Ronald Gift Mullins examines how the prices for the reinsurance industry may have a healthier glow in the future.
Declining investment portfolios, increased reserving for World Trade Center (WTC) losses, the reemergence of asbestos claims and the uncertainty of future profits have resulted in a negative outlook for share prices of the re/insurance industry now, but the future may be more promising.
The latest figures from the Reinsurance Association of America (RAA) show that premium growth has not continued the spurt in pricing following September 11. According to the RAA, net premiums written by a group of about 30 reinsurers, comprised of US and non-US affiliates, were $14.6bn in the six months ended 30 June 2002, up just 6% from $13.8bn in the first half of 2001.
For the six months ended 30 June 2002, the group racked up a net loss of $814.4m, compared with a net profit of $484.8m for first half of 2001. In spite of the net loss, however, policyholders' surplus from period to period increased a staggering $12.4bn, a surge of about 50% from $25.8bn to $38.2bn. This additional capital was mainly used to set up new reinsurance operations in Bermuda and Europe, leaving the balance of the reinsurance industry with inadequate capital.
The ratio of surplus to net written premiums (NWP) declined from 1:54 in the 2001 period to 1:38 in 2002, indicating that either the additional billions of capital were not being used to write business or that re/insurers were finally being highly restrictive in risk selection. With such unprofitable underwriting results, Wall Street investors began a wait-and-see attitude concerning the industry's potential for producing sustained profits in the last half of 2002 and early 2003.
According to a report in February 2002 by the Insurance Information Institute (III), in 1999, property/casualty re/insurance stocks (on a market cap weighted-basis) lost 25.7% of their value (compared to a gain of 21.0% for the Standard & Poor's 500 index). In 2000, the first hints of a hardening insurance market brought a 43.4% increase (compared to a 9.1% decline in the S&P 500) in re/insurance stocks.
Following the September 11 terrorist attacks, re/insurance company stocks dropped precipitously, but recovered by year end to be down only 1.2% for 2001 (compared to a decline of 10.9% in the S&P 500). Investors have recognised, the III report said, that insurance companies are "both paying claims stemming from September 11, and are taking steps to adapt to a very different environment in the aftermath, while preserving their long-term financial strength."
Most insurance stocks were keeping pace with the S&P 500 Index in early 2002. Comparing share price changes (see charts) from 10 September 2001 to a year later, according to figures furnished by SNL Financial, p/c primary insurers were up 3.5% and reinsurers up 2.2%, compared with a decline of 3.9% for all insurers and a drop of 16.7% for the S&P 500.
In a special report issued earlier this year, rating agency Fitch noted that the result of Europe losing more capacity than the US over the last year has been a commensurate faster rate increase. "In addition, we believe some US companies have made a conscious effort to reduce their limits and risk aggregations in response to capital market pressures and that these decisions are constraining premium growth," Fitch stated.
However, the report said, the global reinsurance industry, despite substantial rate increases, has not recovered sufficiently to earn reasonable returns, and Fitch continued its negative outlook for the US and global reinsurance markets. The rating group did observe that "there is generally a renewed commitment to disciplined underwriting by reinsurers.... This commitment will be strongly tested, and there are many challenges that may hinder progress towards underwriting profits."
A recent report from Moody's, the credit rating agency, said the performance of the reinsurance industry would be hindered by poor investment returns and the burden of building adequate loss reserves for WTC losses and new asbestos claims. The report noted that while these forces could dampen operating earnings, "we believe that the industry will continue to demonstrate the resolve necessary to maintain the pace of rate increases and will tighten underwriting guidelines to improve profitability."
It then warned: "If companies do anything less, investors and creditors could begin to question their involvement with the reinsurance industry."
Rating agency Standard & Poor's maintains that even with the market correction of rates brought about by the WTC loss, it continues to adhere to its negative outlook for the reinsurance industry because of uncertainty over the sustainability of the rate increases. S&P believes that although the reinsurance market is making firm statements, saying it does not want to return to a cyclical market, it has yet to prove that it has forsaken its old habit of writing at a loss to gain market share when competition increases.
William Coyner, senior research analyst at SNL Financial, said the low point for re/insurance stocks came in July 2002, and started rising in August and September. "I think that after September 11, 2001, pricing was not necessarily up to what most analysts and investors wanted it to be," he said. "Company officers were telling us that six months to a year would have to lapse before positive results would be evident." He added that the pricing increases that have been seen have not yet resulted in higher earnings.
Though there has been about $20bn of capital added to the re/insurance industry within the last year, more than $9bn has been sent to Bermuda and Europe to set up new reinsurance companies. "We're certainly concerned that the new capital in Bermuda is having a controlling effect on pricing in property catastrophe coverages," said Gary Ransom, managing director of investment bank Fox-Pitt, Kelton. He said there were a lot of scenarios for the future of these start-up companies: "A couple of them will evolve into real companies and become competitors, others will return their investments, then be absorbed into other companies."
SNL's Mr Coyner saw the new reinsurance companies as increasing competition, which could pressure reinsurers to lower prices. "This will help primary insurers," he said, "in that they will not have to pass on as much of their premium to buy reinsurance."
