Investment bank Morgan Stanley has taken a cautious view of the pan-European insurance industry in 2003 but it is a little more positive on the prospects for large reinsurers.

In its latest report on the European reinsurance industry, The Empire Strikes Back, Morgan Stanley has identified four key drivers of non-life and reinsurance business this year: pricing trends, investment returns, adverse reserve development and industry restructuring. And it argues that price strengthening and industry consolidation are two major factors that will make reinsurance stocks attractive, relative to their primary and life insurance counterparts.

Pricing trends
For the second year in a row, pricing power, due to a shortage of capacity, is very significant, says Morgan Stanley. Unlike life business, non-life and reinsurance is arguably not a discretionary purchase - in fact, clients often need more cover in difficult economic conditions, like the ones the world is facing now.

"We believe the impact of this pricing power will be clearly evident in 2003 and 2004 earnings," says Morgan Stanley. It adds that, like 2002, it thinks reinsurers will have been able to secure significant rate increases in the January 2003 renewals.

While acknowledging that rate hikes will vary across line and geography, the investment bank expects that property rates will generally enjoy a moderate increase, with some liability lines increasing by 20% to 30%.

It says another positive factor for reinsurers this year, and in 2004, is that the effect of higher rates will start to have an impact on reinsurers' bottom lines.

"One reason that investors were not rewarded for playing European reinsurance in 2002 is that there is a lag effect before higher rates hit the bottom line," says Morgan Stanley. "Investors generally regarded underlying combined ratios for European non-life companies and reinsurers in 2002 as disappointingly high. This was because part of the calendar year 2002 earnings were still driven by 2001 written premiums (i.e. before the large rate hikes). This effect will have progressively dropped out and will disappear in 2003."

Investment returns
Morgan Stanley is not optimistic that investment returns will recover in 2003, despite the losses suffered over the past three years. In fact, it says it thinks some companies have been overly optimistic about such returns in their pricing.

"We are also concerned that in such a low return environment, insurers chase higher yields by taking more risk - for example, investing more in corporate rather than risk free bonds."

However, the upside for investors in non-life businesses is that life companies appear to have taken greater risks in this respect than non-life companies.

Reserve developments
Although 2002 was characterised by numerous reinsurers increasing reserves for prior years' business, which sometimes had disastrous effects on the earnings of reinsurers such as Munich Re and SCOR, Morgan Stanley believes that the industry has broken the back of its reserving requirements.

"It is impossible to say whether such strengthening is sufficient - more could be required, if, for example, court award inflation were again to accelerate - but we believe we are past the worst," it says. "Our US colleagues have estimated that in respect of the US market alone, reserves may be deficient by as much as $120bn - a large number but, nonetheless, one we believe is manageable in the context of the global non-life industry."

Industry restructuring
The good news for reinsurance in 2003 is not limited to rate increases and higher demand (cedants needing more reinsurance because their balance sheets are thin). There are also supply side issues.

Morgan Stanley estimates that the reinsurance industry's solvency ratio has fallen to 76% currently, from 102% at the end of 2000 - even allowing for around $20bn of new capital having entered the market. It appears that several top ten players are going through a period of restructuring or reduced focus on their core business, says Morgan Stanley: GE has declared its desire to exit Employers Re and will withdraw capital throughout 2003; Hannover Re may have to curtail growth after strong top-line improvement in 2002; Gerling Global is no longer writing new business; SCOR is reducing activity in several areas of its business; and Allianz and AXA are both short of capital (on Morgan Stanley's estimates).

"For those remaining among the largest players - and that are well capitalised and fully committed to reinsurance - we believe there is a unique opportunity to profitably capture market share," says Morgan Stanley.

Replacing the traditional
Another factor that plays into the hands of the bigger competitors is that non-traditional forms of reinsurance, such as financial reinsurance, finite cover and structured risk finance solutions, are replacing traditional coverages. At the same time, capital markets solutions like catastrophe bonds, after being little used in the soft market of the late 1990s, are again becoming more appealing.

"Those that are market leaders in reinsurance and are able to understand, price and execute such transactions will likely capture market share," says Morgan Stanley. "Those that lack critical mass, or are part of larger group where reinsurance is not a key focus, will likely suffer."