Are the days of boom and bust over? Ronald Gift Mullins asks if we are starting to see true evidence of underwriting discipline or is it just the calm before the storm?

In the past when the reinsurance industry began its inevitable decent into no-holds-barred competition by slashing rates to gain market share, the primary industry willingly followed suit. It cut rates and greedily appropriated the fallout from battling reinsurers. This negative situation continued until a powerful stimulus, usually a costly catastrophe, shocked the cycle back into profitability.

Now for the first time in recorded history, the reinsurance industry may have broken, or at least crippled, the devastating cycle that begins with rates going downward. Beginning in 2007, instead of hefty discounts in rates across the board, reinsurers exercised a measure of underwriting discipline and grudgingly offered slightly lower rates in selected lines.

Because reinsurance did not become readily available at attractive rates, primary insurers were in turn reluctant to chop prices. Primary insurers have learned that they can tap into the unfathomable resources of the global investment community and avoid, up to a point, reinsurers altogether. Consequently, while the two industries are tripping along in a softening rate climate, they have so far resisted a wholesale, free-fall of rates.

Less boom or bust

Sean Mooney, Guy Carpenter’s chief economist, says there are reasons to anticipate less of a boom-bust cycle in reinsurance markets. “Principal among these are changes at the management level, with reinsurance executives more closely attuned to the demands of their owners and more focused on generating above-average returns to shareholders,” he says, “as opposed to more traditional goals such as increasing top-line growth and market share.”

In prior soft markets, lower reinsurance rates led primary companies to buy more reinsurance, says John Iten, director at Standard & Poor’s. “We are not hearing a lot of stories like that now,” he said. “I think there is some pressure on reinsurers to lower rates, coming from less demand from primary companies for reinsurance. However, it is not anywhere near the competitive environment that existed in the late 1990s.” The soft market following Hurricane Andrew in 1992 persisted for six years.

Primary insurers, fat with capital from two years of extraordinary profits, have tactically decided to retain more of their risks. They are only passing on those risks that could extract a knock-dead blow such as collapse of oil platforms, hurricanes sweeping up the East Coast of the US or a pandemic to reinsurers.

According to the Guy Carpenter World ROL [rate on line] Index, reinsurance prices were down a modest 9% on average worldwide at 1 January 2008 renewals. Prices went down by 10% for US national programmes and 12% for US regional programmes. Average decreases in the UK and Continental Europe were 7.5% and 7% respectively.

Between the third quarter of 2005 and the first quarter of 2007, the average commercial property insurance premium actually increased 5%, according to David Bradford, executive vice president, Advisen. Citing Advisen’s Program Benchmarking database he reported that property premiums in regions without significant catastrophe exposures fell during this period. Between 2005 and 2007 the average premium per $1m of policy limit fell 19% for companies in the Midwest, and 25% for companies in the Western plains states, which have very low exposure to natural catastrophes.

“For the first time in recorded history, the reinsurance industry may have broken, or at least crippled, the devastating cycle that begins with rates going downward

More risk retention

There are insistent calls from rating agencies, regulators and investors to manage capital more efficiently. This oversight continues to exert some discipline on the reinsurance industry said Benfield in its report, Changing the Game. “Increasing retentions were a theme throughout 2007, suggesting reinsurance pricing is still relatively robust, in property lines at least,” the report says. “Demand for high level catastrophe cover, driven by updated catastrophe models, continued to increase. Credit crunch and dollar weakness had little adverse impact.”

Standard & Poor’s acknowledges that a softening market is driving the commercial lines sector to become more price-competitive, but says there is no agreement on the magnitude of the decline in rates. It cites a study of insurance intermediaries that showed the current average rate decline at about 13% year-over-year. Yet, the rating agency notes that while there is a tremendous amount of noise surrounding the issue of how quickly rates are declining, “the rate declines reported by intermediaries are good directional tools but are overstating the actual rate changes occurring for the large majority of renewal business”.

