Howard Cheetham explains how the reinsurance book has been unravelled over recent months.

The events of September 2001 precipitated a rapid realignment in the reinsurance marketplace. Rates had been moving upwards all year, but the immediately obvious magnitude of the World Trade Center (WTC) loss stopped reinsurers in their tracks, forcing a radical reappraisal of many previous assumptions.

The realisation that almost all the claims arising from September 11 would be covered by the insurance community, and in turn come in to the reinsurance market, made it painfully clear that massive risks had been assumed without appropriate price consideration on the part of the re/insurance community. This is, however, typically the way with insurance perils; it is only once significant high-profile losses throw particular risks into the spotlight that the market faces the reality of pricing for that risk - or excluding it. The immediate, reflex reaction following WTC was for reinsurers to exclude terrorism.

But the shockwaves of WTC and the massive losses it produced have reverberated far further than terror-related risks. Combined with an ever-deepening bear market, and the diminished opportunities this implies for investment income, September 11 has prompted reinsurers to look far more closely at what is written, where, by whom and at what price, across the business.

Opinions vary widely about how long the current hard market will last. Nevertheless, by any objective standard, we are now looking at a seller's market for reinsurance. When capacity is plentiful the markets are far more willing to move towards the buyer's ideal of a piece of paper that says, `You're covered, come what may.' Now, the boot is on the other foot: rates are up; retentions are up; and multi-year, multi-line covers are a thing of the past.

There is an historic parallel to the current hard market when in the early 1990s, following Hurricane Andrew, the market hardened over 1992 and 1993 and then began to soften from 1994 onwards. Like WTC, Andrew forced reinsurers to look at the specific risks they were assuming far more closely than they had ever done before. Up until the early 1990s, reinsurance had been a remarkably relaxed and entrepreneurial sector. Whilst an event like Hurricane Tracy in 1974 would have had a comparable, if less marked, effect in reminding reinsurance carriers that they may have been covering more risk than they had been aware of, it is only really in the last decade that we have seen losses of a sufficiently thought-provoking magnitude to induce an industry-wide determination to look in detail at the specific risks assumed within the reinsurance book.

Once greater capacity began feeding through into price competition in the wake of Andrew, the market softened in the mid-1990s and coverages began to widen again. Immediately post-Andrew, the issue was catastrophe, and new capital flooded into Bermuda specifically targeting the cat market. Post-WTC, terrorism is in the spotlight, but the pattern is broadly similar. Less than a year after WTC, reinsurers have now had time to do their homework on terrorism exposures and come back with specific covers to address the range of risks excluded following September 11. Though the market's appetite for terrorism covers appears effectively sated, equally, it seems that buyers have generally bought what they feel they need.

A key difference between Andrew and WTC is that the latter came against a background of already poor results, magnifying and intensifying its impact. The investment markets had been down for 18 months prior to September 11 and, despite some signs of hardening, rates had failed to reach what most commentators saw as realistic levels. With the reinsurance markets already on the back foot, the losses from WTC landed a devastating blow. Had they come in 1993 or 1994, the market might have taken them on the chin; but the cruel timing of the WTC losses forced the markets into what I believe was a significant over-reaction - a completely understandable, but nonetheless exaggerated, reflex withdrawal.

The initial response was purely negative. Senior management in reinsurance organisations around the world were adamant: with their companies' previous policies on terrorism now meaningless, there was no way anyone was writing terrorism, until further notice - no new policies, no renewals, full stop. This is where the unbundling all began. The imperative was to price every risk. Composite pricing means evaluating every risk on its own merits, not throwing in cover for free. And in the current climate this inevitably means the sum price will be greater than before. Essentially, what happened after WTC is that coverages were `refined', and it was that impetus to dissect and re-evaluate that has rid the market of coverages that suddenly looked dangerously ill-defined after the events of September 11.

