A year on from the largest ever loss, Dermott White examines how the reinsurance community has come to terms with the events of 2001 and reports with the latest analysis from Monte Carlo's Rendez-Vous 2002.
Courage. Strength. Resilience. The reinsurance industry is coming to terms with September 11. No one in the industry will ever forget it, but painful memories of that day in 2001 have given way to a sense of pride at the way the industry coped, first with the emotional and personal blow and then with the ensuing financial losses.
For delegates at Monte Carlo's Rendez-Vous de Septembre 2002, the test provided by the World Trade Center (WTC) disaster proved the strength of the industry's backbone: the underwriting market kept moving in the face of its biggest loss ever. And, while acknowledging difficulties ahead, there was optimism at this year's Rendez-Vous for the upcoming renewal season and the market's medium-term future.
"Gradually ... the traditional industry has successfully generated the capital necessary to handle the claims and I look back with admiration at the way the industry dealt with that," said Nicholas Munday, a partner at London-based law firm Clifford Chance. "I would say the world hasn't changed, although we do need to look very carefully at the way we do things because the industry could not have handled another September 11. We must learn from that experience."
Charles Cantlay, the deputy chairman of Aon's UK reinsurance group, had a similar perspective. He said: "As we sat there after the September 11 loss, I think it's fair to say the market was in a total state of shock. Nobody quite knew what the future was going to bring. And we weren't certain how much capacity was going be there in the traditional risk market. So, there was the ART alternative and there was the capital market alternative. But neither of these have come remotely close to challenging the demand for traditional risk transfer in the traditional market. That's not say that they're flawed products because they're absolutely not. But the demand from our clients at the moment is very much still for the traditional risk transfer ... and apart from the hotspots, there is that significant capacity which is still there."
Perhaps too much capacity. One concern raised at the Rendez-Vous was that the strong flow of capital into the market since September 11 has diluted rate rises to the extent that the hard market will not last long enough to truly help the industry. The reinsurance sector faces problems on two fronts; on the liability side of the balance sheet because of last year's catastrophic losses, and on the asset side of the balance sheet because of depressed equity and bond markets. Evan Greenberg, the vice-chairman of ACE Ltd in Bermuda, said: "The global reinsurance market is under a lot of stress. There is a price to be paid for the past, in terms of balance sheet weakness from underwriting during the soft market and there is a lot of development that continues to plague and affect the incumbent players. That, coupled with a greater recognition of risks - 9/11, natural catastrophes, developments in the financial lines areas, D&O, E&O - all of these areas of risk are plaguing new players but incumbent players more so. Therefore, there has been reassessment of risk and what you're willing to expose your balance sheet to. And if you are, what's the proper risk/reward for that exposure? ... And on top of all this, you load on to it what has happened in the equity and bond markets and how that has affected the balance sheets."
However, some delegates saw possible long-term benefits from the inflow of capital. "I think the result of new capital might not have been what many existing reinsurers wanted to see. Rates might have been somewhat higher if we were not on the scene but that dampening effect in the long run might be somewhat wholesome, in that there will be a little bit less drive to set up captives, a little bit less dislocation with the buyers. It's just possible that in five years people will look back and say it wasn't a bad thing at all to have new capital come in," said Paul Ingrey, chairman and chief executive of Bermuda-based Arch Reinsurance Ltd.
Most observers said that while the most significant price increases had already taken place, they still expected further rate rises this year because the amount of capital that had entered the market had not been enough to fill the gap created by existing reinsurers downsizing, refocusing or pulling out of the market. Many at the Rendez-Vous said they saw good opportunities for growth and profitability.
Mr Greenberg added: "Prices have risen but the perception in the marketplace, which I believe is correct in many lines of business, is that it is still underpriced so the market should continue and will continue to tighten."
Henry Keeling, the chief executive of XL Re had a slightly different perspective: "Traditionally, in hard markets, clients tend to say, `I've only got so much money to spend, my prices are going up, I'm only going to buy less cover for the same premium'. We're now seeing situations where the prices are going up but they're buying more cover because they're under shareholder pressure and they're under management pressure not to get it wrong, not to get caught out in the event. So we're seeing a slight reversal of previous trends. And that's why I'm very confident that even in the shorter tail lines we're going to see a harder market environment for some period to come."
The last renewal season was particularly difficult for the re/insurance industry because the WTC disaster happened so late in the year, and because it altered the perception of risk. This left the industry with little time to reassess its reinsurance agreements.
