After years of talk, it looks as though the flight to quality is underway, but at what future cost, asks Phil Zinkewicz?
Flight to quality is the buzz phrase among buyers of reinsurance these days. We've all heard the phrase before, but never before has it had more relevance. It now means that primary insurers and self-insurance vehicles purchasing reinsurance are determined to do business only with those reinsurers strong enough and dedicated enough to be there for the long haul. From the buyers' perspective, the problem is finding out who those reinsurers are. Another problem, once you've flown to the reinsurer of your choice, is knowing how to negotiate the reinsurance contract so that claims will be paid when the time comes.
Thus the days of wine and roses between reinsurers and their buyers are over. The fact of the matter is that reinsurers are, out of necessity, playing things very close to the chest in today's uncertain reinsurance industry environment.
In the classic American western, `High Noon', one character remarks: "It seems that a man with busted knuckles doesn't need to get arthritis too." Well, the global reinsurance industry got its knuckles busted during the soft market years of the 1990s when cash flow underwriting was the order of the day. Investment returns were sufficient to ease the pain for a while, but then the stock market took a nosedive and reinsurers' knuckles began to swell.
Arthritis, of course, is a lingering and degenerative disease. The ultimate financial impact of the World Trade Center (WTC) disaster will not be realised for years to come. The New York-based Insurance Information Institute (III) recently estimated the total insurance loss from September 11 will reach about $40.2bn, significantly higher than the $30bn figure previously estimated.
As far as reinsurers are concerned, those losses are spread across all classes. There is an estimated $11bn (27%) in claims for business interruption; $10bn (25%) in liability claims; $8bn (16%) in property claims for damage to property, including vehicles, other than the twin towers; $3.5bn (9%) for WTC buildings One and Two; $3.5bn (9%) for aviation liability; $2.7bn (7%) in life insurance claims; $2bn (5%) in workers' compensation claims; $1bn (2%) in claims for event cancellation; and $500m (1%) in hull claims for the loss of the four commercial aircraft. Therefore, the terrorist attacks involved multiple losses in different lines of coverage due to an unpredictable, unusual and unanticipated event outside their normal assessment of aggregate exposures. Moreover, the corporate scandals that are rocking the US are bringing and will continue to bring directors' and officers', errors and omissions, and fiduciary claims to reinsurers' doorsteps The current hard market, wherein reinsurers are reaping the benefits of high premiums and more restricted conditions, may look good in the short run, but these benefits may be too little too late for some reinsurers.
Rating agencies such as AM Best and Standard & Poor's (S&P) have already downgraded some reinsurers' financial strength ratings as a direct result of the September 11 terrorist attacks and are keeping a watchful eye for more, inevitable, fallout. A recent report from investment bank Morgan Stanley indicated that many insurers' balance sheets could be "flat wrong" because they are "assuming" reinsurance recoverables on their balance sheets. However, if there are reinsurers that fall by the wayside because of September 11, it is axiomatic that "failed reinsurers can't pay", said the Morgan Stanley report.
"The cracks are beginning to appear even in the mightiest of reinsurance fortresses," said Don Watson, former managing director inS&P's financial services ratings. "They'll be losing all the `AAA' ratings in the reinsurance industry if trends are not reversed."
In addition to reinsurance company downgrades, some participants in the worldwide reinsurance marketplace are fleeing the business or attempting to slip away. In October 2001, Zurich Financial Services spun-off its reinsurance operations into Converium. Shortly afterwards, the Danish mutual insurer, Alm Brand, withdrew support for its subsidiary, Copenhagen Reinsurance Co Ltd, which was subsequently put into run-off. Deutsche Bank AG is looking to offload its stake in Gerling Global Re, which in turn is looking to divest itself of Gerling Global Re Corp of America as part of its restructuring of reinsurance operations. CNA Financial has announced that it is selling CNA Reinsurance Co and St Paul Cos is trying to spin-off its scaled-back reinsurance operations through an IPO of the newly formed Platinum Underwriters Holdings Ltd.
Even when reinsurance arms are retained, said Mr Watson, they are often on a much tighter rein. In September 2001, Berkshire Hathaway Inc replaced the CEO of General Re Corp, the largest unit in its franchise, after snowballing underwriting losses at the reinsurer since it was acquired in 1998. In March 2002, Munich Re put new management in place at American Re following a net loss approaching $1bn.
"Major financial services corporations are saying that the volatility that the reinsurance industry is producing inhibits their getting a decent return," said Mr Watson. "As a result, they are looking to unload in a hard market. Yet there is little interest on the buy side."
According to Laline Carvalho, a director for S&P's financial service ratings, a brief period of catastrophe-induced price hikes is not going to turn around an industry that for several years indulged in lax underwriting, then took the brunt of terrorism losses. "Higher prices should lead to good earnings for reinsurers through 2002 and 2003, but that follows years of poor results, with many other exposures on the horizon," she said.
Ms Carvalho said that the combined ratio for US reinsurers reached an exorbitant 140% in 2001, but that terrorism losses are not entirely to blame. Even without WTC payouts, she said, the combined ratio would extend the sharply rising trend begun in the late 1990s, when reinsurers exercised poor pricing discipline.
