Inadequate rates continue to plague industrial fire insurance and reinsurance in Europe. Dirk Herrenpoth and Iris Zeisig demonstrate how "cash flow underwriting" in this sector provides a much broader lesson in cycle management.

Despite efforts to maintain underwriting discipline, property rates in general and industrial fire rates in particular are once again in sharp decline in Europe and overseas. If the recent to medium-term loss history of this segment is examined, it becomes apparent that the situation is caused by ever-more aggressive competition rather than by improved underwriting results.

One of the most dramatic examples can currently be observed in the German market. This is one of the most competitive, with rate reductions of up to 30% a mere 12 months after the German insurance industry experienced the biggest fire loss in its history. The Thyssen Krupp fire of June 2006 resulted in a loss of ?285m, most of which was borne by reinsurers. Other markets, most notably in Western Europe, show similar tendencies, with rates declining despite unchanged loss experience.

However, the current market situation is not a new phenomenon. Results in industrial fire insurance have seldom been positive over the last 20 years, mainly due to the inadequate rates which now appear to plague this sector. Given this situation, it seems reasonable to question why the segment nevertheless continues to be oversubscribed.

From the insurer's perspective, having a presence in the market where the "prestigious" accounts are placed enhances the reputation. From the reinsurer's perspective, those same accounts are, in turn, usually written by the major players that represent their key accounts and produce a significant proportion of overall premium volume.

While industrial fire business represents only a small fraction of the typical composite insurer's book of business, the reinsurer's share of such business is usually disproportionately higher. Hence, it is the reinsurer that is most affected and consequently needs to ensure an adequate return on risk capital throughout the cycle.

Getting the right price

The overriding principle in this respect is to maintain adequate prices. In the current industrial fire market, this implies that reinsurers will need to detach their portfolios from the original conditions. This can be achieved in different ways. The most simple but effective would be to write this business on a facultative basis only, giving underwriters access to more detailed information and greater flexibility in selecting risk quality and type of participation (eg high excess layers compared with primaries). By this means, overall portfolio quality can be effectively enhanced.

“Results in industrial fire insurance have seldom been positive over the last 20 years, mainly due to the inadequate rates which now appear to plague this sector

On the treaty side, the preferred solution is clearly excess-of-loss cover which is less sensitive to changes in underlying conditions. The fixed minimum reinsurance premium also limits the negative effects of any original rate cuts. There will be cases where a change to a non-proportional participation will simply not be an option. The underwriter will then need to ensure that the proportional treaty includes mechanisms to manage the increased downside potential and high volatility of the original losses.

A typical feature of the industrial segment, which is characterised by low-frequency, high-severity risks, is the high fluctuation in loss-expectancy. The problem with this is that it helps to disguise inadequate pricing on the original side. Accordingly, years where the loss burden has been below average may be attributed to portfolio quality when, in most cases, they are actually the product of mere chance.

In addition, the inherent volatility demands that a larger amount of risk capital be committed, increasing the cost of capital for reinsurers by comparison with the other segments and further decreasing the rate of return. Despite this, commission levels on proportional treaties, particularly the less balanced surplus treaties, come under pressure in the good years, further eroding the premium income needed to counterbalance future large losses.

It takes a lot of foresight to ensure treaties stay profitable in these circumstances. Elements such as judicious application of sliding scale commissions and loss participations help to ensure that cedants retain a meaningful interest in the business. However, underwriters should refrain from granting straight profit commissions. From a pricing perspective, it is imperative to reflect market developments by using appropriate indices to anticipate the effects of changes in original rates and forecasted trends. Regular result monitoring is essential throughout the treaty period if negative trends are to be identified in time to alter their course.

Managing the vicious cycle

Should the original conditions reach a point where the required return on risk capital can no longer be achieved, reinsurers will ultimately have to let go of unprofitable business - even if it means a loss of market share. The so-called "cash-flow underwriting" approach (where underwriting losses are knowingly accepted on the assumption that they will eventually be offset by investment gains) is still evident, although it has proved to be a fallacy for a number of reasons.

Firstly, with contract periods of around 12 months or more, it is nearly impossible to perform the necessary, quick underwriting-strategy about-turn when the capital market turns from bullish to bearish. The resulting twofold impact on the assets and liabilities sides of the balance sheet can have devastating effects. This was certainly the case in 2001 when poor insurance and reinsurance results, combined with a downturn in the capital markets, brought numerous downgradings in its wake.

“It is very unlikely that reinsurers will get a sufficiently large slice of the desirable business in a hard market to counterbalance the unprofitable business they are prone to acquire in a soft one

Secondly, analyses of long-term results show that underwriting losses in a soft market phase have, in the past, never been fully offset by gains during a hard phase. To put it simply, it is very unlikely that reinsurers will get a sufficiently large slice of the desirable business in a hard market to counterbalance the unprofitable business they are prone to acquire in a soft one. Those players that have followed the cycle down to the bottom will need to re-underwrite their existing portfolios and hence act in a restrictive manner rather than proactively taking advantage of the hardening market.

Their managements are likely to adopt a "once bitten, twice shy" approach and focus on a major turnaround. "Cleaning up" will consume even more time and effort that would otherwise be better spent on crucial issues such as product innovation and business process optimisation. The latter is of special importance, as greater process efficiency leads to cost reductions that ultimately increase business resilience and confer a competitive advantage.

By contrast, reinsurers that show an ability to negotiate their core business profitably through the cycle will be able to concentrate on long-term business strategies and explore growth potential in other reinsurance markets. If diversification by region or business segment is limited due to a downward cycle, they may even ease back on capacity. After all, what reinsurers need to focus on are bottom line results.

In this context, the straight talking by Lloyd's franchise performance director Rolf Tolle, in his recent speech at the Chartered Insurance Institute, had a particularly useful message. He believes that underwriting should not be dictated by surplus capital, while risk capital that cannot be deployed profitably should either be invested where it had growth potential or returned to shareholders.

Shareholders, rating agencies and other stakeholders will monitor closely how reinsurers tackle the current downturn in core-business performance. This should ultimately also be in the interest of cedants and insurers, which have to be able to rely on the reinsurers' ability to settle claims - especially in the event of a major loss or catastrophic event. However, being able to provide this kind of security ultimately depends on maintaining a consistent, risk-adequate pricing level.

Managing the vicious cycle, particularly in the industrial and large commercial risks segment, where the effects are most dramatic, is a major challenge for reinsurance companies with a long-term approach. Those that cope best will be the most successful in terms of profitability and attractiveness to clients and investors.

Dirk Herrenpoth and Iris Zeisig are part of the corporate underwriting property team at Munich Re.