there will be growth over the longer term in the reinsurance market. We have some confidence in this projection, based on history, which we now review.
DOWN MEMORY LANE
To provide some longer-term perspective on cedent risk transfer, we looked at a longer-term data series on ceded reinsurance, as shown in chart 1 (on previous page).
Reinsurance demand was at $77bn in 2003, 45% higher than at the start of the 1990s. Since we have adjusted for inflation, this means that there was real growth in the demand for reinsurance over this period. Our prime suspect on the source of growth would be the need for catastrophe protection against the increased risk of natural catastrophes in the 1990s. This is confirmed by reviewing the growth rate broken down by line.
As shown in chart 2, allied lines (mainly commercial property, excluding fire) and homeowners were the major contributors to growth in reinsurance demand over the whole period from 1991 to 2003. Most of the growth occurred in the first half of the 1990s, following the mega-catastrophic events of that period. In particular, reinsurance ceded for homeowners doubled in a short period of three years.
We now have a bit of a mystery. If the growth in property catastrophe reinsurance only explains the growth in total reinsurance demand in the first half of the 1990s, what explains the growth in the second half?
To answer this, we confined the analysis to the years from 1997 to 2003, the latest year that data is available for.
Between 1997 and 2003, as shown in chart 3, total ceded premium increased by 58.6%. As the chart indicates, the casualty lines of liability, up 131.9%, and workers compensation, up 82.9%, were the major areas of business causing the significant increase in reinsurance purchased over this period.
The most likely explanation for the growth in casualty reinsurance is the use of quota share reinsurance for umbrella and excess casualty lines in the soft reinsurance market of the late 1990s. In addition, increased growth on the primary side of such lines as EPLI and D&O may also explain this increased need for reinsurance protection.
Our purpose here is not to pinpoint the causes of change in reinsurance demand, but rather to reinforce the point that the market is complex and not normally explainable by the interaction of price and demand, but rather is subject to widely different influences.
Historically, we actually observe stability in the long term that is concealed in the short term. Specifically, the cession ratio for US cedents (reinsurance premium ceded as a percent of direct primary insurance premiums) was 16.7% in 1991, the first year of our data. For 2004 we estimate the cession ratio to be 17.0%.
If the French chose to speak English, they would say: "The more things change, the more they stay the same."
- Sean Mooney is chief economist at Guy Carpenter.