However, this year's renewals are still expected to be testing. Aon's Mr Cantlay said: "What we've found is that this year every one of our clients has come to us looking for alternative strategies, looking to benchmark what they've already bought, to see whether it's the best they can buy or whether there's something else out there that they could do. That's been a real challenge for us this year - providing clients with the right buying strategy as they go into 2003 is going to be a major challenge for us."
September 11 has given cedants and reinsurers a greater understanding of the systemic nature of risk as well as the possibility of greater risks created by terrorism and changing political environments. Also, the market is now more aware of risks in the financial lines and D&O areas, thanks to Enron, WorldCom et al, as well as the nosedive of the US equity markets.
Lars-Eric Lundqvist, the senior vice president of insurance at the International Cooperative and Mutual Insurance Federation (ICMIF), said: "There is definitely a different appetite for risk among our members. There is definitely more caution to make certain that whatever risks the companies assume, they can live with them and feel very comfortable with them. I think this will also be looked at very carefully by the insurance companies as it's still not clear what will be covered by the reinsurers in the next renewal."
XL Re's Mr Keeling said: "I'm not sure we now actually live in a riskier world but our perception of that risk has changed. And the way in which so many lines of business were brought together in 9/11 demonstrated that the conventional theory of non-correlated, non-accumulating businesses as being a good thing to aim for, has been debunked to some extent. We now know that most of these lines of business really can aggregate in extreme scenarios."
A deeper understanding of risk requires more accurate, detailed information. Geoffrey Bromley, the chairman of broker Guy Carpenter & Co Ltd in the UK, pointed out that renewals for 2003 would also be characterised by reinsurers' needs for far greater information about the risks they were underwriting. "What many companies have appreciated is that we were doing things shorthand in many ways and to fully appreciate the width and breadth of the risks which face us, we must better understand the risks we are covering. I think this is a major and probably lasting change as a result of September 11 and the losses which occurred. There are far greater requirements on information now, and for many, if you cannot provide information of the depth required, coverage will just not be available, it won't be a matter of just price," he said.
Quality of information has taken on a new significance for reinsurers and it emerged at the Rendez-Vous that many were starting to differentiate in terms of the quality of the submissions they received. Mark Boucher, the executive vice president of Bermuda-based Endurance Specialty Insurance, said: "We're a technical shop. Some might say that is a bit boring, or even old-fashioned, but we think it's the basis of underwriting that if you don't have your core competency of underwriting, you're not going to be able to make the right decisions for your shareholders or even your customer base. So, for us, quality of data is absolutely the cornerstone of our underwriting models."
Richard Smith, president and chief executive of Employers Reinsurance Corp, said his company was following a similar strategy: "We're focused on getting back to the basics of underwriting discipline. Differentiating our products and our customers - those that are core and strategic versus those that are opportunistic. Focusing on making an underwriting profit is critical - for us it means not renewing pieces of our business that no longer fit our risk-return equation."
The driving force behind the need for underwriting discipline is the desire to achieve shareholder returns in the current weak investment environment. PricewaterhouseCoopers (PwC) partner Paul Delbridge said that a new PwC survey of the London Market showed that re/insurers were now focusing much more on return on capital and were being far more discerning about the risks that they took on. He said: "People are pulling out of aviation, US casualty, US property and, particularly, US D&O.... Post-September 11, and even before that, there has been a much greater focus on discipline around underwriting. In particular, pricing risks more accurately ... more prominent monitoring of risks. More modeling is being brought to bear. People who historically have not used the more advanced modeling techniques are now exploring those and upgrading their IT systems." Mr Delbridge added that the flight to quality related not only to better information but also to greater financial security among reinsurers.
"What we have seen post-September 11 is a move very much towards those very secure reinsurers, even at the prices that were being demanded," he said. "We're seeing much higher thresholds in terms of minimum security requirements and if you've seen the way the London market has historically been very geared, you can understand why secure reinsurance has become much more prominent."
Mark Hewlett, Europe managing director of insurance at Moody's Investors Service, agreed with this view: "I think there is a flight to quality. Size is becoming a much bigger issue than before. People are taking a lot more time before making decisions about where they place their business, generally being a lot more thorough in that process."
When talk turns to security in the financial sector, inevitably it relates to ratings. Mr Keeling, from XL Re, said ratings had always been an important issue but they had become even more important: "With all the instability and uncertainty surrounding companies - are they for sale? are they financially secure? - people are prepared to pay a premium price for quality, security and good products."
However, there was a growing awareness at the Rendez-Vous of the difficulties associated with maintaining the highest ratings and that they were not always reliable indicators of financial strength.
