The cycle is turning just as reinsurers are about to face an unprecedented wave of capital, governance and financial reporting reforms Jeremy Scott looks at the critical challenges ahead.

The reinsurance industry has demonstrated its trademark resilience and enterprise in bouncing back so strongly from the annus horribilis of 2002. Companies have clearly benefited from two years of favourable premium rates. However, their success also owes much to incisive underwriting and smart capital allocation, underpinned by a more informed and systematic approach to risk/capital evaluation and management.

It is clear that the quality of underwriting will continue to be the key to profitability in the absence of any substantial cushion from investment returns. During the stock market boom of the 1990s, many companies were happy to run a combined ratio of up to 115% in the hope that equity returns would offset any underwriting losses. Even though share values are beginning to rise once again, successful reinsurers now insist on target ratios of 100% or less.

The initial indications are that this more informed and disciplined underwriting is already helping to soften the landing for premium rates as the cycle turns. Casualty prices are still rising and while marine and property classes are beginning to decline, the margins remain attractive. The real test is likely to come in 2006, though today's industry-savvy investors are unlikely to commit too much capital to unprofitable risks. While by no means assured, the ideal outcome would be a fairly swift capacity correction that would ease or at least shorten the downturn.

Any margin of error will inevitably be squeezed by the renewed pressure on reserves, which have highlighted once again that the liability legacies of the 1990s still have a sting in their tail. In particular, the full extent of the fallout from the business failures and accounting scandals of recent years is only just beginning to emerge, and reserves will almost certainly have to be increased as a result.

Moreover, while plans for a new jointly financed trust fund may help to set a limit on US asbestos liabilities, any further reform of the American civil claims system appears unlikely this side of the election. Tort costs in the US now exceed $200bn per year according to the Insurance Information Institute and are set to grow as class actions spread to fresh areas ranging from obesity to environmental damage. There are also clear indications that this litigious environment is beginning to take hold in Europe.

Market concerns

Further concerns were highlighted in PricewaterhouseCoopers' latest annual survey of the London insurance market, which found that less than a quarter of participants believe their reinsurance programmes provide value for money. Retentions have risen as a result. "If the business is good, why cede the profit?" said one interviewee. Nevertheless, at least half of respondents expect outwards cover to increase once again as the market softens through 2005.

The survey also found that some respondents are concerned about what they see as increasing difficulties in recoveries and the withdrawal of capacity in certain lines, particularly casualty. Indeed, the strength of the historic relationship was ranked near the bottom of a list of considerations for choosing where to place cover (credit rating was by far the most critical).

"I'm not going to try to build a relationship with someone who is not going to be there in a few years time," said one participant.

Clearly, some element of tension between the direct and reinsurance markets is inevitable and participants recognise that reinsurers give them "far more capacity to write business than we could ever achieve on our own".

"You can't write risks without reinsurance and higher risk equals higher returns," said another.

Reputation on the line

The impact of new regulation poses what may be the greatest challenge to reinsurers, not least in the time and investment that will need to be devoted to what for many global groups could be multiple, cross-jurisdictional compliance.

The Sarbanes-Oxley Act ('Sarbox') aims to tighten up financial reporting in the wake of Enron and other accounting scandals. Senior managers from US-listed firms will be required to certify the effectiveness of their internal control procedures. In practice, this calls for an extensive audit trail of appraisal, validation and documentation across all areas of the business including outsourced operations and special purpose entities.

PricewaterhouseCoopers' work with a range of reinsurance clients suggests that the scale and complexity of implementation is considerable, especially within the extended IT and management infrastructures of large global entities. However, it is the cultural shift to a formal framework of control that could prove most challenging for a sector that has always prided itself on the agility of its capital, the enterprising autonomy of its underwriters and the informality of its relationships. Deals will no doubt continue to be closed over a quiet chat. However, the discussions now have to be scrupulously documented and made available for subsequent scrutiny.

Moreover, the penalties for non-compliance are likely to be pernicious and very public. Indeed, Sarbox may provide a fresh boost for auditors' D&O and E&O business, especially as the certifying executives and their auditors will be personally responsible for any lapses on their watch, whether they were aware of them or not. For the company as a whole, any failures in compliance could cause grave reputational damage. 'Uncertainty tamed? The evolution of risk management in the financial services industry', a recent study by PricewaterhouseCoopers in association with the Economist Intelligence Unit, found that organisations now regard reputational risk as the greatest threat to their market value.

Called to account

Over the other side of the Atlantic, EU-listed companies are moving to International Financial Reporting Standards (IFRS). It would be easy to dismiss IFRS as a mere technical issue with little impact on the fundamentals of the business, especially as designated re/insurance contracts will continue to be covered by existing accounting principles. Yet, dig deeper and the devil begins to emerge from the detail, with the vast majority of the new standards affecting reinsurers in one way or another.

Moreover, many financial reinsurance and other alternative risk transfer (ART) contracts will no longer qualify as insurance under new classification rules, which are in part designed to eliminate the very opportunities for regulatory arbitrage that such structures often seek to exploit. Above all, the enhanced disclosure framework will open up insurers' underlying risk, earnings and reserving assumptions to unprecedented scrutiny.

On the plus side, the spotlight of transparency could spur companies to improve the quality of their risk selection, monitoring and mitigation.

A more realistic assessment of insurers' risks could also encourage them to offset more of their liabilities through reinsurance. Eventually we could see the emergence of innovative ART structures that could help firms ease the potential earnings volatility associated with the fair valuation of financial assets.

Capitalising on risk

A forthcoming EC directive will bring the solvency requirements for reinsurers into line with direct insurers. The new rules are being fast-tracked through the European Parliament and could be in place as soon as next year. While controls already exist in the UK and Scandinavia, this will be the first time that reinsurers in many other countries will have been directly regulated.

As such, some say that this will put EU companies at a competitive disadvantage to their Swiss and Bermudian rivals, which will continue to enjoy the same capital flexibility as before. However, it appears that regulators from around the world are increasingly hunting in packs, and reforms in one territory are more often than not now mirrored elsewhere. The challenge for reinsurers is to look at how they too can speak with one voice and ensure that new regulation reflects the distinctive characteristics of their industry and its pivotal place in the economy.

The directive is only a start, and a more proactive, risk-based capital management framework for insurers is being developed (Solvency II). The UK's Financial Services Authority is already pioneering what is likely to be a model for this eventual EU-wide regime, requiring firms to make their individual capital assessment from the start of 2005. While many of the larger international reinsurers have already led the way in the development of such capabilities, some smaller firms may find this a challenge.

As many reinsurers have demonstrated, improved risk/capital evaluation can enhance the basis for decision-making and help to target investment where it can earn its best return. The practical advantages of such capabilities are likely to come to the fore in identifying what could be the marginal differences between profit and loss in the coming downturn. In the longer term they can help reinsurers to respond to a new set of emerging threats and opportunities.

In particular, obesity is fast overtaking smoking as the biggest cause of preventable death in much of the developed world and is now the focus of a series of class actions. Value at risk measures can help reinsurers and their clients to gauge the true extent of their liabilities, some of which may stretch back many years. They can also help companies to design effective and competitively priced protection. Ultimately, they could provide a valuable aid to creativity as organisations seek to develop new products covering new risks that push back the boundaries of commercial insurability. The pioneering of terrorism cover by Bermudian reinsurers exemplifies the qualities of innovation within the industry.

The uses of adversity

Rating, reserving and regulatory pressures mean that 2005 will be a testing year for the reinsurance industry. Yet they also offer leading companies an opportunity to demonstrate their ability to sustain profitability in a downturn, respond positively to change and ultimately enhance shareholder value.