A research note from Standard & Poor's said the Bermuda start-up ventures have remained very disciplined. They have not been cutting rates yet, but as competition increases for quality business, and as their investors began to demand higher returns, the pressure may start to build by year-end 2002, "followed by marching orders to management teams in the spring of 2003."
Believing that the volatility of reinsurance has negative appeal for investors, several insurance companies and some holding companies have decided to shed their reinsurance operations or close them down. "In today's environment, unless reinsurance operations are truly a core earnings generator of an enterprise, they will be sold, spun-off or shut down eventually," said Fred Loeloff, director at Standard & Poor's.
There has been speculation that General Electric has been shopping around for a buyer for its reinsurance operation, Employers Reinsurance Corp, or exiting the line through a partial initial public offering (IPO). Gerling Global Re Corp of America has been put into run-off by its owner, German re/insurer Gerling Group, and in June, St Paul Fire and Marine Insurance Co said it was opting out of reinsurance when it announced it would spin-off St Paul Re in a $1bn IPO to form a new Bermuda reinsurer, Platinum Underwriters Holdings. St Paul was to retain less than 25% of Platinum, but the IPO was delayed due to the sagging stock market. In August, the IPO was amended to about $920m, but no new issue date was provided.
Additional contributions to reserves also did not provide comfort to investors. German giant Munich Re said in July it had kicked in an additional $2bn to boost reserves at its US subsidiary American Re, as well as shifting another $500m into reserves for its group-wide operations to cover WTC claims. Other companies adding to reserves include Berkshire Hathaway's General Re, XL Capital Ltd and Employers Reinsurance Corp. More reinsurers are expected to announce reserve increases in the coming months as claims from the WTC destruction continue to crystallise.
As the lead reinsurer on the WTC cover, Swiss Re could suffer the most if the impending court case brought by WTC leaseholder Larry Silverstein results in a judgment that the destruction of the twin towers was two separate events. Should the court fall on the side of two events, Swiss Re faces a doubling of its current payout of $3.6bn. Uncertainty about what that decision could mean for Swiss Re sent its share price to a low of $68 in early September, down from $101 at year-end 2001.With the decline in share prices for re/insurance stocks has come a brake on mergers and acquisitions as `share currency' has been deflated.
"There has been a slowdown in mergers and acquisitions because capital positions are lower than they have been in a while," said Mario Mendoca, life insurance analyst at investment bank CIBC World Markets. "Now is not the time to use cash to buy something - very small deals are going on, but not the big ones."
Fox-Pitt, Kelton's Mr Ransom noted that the most immediate impact of the decline in share prices is the increased difficulty in raising capital. "You would think that acquisitions would be attractive with most companies' share price at their low point," he said, "but no insurer has a lot of cash to do that, and companies are unwilling to make use of their own stock."
Strong will survive
There is also an emerging attitude that as insurance buyers leave weak companies and take a `flight to quality', the strong re/insurance companies will gain in market share at a fair price and avoid the hassle involved with acquiring other companies altogether.
And while p/c re/insurers have been having problems, the life re/insurers have also been suffering, according to analysts. "Definitely, life companies have been hit the hardest by the fall in the stock markets," SNL's Mr Coyner said. "Main reasons: p/c companies don't have money tied up too long, so they can recycle it rather quickly. Life and health have long-term investments in bonds and real estate, little in equity. Also, the variable annuities sold in such huge quantities in the roaring 1990s take a chunk of a company's market capital when the stock market doesn't do well."
Standard & Poor's observed in a report that in North America since the 1990s nearly 70% of all new life insurance is being reinsured. "Clearly there is a natural limit to this number, and that limit could be very near," the report said. Overcoming the combined influences of difficult investment conditions and volatile mortality results may make profitability hard to come by in the next year or two.
Mr Coyner believed that share prices of p/c re/insurers will about breakeven at year-end 2002 compared with last year. "Price increases are coming and there have been no re/insurer collapses from losses. I think the third and fourth quarter of 2002 will see continued pricing increases for p/c and this will result in improved financials in 2003. I think they will do well in 2003."
He continued: "There is still a terrorist risk, but depending on what is in the bill the US Congress passes, if it benefits insurers it will help improve insurance stocks. Further, with improvements in investments it will be a positive all the way around."
"The future for reinsurers is starting to shape up better than what would have been expected," said Mr Ransom of Fox-Pitt, Kelton. "The forces that are driving rates higher are beneficial for share prices. One is that the big insurers and reinsurers, especially in Europe, are pushing price a lot more, and being global players, they have an impact on the market. Two, claims and expenses are continuing to hit reinsurers and this will perpetuate the need for rate increases, especially on the casualty side.
"In another year, I think the shares of insurance and reinsurance companies will be up. The next real catalyst for these stocks is to see that real earnings are starting to grow and are sustainable. And are convincing. A good combined ratio, if it is made up of a lower ratio that has a lot of increased reserves, is a better sign for a positive return than if it were for lots of claims paid. The question is, how sustainable is the rise in pricing?"