Of course, the companies that have suffered most from WTC are keen to make up for their recent losses. But although the desire to get rates back up may seem more urgent now than ever before, it is nothing new. In fact, it is the realisation that many carriers had so little idea of their real exposures that has played the critical role in reshaping the market over the last year. One silver lining in the WTC cloud, from the market's point of view, is its unprecedented visibility as an event. Few eyelids bat when an earthquake strikes in Guatemala. A major windstorm - even when it hits the US mainland - is soon enough forgotten. But an event like WTC is imprinted on the consciousness of virtually the entire world. If explanations about the need for rate rises were ever unnecessary, now is surely that time.

In reality, much of the unbundling process takes place at the primary level where carriers are directly exposed to the original peril. Focusing on particular risks fuels specialisation, and as niches become better defined, the reinsurer's task of attaining clarity becomes easier. At all levels of the market the trend is now clearly towards having specialist underwriters writing close to the source of the risk. At least until equity markets pick up significantly, this tightening of focus is unlikely to be reversed. In a sense, it is not only covers, but also the market itself that is becoming unbundled.

Prior to September 11, many companies were trading at what the blue chip markets would have said was substandard pricing and taking on substandard risks. WTC pushed a lot of these over the brink. How much of that was down to actual losses is questionable. A more significant factor, in the final analysis, was a widespread loss of nerve on the part of senior managers. Many reinsurers have been involved in mergers, acquisitions and intra-group realignments over the past year, and have reviewed and rationalised underwriting activities in the process. Where they have seen little in the way of profits for the last five years, and suffered significant losses, they may well have concluded that discretion is the better part of valour. So there is certainly a degree of corporate unbundling going on, as well as several hundred underwriters who have found themselves unbundled from their former roles.

New capital demands
The new money that has come into the industry has come in with a fixed agenda. There is no lack of clarity in the approach of these new players. Of course, many of them genuinely intend to be around for the long term, but inevitably there is a degree of opportunism in their capital provision. Not least, it is easier today than ever before for capital to flow into and out of the reinsurance sector. It's no surprise that in an entrenched bear market the potential returns available to investors from reinsurance look relatively attractive - especially when rates are rapidly hardening. As a consequence of this phenomenon there is not the same shortage of capacity now as following Andrew. Outside the US, there still appears to be no real strain on capacity for most risk types, and catastrophe cover is certainly not in short supply. Here, as to a lesser extent elsewhere in the market, Bermudian capacity has acted to moderate price increases.

The effects of reinsurers' renewed commitment to underwriting discipline have perhaps been less marked on the casualty side, where the business has traditionally been written by a smaller number of markets on a more focused and professional basis. There was less unbundling to be done here, although WTC did draw attention to some worrying grey areas as to what terrorism exposures might exist within the casualty book. What exposure, for example, might a building owner have to liability for the adequacy or otherwise of the provisions made to protect occupants, visitors and passers-by against the harmful consequences of terrorist actions? Casualty pricing has clearly moved upwards, and coverages have been reviewed, but the motivation for this owed more to a continuing pattern of bad loss experience (particularly in such instances as D&O, Enron and others) than the direct influence of WTC.

Where property business is concerned, the immediate focus following September 11 was on named perils. Reinsurers took flight en masse to clearer definitions, ensuring all applicable clauses were in place. Terrorism was the obvious focus. After some initial procrastination as to how exclusions should be worded and whether they should follow original wordings, the industry has broadly come out in favour of NMA 2930 A and B, with the aim of establishing an effective firewall between the reinsurer and terrorism exposures in the original business. Personal lines business has been allowed back in, due to the low concentrations of risk involved, but nuclear, biological and chemical attacks are categorically out. This has led buyers to take out the stand-alone terrorism products that are now available - often with the same carriers which excluded their terrorism cover in the first place. Arguably, the prices at which terrorism covers are available look barely adequate, but at least reinsurers have the comfort of having isolated the peril and priced it separately.

On the retro side, a lot of the covers in place took in business written worldwide. This left many reinsurers wide open yet again to unanticipated claims. The majority, in this case, arose from WTC. The nature of the unbundling that has taken place here has been territorial rather than risk-related. A very strong aversion has emerged to combining US business with other international catastrophe business. The focus of senior management is on who writes what, where. The London offices of international reinsurers are not exactly being encouraged now to build up major books of business emanating from the US, and this discipline is being applied worldwide. Regional offices are being instructed not to write business originating outside the region in question, thus sectionalising the parent's underwriting.