If all that is not enough, the reinsurance industry is being visited by one new friend and revisited by one very old one. The toxic mould problem in the US, at present considered to be a headache for the personal lines sector of the insurance business, is threatening to seep into the reinsurance arena. And the old friend is asbestos.
"After widespread bankruptcies of asbestos manufacturers, which were their first target, plaintiffs' attorneys have recently diverted their attention to users and installers, which in turn make insurance claims under their liability coverage," said Ms Carvalho. "A significant portion of claims now originate with individuals who might have been exposed to asbestos, but have yet to show any symptoms. According to the III, the number of asbestos defendants has risen sharply, to several thousand now from about 300 in the 1980s. With most estimates of the insurance industry's current reserve shortfall in the range of $20bn-$40bn, asbestos represents a deep abyss for future payouts."
Vincent Liotta, head of the marine practice at Guy Carpenter, said that the situation smacked of Darwinian overtones. "It is becoming a question of the survival of the fittest. There will probably be reinsurance companies that don't make it through the next cycle - all the more reason for reinsurance buyers to look for that reinsurance `quality' that is becoming more and more important to them."
Mr Liotta said that in the `per risk' category of the property market, there is pressure for "clarity with regard to risk definition, risk accumulation and large risk participation." At the reinsurance level, he said, "current exclusions include terrorism, cyber risk and toxic mould. There is a focus on both exposure and experience as far as pricing is concerned. In the catastrophe category, quotes are now coming in on named perils bases and there are surcharges for all risks."
He went on to say that reinsurers are selectively allocating capital. Pricing is rising 35%-100% and clients are electing to buy less, he added.
Even the new capital that has been raised for the Bermuda reinsurance industry doesn't do all that much for the `flight to quality' issue. Analysts say that this new capital will be used very cautiously in light of the general state of the reinsurance arena.
Therefore buyers of reinsurance, concerned about the current state of the industry and desiring to execute that `flight to quality' will probably find the fields of opportunity diminished in the next few years. Those reinsurance entities that survive will, without doubt, represent `quality' in the financial sense, but does that assure reinsurance buyers that their claims will be paid on time?
Paul Walther, CEO and principal consultant of Reinsurance Directions Inc, a company providing specialised consulting services to address reinsurance-oriented issues, said that buyers of reinsurance needed to examine more than just financial statements when choosing a reinsurer. There is a number of external and internal factors that come into play, and among the external factors, proper communication with the reinsurer is of inestimable importance, he said.
"If anything demonstrates clearly the need for clear communication among negotiating parties in an insurance arrangement, it's the current dispute over the World Trade Center," he explained. "Was it a Willis contract or was it a Travelers contract? Was the terrorist strike one event or two? Although no one could have foreseen such an horrific event, issues such as these need to be spelled out clearly at the outset. Especially these days, when reinsurers are being bombarded with new and unexpected exposures from all sides, they are going to be extremely judicious when paying claims. The buyer of insurance needs to make sure every `i' is dotted and every `t' is crossed."
Mr Walther said that not promptly reporting a claim to a reinsurer might be perceived as a reason for denying a claim. "Let's face it, we're in a tough market. Professional reinsurers will pay every claim that falls under the wording of a contract, but if the wording or late reporting or not reporting of claims will give the reinsurer a way of getting out from under a contract, then that's what will happen."
In addition, reinsurers should continuously monitor developments. "There has been a major consolidation in the reinsurance arena, not only with respect to the risk-bearing players, but also the intermediaries that place and service the business ceded to a large portion of that market," he said. "That affects the identification and collection aspects of the recovery process."
Mr Walther said that among the factors which complicate the reinsurance identification process is the literal disappearance of many reinsurance markets and intermediaries, whose very identities have been absorbed by their new parents. "Not only have various corporate identities been stricken from the record, but their corresponding contact personnel, who were integral to the reinsurance collection process, have likely suffered a similar fate, resulting from the downsizing that often accompanies the consolidation process."
Even if one can find the surviving intermediaries and reinsurance companies with the lawful obligation to assume responsibility for claims from old business, the collection process may well be hampered by the lethargy and/or blatant unwillingness of those parties to respond to obligations under old agreements. "In some ways, it's like two married people getting a divorce. While they were married, there was probably a cooperative spirit in their relationship. But now that the relationship is ended, further cooperation may be lacklustre."
Mr Walther said that such attitudes may be particularly prevalent if there is no ongoing commercial reason, nor income to provide an incentive to properly address those obligations. "Cedants to reinsurance markets should maintain accurate records at all times so that, if identification is achieved, then at least the cedant will be able to deal from a position of strength," he said. "Those records must also be kept current. It is fair to say that almost all reinsurance markets have undergone some sort of transformation in recent years, and an updated record of those markets will therefore be essential in order to have any chance of tracking down a debtor reinsurer."
So, there we have it. The `flight to quality' for reinsurance buyers is going to be a difficult one, given current market conditions and unusual developments in the reinsurance arena. When Mr Liotta's Darwinian effect is complete and only the fittest are left, the quality reinsurers may be easier to identify. But most likely they will also be more difficult to deal with in terms of rates and conditions, and much more hard-nosed about paying claims that are not reported on time, documented accurately and negotiated properly.