The US reinsurance market, after reporting several years of growth and profitability, has finally succumbed to the underlying pressures that have been brewing for some time. An intensely competitive environment has resulted in declining rate levels and relaxed underwriting standards as reinsurers have sought to maintain or grow their premium base, in response to shareholder pressures. Growth has come in the form of acquisitions, international expansion, new product lines and lower retentions by cedants, who have sought to take advantage of cheap reinsurance rates. This growth has not been without risk, and the results posted in 1999 indicated that many reinsurers bit off more than they could chew. Moody's expects that US reinsurers will have a difficult time reversing the impact of deteriorating fundamentals, and while recent indications of rate firming indicate light at the end of the tunnel, a number of factors will work against a dramatic recovery.

Deteriorating fundamentals work their way into earnings

The results for the US reinsurance market have tended to be volatile, due to the high exposure to catastrophes, and the long tail nature of casualty coverages, which can be greatly impacted by inflation or a changing legal environment. However, though poor results in the past may have been attributable to unexpected events, as in the case of the liability crisis in the 1980s, asbestos and environmental losses, or Hurricane Andrew in 1992, much of the damage to reinsurers' results in recent times has been self-imposed. Last year, US reinsurers reported their worst result in over a decade, and despite the widespread acknowledgement that rates were not increasing, managed a double digit increase in written premiums.

To be sure, 1999 results were influenced by a spate of global catastrophes, but inadequate rate levels for all exposures - not just catastrophes - have left little margin to absorb extraordinary losses. Additionally, adverse reserve development on the 1997 and 1998 accident years indicates that past reported results had overstated the true profitability of the market. Adverse development on reserves impacted reinsurers' bottom lines to varying degrees, as a number were able to offset increases in the most recent accident years' reserves with releases on earlier years. Moody's believes that the strength of many US reinsurers' reserves has diminished, and the ability to fund current year losses with reserve releases will be limited going forward.

Poor results contributed to a significant decline in operating cash flow in 1999. Data reported by the top 30 US reinsurers reveals that cash inflows from operations barely exceeded cash outflows. Furthermore, several large reinsurers posted negative cash from operations and were thus forced to liquidate assets to meet operating needs.

The drying up of retrocessional capacity, due to significant global catastrophes and the poor results posted by reinsurers worldwide, is undoubtedly a factor behind the recent firming of rates. Some see this as certain evidence that a robust market turn is on the horizon.

Moody's is less convinced that a dramatic recovery is underway, and believes that price firming to date may reflect nothing more than a knee-jerk reaction to a very bad year.

While prices are firming, a dramatic turnaround is not expected

In fact, there are a number of factors at work that will limit the ability of reinsurers to recover past losses by raising rates to levels that imply excess profits.

First, the market continues to exhibit overcapacity. Although some have given a portion of their capital back to the market (via net losses) and others have seen capital withdrawn in acquisitions, capital and capacity are largely intact. To put that capital to work, reinsurers will pursue business that is adequately rated and will underbid others seeking excess rates. Second, alternative forms of risk financing will tend to dampen a rebound in pricing as ceding companies take business outside the traditional risk transfer market when excess reinsurance rates emerge.

Third, some reinsurers may see the firming of the market as much as an opportunity to further squeeze out their less secure peers. And finally, primary companies that in recent years have used reinsurance as a form of arbitrage will likely increase their risk retentions, anticipating improved price adequacy on their books of business.

In this environment, reinsurers face a balancing act: the preservation of relationships with their profitable clients versus the achievement of rate adequacy. While the task is easier in cases where rate levels do not support burning cost (that is, premiums fail to cover expected loss payments), achieving overall rate adequacy on one's entire portfolio of risks will be more elusive.

Taken together, Moody's expects these forces to hold down any major market improvement, with downside volatility offsetting upward pricing trends for the reinsurance industry as a whole.

Firming may not always translate into adequate returns

At mid-year 2000, earnings reports by stock companies boasted of rate increases being achieved on renewals. Mostly absent from these rosy reports, however, is a reminder that rates have been on a steady decline for several years, and that for a number of companies, profitability has been delivered only through realized capital gains and/or understated reserves. Moody's believes that despite efforts to increase rates and re-underwrite books of business, earnings in the near term will continue to be impacted by poor underwriting and pricing decisions of the past. This is because of the long-tail nature of many reinsurance liabilities, the greater use of multi-year contracts, and the cost of expanding terms and conditions, often not considered in rates at the time of negotiating renewals. Furthermore, the ability to fund underwriting losses with investment income will be decreased going forward as cash is reinvested into lower yielding bonds.

Market inefficiencies create opportunities for arbitrage

The value of reinsurance is in its ability to provide capacity and stabilize results, thereby assisting in creating a more competitive and efficient marketplace. The abundance of capacity has created inefficiencies in the US reinsurance market. The trend toward consolidation among primary insurers, low growth rate of insurance demand, and increasing sophistication of insurers and their clientele would indicate that the amount of reinsurance utilization should decline. This has not been the case. Growth at any cost appears to have been the call of many reinsurers, as evidenced by recent results. During 1999, the growth in reinsurance premium exceeded that of the primary market, and so too did the combined ratio.

While soft primary market conditions and catastrophes impacted reinsurers' results, there has been an increasing tendency for primary insurers to use reinsurance as a form of arbitrage, allowing them to price their policies more competitively, at the expense of the reinsurer. An extreme example of this practice can be seen in the ill-fated Unicover workers' compensation pool.

Direct reinsurers pay the price for long-standing relationships

While the deterioration in results in 1999 was not unexpected, what may have been surprising was the degree of deterioration in the operating returns of the largest direct writers, who collectively comprise over 40% of the US market. Superior operating returns in years past have substantiated the view that direct reinsurers enjoy a strategic advantage over their broker reinsurer counterparts. This advantage relates to the intimate nature of their relationship with their cedants, which prevents business from being shopped around, and the underwriting advantage of access to underlying loss data. However, recent experience shows the price of these enduring relationships during a prolonged downcycle.

In the near term, direct reinsurers will find it a challenge to balance profitability with maintaining long-standing relationships.

Furthermore, a number of relationships are based on broadly meeting the reinsurance needs of regional and medium-sized insurers, which constrains direct writers from abandoning lines of business that are performing poorly, such as workers' compensation and commercial auto liability.

While these reinsurers have been pruning their books of unprofitable accounts, the increase in overall premium written in 1999 indicates that they (as well as some broker reinsurers) are taking the bet that rising underlying commercial lines rates will flow to their bottom line.

Limited growth opportunities and weak capitalization will drive consolidation

The trend toward consolidation among reinsurers has sought to take advantage of economies of scale, greater access to markets and distribution, and enhanced market acceptance created by stronger capitalization. After significant consolidation among the direct reinsurers, followed by mergers between mid-sized broker reinsurers, opportunities for truly strategic unions appear few. Moody's expects that continued difficult market conditions will force marginal players to be acquired, a trend that commenced in 1999, with Folksamerica's acquisitions of USF Re and Risk Capital Re, and Trenwick's acquisitions of Chartwell Re and La Salle Re. These acquisitions will focus on capturing profitable segments of the acquired portfolio, in the pursuit of sheer premium volume to ensure long-term viability and market presence.

Karen Davies is vice president, senior analyst, at Moody's Investors Service and Ted Collins is managing director in Moody's Property/Casualty Insurance & Reinsurance Group.