It’s becoming a buyer’s market but the signs are good that reinsurers will stand their ground at mid-year. Chris Klein predicts a long glide down.

So far this year, the reinsurance market has been soft. Rates have declined at the key renewal dates of 1 January and 1 April. Barring surprises in the physical or financial worlds (or perhaps a combination of both), further rate declines throughout this year and into 2009 are anticipated. Looking further out, history suggests that the downturn will be both gradual and prolonged.

As shown in figure one, following the shock of Hurricanes Andrew and Iniki in 1992, catastrophe reinsurance rates more than doubled, and then began a gradual decline over a period of seven years. Following Katrina in 2005, the market again took a large jump, and now has been declining for two years from that last peak in 2006.

The softness in the market is expected to persist for a number of years, reflecting two major factors: the profitability of the business and the increased discipline in the industry. The latter suggests that the downward drift in rates and terms and conditions is likely to be at least as gradual as in the earlier decline in the 1990s.

From a straightforward financial perspective, the reinsurance industry is in great shape.

Results so far this year indicate that the average combined ratio appears to be in the low 90s. While there were increased catastrophe losses this year, their impact was greatly offset by favourable reserve releases.

Bullish in Bermuda

Because of differences in reporting requirements, it is difficult to present accurate data on the total reinsurance market. However, data for the Bermuda market is reported in a fairly consistent manner. This data points to a high level of profitability and overall financial strength.

According to the Guy Carpenter Composite for Bermuda, underwriting profits were very strong in 2007, with a combined ratio at a record low of 84.9%. The return on equity (ROE) at 18.4% in 2007 is enviable compared to most investment opportunities in today’s economy. Retained earnings increased companies’ capital by 14.2% in 2007.

A fundamental value benchmark used by many analysts is the increase in book value plus accumulated shareholder dividends. This measure is also important in credit analyses, as it may enhance the financial flexibility of the entity. The increase in book value result needs to be measured against the risk assumed by each individual group, its caution in reserving and the strength of its capital.

All six companies measured showed substantial increases in book value over the past decade. RenRe led the field with a gain of more than 400%. Four of the six companies had growth rates that exceeded the gain in the overall S&P 500.

Slash and burn

One cloud on the horizon is in terms of investment income. So far this year, investment earnings are down for many companies. Two factors appear to be at play. Stock prices have fallen this year in most countries, headlined by the 27% decline in the Chinese stock market. In addition, earnings are under pressure from the decline in short-term interest rates. While insurers normally maintain less than 10% of their assets in cash and near-cash, the dramatic decline in short-term interest rates would by itself result in a 5% decline in overall investment income.

The basic question that needs to be addressed is whether reinsurers will feel the need to stand firm and refuse to move from their technical rates. Given the high level of profitability, reinsurers are cutting their rates, as clients and their brokers push for premium reductions. However, once rates decline to more reasonable levels, will we see destructive price-cutting?

One signal that there will be discipline in the market is the experience of Japanese renewals at 1 April. Rates in Japan are viewed by most reinsurers as close to their technical levels. In recent years, there has been over-placement in this market, as reinsurers have offered capacity in excess of the market’s needs. However, at 1 April this year, over-placement was minimal, providing a strong indication of restraint on the part of reinsurers.

In addition to this development in the Japanese market, brokers in other markets have reported that a number of reinsurers came off programmes in situations where they felt that firm order prices were inadequate.

The next shock

The low level of insured losses from catastrophes played a major role in delivering strong results for reinsurers in recent years. But it is unrealistic to expect a third benign catastrophe year in a row. Forecasts from the Department of Atmospheric Science at Colorado State point towards a year of increased activity in the North Atlantic.

Further, while not a great threat to insurers and reinsurers, the devastating Typhoon Nargis in Myanmar and Sichuan earthquake in China in May serve as a reminder that mega-catastrophes can arise almost anywhere in the world. Indeed, the underwriting results of some reinsurers have come under pressure as a result of a number of diverse facultative losses. These include the flooding of coalmines in Australia, an explosion at a sugar plant in Savannah, Georgia, USA and the cut of a power cable in a South African goldmine.

The industry cannot restrict its concerns to the natural world. Terrorism and financial crises can play havoc with reinsurer finances, as we know from the current subprime debacle, and from the tech stock collapse of 2000.

When the next shock occurs, it is expected that the impact on price will be less severe than with prior mega events. This is because of the increased availability of insurance-linked securities, which allow for fast participation by the capital markets in insurance and reinsurance markets. In particular, the use of sidecars is likely to play a re-balancing role in insurance markets.

Sidecars are special purpose vehicles through which third-party investors (eg hedge funds and private equity funds) provide extra underwriting capacity to existing reinsurers and insurers. Thus, they ease capital into and out of the reinsurance market. Sidecar usage has dropped, as rates receded from the record highs of the summer of 2006 and discouraged the entry of new reinsurance capacity into the industry. Sidecars successfully served their purpose, having facilitated the flow of capital into and out of reinsurers without disrupting balance sheets, ultimately making it easier to manage supply. They may regain prominence in the event of high catastrophe losses and a hardening market.

The reinsurance industry faces the challenges of an increasingly competitive environment in 2008 and beyond. The good fortune of low catastrophe losses in 2006 and 2007 have caused balance sheets to swell, but the opportunities to earn the outsized returns desired by investors have nearly vanished. For the coming few years, soft market conditions are likely to prevail, a welcome result for cedants.

Chris Klein is managing director and global head of business intelligence at Guy Carpenter.