For the broader US commercial lines market, Standard & Poor’s believes the average rate decrease for the large majority of accounts grew to a more challenging mid-single-digit level in the second half of 2007 from a very manageable low-single-digit level through 2006 and early 2007.

Casualty reinsurance rates have not flattened that much, says Stephen Hitchcock managing director of Lockton Re. But he said there is pressure on casualty rates with so much capacity available. “Property rates are dropping dramatically in various lines,” he says, but observed that while rates are dropping, the underlying exposures on real rates for reinsurance are increasing dramatically.

Fantasy rate levels

Apparently, the rate declines in both primary insurers and reinsurers have remained relatively calm compared to past cycles where rates deteriorated to fantasy levels. Stephan Christiansen, director of research at Conning Research and Consulting, says, “I think that the weakening in rates for primary and reinsurance are somewhat in parallel. This year, a number of factors have caused reinsurers to be more moderate in rate cuts than primary.” As a reason for the moderation of rate reductions, he cites the fact that reinsurers are now more willing to release excess capital back to shareholders rather than use it to increase market share. “Capital seems to flow in and out of the industry more easily than in the past,” he continues. “Maybe reinsurers are not as concerned now as they once were to attract capital when they need it. They can utilise capital markets when they want to.”

“It is a truism that the (re)insurance market is always reluctant to return surplus capital, preferring to spend it in buying market share,” Benfield says in its report, but recent history suggests the “industry’s capital management, at least in some quarters, may have taken a new turn.” Benfield estimates that planned buybacks, special dividends and restructuring of capital all featured in more robust capital management strategies and have totalled more than $20bn since mid 2006.

Other factors influencing primary insurers’ tendency to retain more risk, Christiansen said, is that “they have excess capital too, and they are using better capital models and risk modelling to both evaluate risk and its trade-off to reinsurers.” He also notes that there is less willingness of management to go down the slippery slope by decreasing rates willy nilly.

“Experts are increasingly citing ERM as being a major influence on deterring the rapid descent to unrealistic rates

Evidence that the US reinsurance industry has chosen not to go down the “slippery slope” as well by slashing rates to increase market share is the slight reduction in total premiums in 2007 compared to 2006, but a surprising increase in underwriting gains. This continuing trend could indicate that reinsurers have resolved to write business at rates sufficient to produce an underwriting profit and have not yet resorted to undercutting each other to book more premium.

US reinsurers wrote net premiums of $22.7bn during 2007, a decrease of $3.1bn from 2006, according to a report by the Reinsurance Association of America. Yet, even with this drop in premiums in 2007 the reinsurers reported an underwriting gain of $1.681bn, up from $1.312bn for 2006. Policyholders’ surplus at year-end 2007 increased to $75.9bn from $74.5bn for 2006.

ERM to the rescue

Experts are increasingly citing enterprise risk management (ERM) as being a major influence on deterring the rapid descent to unrealistic rates for primary insurers and reinsurers. Leading reinsurance companies and insurers are implementing ERM as a framework under which they can most profitably manage their various categories of risk, portfolios and product development.

Time and implementation will determine whether ERM will at last be the rational force that will flatten the reoccurring, self-destructive insurance cycles that have long plagued the insurance and reinsurance sectors. This year will be telling. S&P expects to see insurers paying increased attention to ERM into 2008. “The experiences of 2007 and early 2008 have shown that ERM is an important discipline that will continue to be key for the financial health of insurers,” says S&P credit analyst David Ingram.

A study by PricewaterhouseCoopers has confirmed that ERM is now a key driver for a competitive edge in the insurance industry, but noted there is a serious gap between the design and planning stages, and the actual execution and integration of ERM programmes. The study suggests market and regulatory forces will continue to drive insurers to implement ERM as an enabler for attaining financial goals.

Reinsurers have shown consider interest in ERM practices but tools have yet to be tested by gigantic catastrophes, such as the five major hurricanes that occurred in 2005, notes AM Best.

Ronald Gift Mullins is an insurance journalist based in New York City.