There are essentially two types of buyer for retrocessional covers: those who buy retro to live, and those who simply buy some retro. In the current market, things are going to be fairly tough for those who fall into the first category. The size of the retro market is nothing like it was; low rate on line is now a thing of the past and warranties are increasingly prevalent. Most retro business being written today is very much vanilla in flavour, to the extent that we are seeing retro accounts written by companies which would not previously have been players in this market. Nobody writes anything now without looking at the underlying risks in detail, and the days of whole account international retro are at an end.

With US aviation reinsurance agency Fortress Re gone, there is relatively little capacity left in this specialist area. The myth of reinsurance generating annual returns of 25% has also been unravelled, and everyone is working to more realistic expectations. There has been a definite shift from backing the man to backing the book - or at least the man and the book. Investors want to know in far more detail what you are planning to write, how you are going to write it, how you are going to get the business, and what the expected results are. So, as carriers seek to achieve clarity and tighten conditions across the board, there is no longer any such thing as cheap reinsurance, and this will tend to promote underwriting discipline at all levels.

Aviation soars
September 11 saw the largest losses ever for the aviation sector, and rates for direct and facultative aviation reinsurance business have soared as a result. The new threat posed by terrorism has prompted a drastic re-evaluation of the sector's exposure to not only pure terrorism risks, but also others whose implications seemed more threatening post-WTC such as war liability and hull, and satellite liability. Aviation reinsurers have looked very closely at line slips, pro rata treaties and risk excess programmes, and now insist on full declaration. There has also been a dramatic shift from LORA (losses on risks attaching) to LOD (losses occurring during), with the prevalence of the former reversed strongly in favour of the latter.

Another area where specifics are receiving closer scrutiny - in this case from the buyers rather than sellers - is that of security. Buyers are now quite aggressively sifting and unbundling their reinsurers based on the strength of their ratings. The appeal of a better price from a lesser-rated carrier is on the wane; and there is more caution in the air. An increasing number of contracts include clauses whereby if a market's rating falls below a certain level, the client can take that market off the risk. Such clauses were a rarity until very recently; now they are commonplace. So here is a reciprocal instance of the urge to unbundle to achieve greater certainty and clarity.

There is less of a capacity shortage in the reinsurance market today than had been anticipated. But so long as cheques are being signed for WTC claims, I believe the market will remain firm, notwithstanding the influence of new players coming into the market without the burden of major recent losses to try to recoup. It would be fair to say that we are already seeing a levelling-off: the recent Australian renewals, for example, saw rates up somewhere between 10% and 15%, against pre-renewal expectations of 50% to 100%. However, barring further major events, price reductions may well come round again far sooner than the markets would have wished. But I doubt we will see coverages broadened and bundled again in the way they have been in previous soft markets for some time.

Meaningful models
The importance of modeling will certainly not be diminished by recent events, and the race is on to develop meaningful methodologies for modeling terrorism risks. A model is always just a working tool, continually adjusted in the light of unfolding experience. As the market stands today, reinsurance pricing is not too far off the model for some classes, though in others there is clearly scope for further increases to bring premiums into line with expectations for future losses. Modeling is likely to act more as a stabilising influence on pricing than as an active force for driving up rates. The model is one thing, the price the market will stand quite another - and the ideal price remains elusive. Many companies now claim to have created terrorism risk models. But are these truly models, or simply territorial analyses of risk concentration?

The heightened professionalism and attention to detail that has been so apparent at all stages in the reinsurance process post-WTC can only benefit this industry in the long term. In effect, the reinsurance sector is coming of age as a more mature and rationally grounded market. There can be little doubt that - from an underwriting and risk assessment viewpoint, at least - this industry is better prepared than ever before to meet whatever further challenges may lie ahead.

By Howard Cheetham
Howard Cheetham is managing director of Aon Re Japan.