As the 2005 financial results slowly reveal the balance sheet impact of the 2005 storms, Nigel Allen considers the appeal of the reinsurance sector from a client perspective

An overview of the reinsurance market reveals a very divergent picture.

At one end of the scale there are the mono-line property catastrophe reinsurers, heavily reliant on retro cover, that have seen their balance sheets virtually blown apart by the 2005 storms, while at the opposite end there are the well established, well diversified, relationship-focused reinsurers that have weathered the storms well, and have even managed to prise a profit out of the worst year in the market's history. Add to this mix the eagerness of the Class of 2005 to gain a foothold, and the growing appetite of the capital markets for risk, and from a reinsurance buyer's perspective, the current dynamic of the reinsurance sector clearly provides a host of options.

RISK REASSESSMENT

"What we saw at the January 2005 renewal season was a decision by primary companies generally to retain more risk," says Chris Waterman, a senior director at Fitch Ratings, a development which he attributes to a number of factors, including, "the increased cost of reinsurance protection, and also, having experienced the catastrophes in 2005, the fact that the underlying rating environment is hard and that business is profitable and there are some ceding companies that continue to have strong balance sheets that wish to retain more business simply for the fact that it is profitable."

Any suggestion that this increased risk retention is symptomatic of a perceived devaluation of reinsurance on the balance sheet is quickly dismissed by Wilhelm Zeller, chief executive of Hannover Re. "The contrary is true," he states, "the value of reinsurance protection has increased. With the industry-wide reassessment of major risks the supply of reinsurance capacity has shrunk while demand for protection among primary insurers has increased. This has resulted in the observed strong price effects for the now more sought-after reinsurance covers."

Morley Speed, managing director of HSBC Insurance Brokers concurs. What cedants are now doing, he says, is "putting a proper value on (reinsurance)".

This is reflective of a heightened level of sophistication in the buying strategies employed by cedants. Speed believes that buyers are re-evaluating the role of reinsurance and cites a major influencing factor in this reassessment as being a change in those involved in the buying chain. "Since the World Trade Center disaster, when we witnessed examples of panic buying, companies' chief financial officers have gained a much greater influence over the buying process," he says, a move which has eradicated many of the "money swapping deals" which were occurring at the bottom of programmes.

Donald Macdonald, a partner at the Donald Macdonald Partnership, is of a similar opinion. The rise in retentions has seen a commensurate rise in limits, he points out - a clear indication of a greater understanding of how to measure the value of reinsurance. In his experience, Macdonald believes that reinsurance buyers have tended to purchase more than they need, or buy inefficiently, a fact that he is convinced is now changing.

"Reinsurance is being bought much more intelligently - against the balance sheet, and not as previously on a silo-by-silo basis."

This reassessment of the value of reinsurance, it should also be noted, is coming at a time of greater regulatory awareness of the role played by reinsurance on the balance sheet and the potential for a risk imbalance posed by being overly reliant on the "safety net" afforded by reinsurers.

In the UK, for example, the implementation of capital charges by the Financial Services Authority related to credit risks on the balance sheet have served to focus the minds of buyers on the credit risk posed by reinsurance cover.

Add to this more recent moves by the rating agencies, such as that of Standard & Poor's, who confirmed in December that they were introducing into their risk-based capital model from 2006 a risk charge which the agency said would "constitute 20% of the amount outstanding against the reinsurers' share of those technical reserves relating to asbestos, environmental pollution, and other similarly long-tail lines," and the pressure on cedants to ensure that their reinsurance buying strategies are focussed and effective is clearly great when one considers the financial penalties now applied.

As credit analyst Simon Marshall warned, "In this context, our analytical assessment will become increasingly negative when a cedant's commercial strategy and competitive position are found to be overly dependent on an ability to lay off a major part of the 'working layer', as well as the peak risks, to reinsurers."

It is therefore not surprising that, given these reinsurance-related financial penalties, there has also been a re-evaluation of the relationship which exists between cedant and reinsurer. According to Macdonald, buyers are now seeking "a much more tailored response from reinsurers to their individual portfolios", which he says is reflected in cedants' refusals to bear the brunt of rates hikes on loss free programmes in the renewals.

Furthermore, he believes the relationship is now moving beyond that of 12 month blocks to a more long-term outlook. From the perspective of the buyer the relationship "will be much less about a 12 month cycle and more about achieving long-term goals working with a select number of core reinsurance partners." If this is the case, then it would appear to be a system that lends itself more to the relationship building mentality of the European market than the more opportunistic nature of the Bermuda environment.

This theory seems to bear fruit when one considers the actions of the European heavyweights of Munich Re and Swiss Re, which both experienced a successful year-end due to their decision to stick with their technical rates, a fact which went down well with their client bases and also saw them win back some of the market share which they have lost to Bermuda and London.

But the foundations of the reinsurance relationship must be built on sufficient levels of information on the risk which is being transferred.

As raised in the February issue of Global Reinsurance, the latest renewals were dogged by delays, partially as a result of reinsurers conducting much more extensive analysis of all programmes offered. According to Speed, one reinsurer explained to him recently that the value of the quality of information provided by the cedant is not only key in the initial assessment of the risk, but is also paramount when a large loss is incurred. "Everyone has to be in a position to provide an estimate in days," the reinsurer explained to Speed, and in order to ensure this fast turnaround the information they hold must be accurate, as any major readjustment of the estimated losses at a later stage can have severe financial consequences. One need only consider the four notch rating slide of PXRE, share price plummet and client departures which occurred in the immediate aftermath of its announcement of a $281m to $311m hike in its hurricane loss estimates, to understand the dangers of inadequate loss assessments.