Mr Lundqvist, from ICMIF, said: "It is very difficult for a company to look exclusively at the rating of a reinsurance entity. There were several reinsurance companies with `A' ratings one or two years ago that are no longer with us. At the same time, for a reinsurance company to keep a triple-A rating is probably not really economical because that will bind so much capacity. So it might not be necessary for the risks they are taking. This means for cedants, it's vitally important to know their reinsurers very well - to know what risks they are involved in and to know if there are some major changes to the underwriting policy."
Paying the right price
Standard & Poor's financial services ratings director Christian Dinesen said the reinsurance industry could overcome this problem in the same way that the banking industry had learned to cope with capital shortages during the emerging markets crises and the recession of the early 1990s. "What happened in the banks was a much more intense management of capital, making the capital much more risk-based, accepting that shareholders want to know the equity part of the return-on-equity equation and communicating that more clearly. Now, the big unknown to us is whether the reinsurance industry will be able to achieve the same increase in buyer sophistication that the banks achieved. Today in the banking world, on a corporate syndicated loan, you will use a number of different banks and you will pay them differently depending on their ratings. Whenever we make this argument, that the only way you can actually sustain different levels of capital in different reinsurers is by paying them differently, the normal response is that you can't do that because of the way the reinsurance industry is structured. We understand that exactly the same arguments were made by the banking industry about eight or nine years ago but today this seems to be working extremely smoothly. If the reinsurance industry does go down that way ... I think it has a very good future."
That future is also likely to involve more sophisticated forms of risk transfer, such as `swaps'. Swaps involve two companies meeting and trading, for example, their catastrophe exposure. A company in Japan could trade part of its Japanese earthquake exposure for a piece of a US company's Californian earthquake exposure.
Richard Clinton, the president of catastrophe modeling company EQECAT, said: "Where we come in is that we can quantify these exposures to ensure that it's an equal swap to ensure that the probability of an earthquake in one area is equal to the probability of a loss in another area. To the extent that that is not possible, that there is some imbalance, we need to quantify that in terms of pricing ... normally we are able to arrange and work through the estimate of losses to get them to be fairly equal."
He added that one of the advantages of swaps was that they involved less frictional cost. "Basically it's two companies sitting down and writing up their agreement. You don't have to go through ratings agencies, or anything else. So it's much more efficient," he said.
Despite the reinsurance industry's returning confidence, Moody's is not positive for the short-term. The ratings agency said in a report released at the Rendez-Vous that its "near-term outlook ... is negative given the lingering effects of the soft market." It added that downgrades would continue to outpace upgrades for the next year to 18 months but noted that it did not expect systemic rating changes.
The main reasons for the gloomy prognosis were familiar factors for reinsurers: lower investment returns, emerging asbestos claims and adjustments to WTC loss estimates.
Even in the long-term, it said, reinsurers faced an "uphill battle" to maintain their credit quality and ratings because of the industry's vulnerability to the reinsurance cycle. Also, it pointed to the challenge that the industry faced in trying to deliver the return on equity demanded by shareholders while holding sufficient capital to maintain the financial strength demanded by customers.
The only positive note was the medium-term scenario, as positive re-pricing led to improved operating results.
Meanwhile, Dirk Lohmann, the group chief executive of Converium, said he expected a renewed focus on traditional reinsurance and underwriting profitability in 2003 and 2004. Mr Lohmann, speaking at PwC's annual Monte Carlo breakfast meeting, added that the market hardening had not yet peaked. However, he said he expected past liabilities to continue to emerge, which would put pressure on results and cause more exits, both voluntary and involuntary. He added that the remaining conglomerates were likely to dispose, close or spin-off non-core reinsurance activities and that, of the new Bermuda players, he expected some to prove unviable and some to be consolidated out of the industry. Lloyd's, he said, would "continue to evolve back to its roots of being a specialist insurance market."
The Rendez-Vous de Septembre in Monte Carlo is the precursor to the hard graft of Baden Baden. It remains the most cost-efficient way of meeting a large number of industry people in a very short time. This year, there were fears that attendance would be down because of market conditions but this proved not to be the case. Activity was high and it continues to be the essential place to start the renewal process. Delegates use it to gauge the mood of the market, to confirm facts and rumours that they may have heard, and to get an insight into what can be expected in the coming months.
If there was one difference between the 2002 meeting and others, barring 2001, it was the memory of the WTC disaster. Ian Lazarus, a partner, at recruitment consultancy The Miles Partnership, said: "If we talk about changes that have taken place in the reinsurance industry in the last 12 months, obviously one's immediate thought would have to go back to what happened this time last year. It's become a very serious industry. I think everyone in the industry from the senior management to the very junior people have recognised that there is no job for life any more, and people are required to work harder, to think smarter, to only focus in areas where they really know what they're doing."