Although much of the market is riding on the crest of the cycle, ratings agency AM Best is warning that only modest underwriting profits may come through for 2003.

Reinsurer security is currently one of the most closely scrutinised issues in the market. The demise of players such as CNA Re and Hartford Re has focused cedants' minds, and the issue of 'can't pay' or 'don't want to pay' has swung the spotlight on to counterparty exposure and reinsurance recoverables on the balance sheet. And all the time, the top-rated reinsurers in the industry have seen across-the-board downgrades in their financial strength rating from all four main ratings agencies.US ratings agency AM Best is doubtful that the ratings will recover to their previous levels for the foreseeable future. It cites both the pressure on risk-adjusted capital adequacy and modest underwriting profits in property/casualty business as combining to keep ratings lower.

Underwriting focusThe current low interest environment has led to reinsurers focusing on underwriting as their main source of income, but although there remains a side-debate into whether these risk carriers should not have been prioritising strong underwriting skills and discipline during the soft market conditions, there is the concern that future capital adequacy could be compromised. This is because, said Best, "ultimately the availability of capital to reinsurers is a function of their ability to produce a sufficient risk-adjusted return."Best is particularly concerned that the higher premium rates do not seem to have fully translated into healthier combined ratios, which reached the mid 90s or higher for the first six months of this year. These, said Best, were "disappointing, especially with few reinsurers recognising any adverse development combined with benign catastrophe experience during the period." Although this can be put down to the lag in booked results, Best contends that this may have started playing out, and that the degree of improvement "appears to be slowing". The current peak in property rates, and what Best describes as a "more competitive" environment in casualty combined with continuing loss cost inflation, means that there are unlikely to be particularly large rate increases in the future. "Accordingly," commented Best, "unless the market's traditional cyclicality has been eradicated, it is difficult to see how healthy returns will be maintained when the market turns."Legacy issues do, however, maintain their own pressure on rating levels, and Best identified both risk-adjusted capital and the continuing potential for adverse development as "major sources of price discipline". "But purely rational pricing behaviour is not a feature of any market and reinsurance is no exception," it warned. "Signs of price-based competition are clearly emerging."

Best's reactionIt is these concerns which lead Best to conclude that it is unlikely to be pushing up the ratings of the reinsurance community, at least for the meantime. "It is unlikely that underwriting returns sufficient to support the capital necessary for the very highest ratings will be a feature of the next few years for most market participants," commented Best. "Consequently, while there may be some individual exceptions due to specific capital raising initiatives, financial strength ratings overall are unlikely to return to former levels. Moreover, the management for many reinsurers is increasingly stressing the need for maximising the risk-adjusted return on capital employed. In that context, very high levels of risk-adjusted capital may not seem to be economically tenable to some reinsurers, and, as a consequence, they may choose to live with lower ratings."Whether Munich Re's recently announced fund-raising initiative will be sufficient to lift its rating, only time will tell, but the industry as a whole may find itself needing to take a relative rather than absolute view of ratings in the future.