FLOCKING TO QUALITY

The January renewals saw the continued flight to quality trend, as once again buyers have attached great importance to the credit standing of their reinsurance partners. Speaking following the announcement of their 2005 financial results, Hannover Re's Wilhelm Zeller said, "The treaty renewals again demonstrated that ceding companies are attaching ever greater importance to their reinsurer's financial strength," a fact which he said had enabled the German reinsurer to "profit disproportionately strongly from this climate." The better the rating, the greater the amount of business shown to the reinsurer and the more selective they can be in terms of the risks which they take on. As Grahame Chilton, chief executive of Benfield, highlighted recently in his talk at Lloyd's on the future of reinsurance, "There is a clear floor rating of 'A-' which is well established as the entry point for any reinsurer wanting to grow its book of business." However, he adds, there is an argument that any ratings higher than "A-" are effectively equal, pointing out the fact that a reinsurer gains no pricing advantage by holding a higher rating. "However," he submitted, "there is a benefit in terms of the quality and volume of business."

It is at this "A-" floor level that the majority of the Class of 2005 have entered in search of that business which is not vacuumed up by their better-rated competitors. But in this highly competitive environment, as reinsurers fight over what would appear to be a smaller amount of better quality business, this does mean that we have seen a marked increase in the number of companies which are now hovering over the "B" rating credit cliff. "There are a number of companies out there which from whatever rating agency have "A-" rating," says Fitch's Chris Waterman, "and there is a danger that if one went through a period of significant stress, that some of those companies would fall into the 'BBB' category, at which point there would inevitably be some anti-selection."

Waterman also raised concerns about the fact that so many of the new start-ups were able to achieve an "A-" rating. "Fitch Ratings has looked at a number of the start-ups, and we felt quite strongly and still feel quite strongly that achieving an "A" range rating out of the box because of the risks associated with start-ups, particularly at this time, would mean that they would be unlikely to get into the "A" range.

Macdonald, however, does not believe that reinsurance buyers are so reliant on such ratings, and considers that most major players employ their own in-house capabilities in the buying process and "have a healthy scepticism of the services provided by other groups such as the brokers and even the rating agencies."

CAPITALISING ON THE MARKETS

There has clearly been a shift towards a much greater role being played by the capital markets in the reinsurance sector over the last 12 - 24 months, not just in terms of their involvement in the bank rolling of the new start-ups but as a means of alternative risk transfer. As Grahame Chilton explained, it has now become much easier for the capital markets to tap directly into the demand for reinsurance, but it must be remembered that this relationship is two-way. "The reinsurance market needs more capital, but the capital markets can't play directly without reinsurance market underwriting expertise," and furthermore are reliant upon reinsurers for their distribution channels.

"I think the capital markets converging with the reinsurance markets is another major potential shift," believes Macdonald. "It has been in the background for the last decade or more, but now on an almost weekly basis there is news of another cat bond having been issued." If one also considers the changes which are occurring in the way risks are being assessed and compartmentalised, there is clearly the potential for the involvement of the capital market to grow. "Increasingly, buyers and sellers will require that the risks that are involved are much more clearly defined," explains Macdonald. "Buyers want differentiation and sellers want transparency. That again lends itself to capital market treatment, because they will insist that risk is clearly segmented."

However, the involvement of the capital markets in the reinsurance sector will always be limited by the fact that what the industry is seeking to transfer is straightforward volatility, which has limited appeal. While Chilton welcomes the greater role investors are playing in the industry, he makes clear that "their appetite for the extreme volatility of catastrophe risk in particular will always be constrained by its unpredictability."

PRICING IN 2006

There is a general expectation that the forthcoming renewals will see further rate hikes, particularly in July, with its focus on the US market and will serve to compensate for the somewhat disappointing and rather restricted rate hikes achieved in the January renewals. Wilhelm Zeller firmly believes that the forthcoming renewal deadlines will see the current advantageous ratings environment improve further. "The adjustment of pricing models will not be restricted to windstorm aggregates in the USA," he believes, "but is likely to be extended to other areas of peak exposure in the portfolios - such as earthquake covers. Competitors who have not yet built the new loadings into their quotations will have to follow suit in the course of the year, a move that should cause prices for catastrophe covers to rise across the board. In view of the rating agencies' more exacting capital adequacy requirements - which also have to be incorporated into the pricing calculations - and the risks that have to be remodelled across a broad front, one can expect increasing demand to go hand-in-hand with shrinking supply."

However, Chris Waterman is not so sure that this will necessarily be the case. While he expects to see the April 01 and July 01 renewals seasons bring further rate increases, he does not believe that it will be significantly different from 01/01, with a number of factors potentially offsetting any significant positive price movements. Waterman cites the continued impact of new capital chasing new business, the fact that many of the established reinsurers have now significantly replenished their balance sheets, and the growing impact of the Class of 2005, with those new entrants who failed to get out of the starting blocks competing strongly for new business. "I don't think we saw the Class of 2005 playing to their full potential in 01/01."

Macdonald sums up the potential 2006 rate movement dynamic as follows, "Just as one sector applies an increase in rates, another sector applies the reverse. There is an interesting tension between all of these factors." We shall wait to see how this tension impacts on the buyer/reinsurer relationship with interest.

- Nigel Allen is editor of Global Reinsurance www.globalreinsurance.com
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