Investment bank Fox-Pitt, Kelton, part of the Swiss Re stable, asks whether the hard market has already run its course.

Fox-Pitt, Kelton entered the January 2003 renewal season looking for at least a 10% global reinsurance price increase, down from 15-20% in 2002. These figures include changes in limits, deductibles and attachment points but exclude the impact of tighter policy wording. As guesstimates, they are a useful guide to the relative hardness of the pricing cycle but cannot be directly translated into companies' premium growth. We looked for price increases of around 10% in property and much higher in casualty business. Europe was expected to be harder than the US given the disproportionate impact on capital of equity market falls, the greater volume of high profile capacity withdrawals and the fact that most Bermudian capital was targeted at the US.

As we end the renewal season, the global price increase may turn out to be no more than 10%, and some commentators have disclosed particularly low numbers for the key US and German markets. Momentum has visibly slowed and disappointed many. Could it be that the hard market has already run its course?

Market caution
We see a number of elements that, at least for the near term, urge caution about the duration of the hard market. The pricing impact of falling industry capital may have been overstated. Swiss Re's sigma estimated in September 2002 that the global p/c industry lost $200bn of capital from its $700bn end-2000 base. This was offset by some $22m of net capital raised. The 25% underlying fall in capital is oft-quoted as the basis for the unusually prolonged hard market that the bulls project. However, the capital base at the end of 2000 was excessive. FPK estimates that the five quoted European reinsurers had some four times the minimum amount of required capital at that time, concentrated in some obvious large names. Coming from a base of excessive capacity, it is likely that a proportion of the fall had only a marginal impact on pricing.

Demand has disappointed some players. Primaries and corporates have been more willing to retain risk than pay the high prices demanded by the reinsurers. Some of this may reflect the lack of catastrophes and low claims inflation in many markets. The weakness of demand also highlights that some reinsurance capacity was bought in the soft market only on the basis of price, not because of the client's own perceived risk needs. If a reinsurer tries to up the price of coverage that the primary never needed, the primary will have few qualms about dropping the business.

We also believe that the impact of the new capacity entering the market has been greater than the $22bn figure implies. The new, primarily Bermudian, names that have emerged in the past 18 months have generally been formed by reinsurance industry leaders. These people know how to tap exactly the hardest parts of the market. They have been particularly aggressive in the US property market where the quickest profits can be made. This new capacity has therefore disproportionately depressed price increases in exactly the areas where the incumbents had hoped they'd be best. Small players can also have a depressing impact on the pricing power of the large names on a treaty. The incumbents may target super-normal profits to rebuild reserves and capital adequacy. The new players have no such problems. Their pricing requirements are therefore structurally softer than the general market's. It is difficult for the lead reinsurer to argue for a 30% price increase if smaller players are telling their client and broker that they are willing to quote a lower price.

Capacity crunch
The best hope we have for the hard market from here is a further major capacity crunch. This could come when incurred claims finally become cash payments, if there is a further deterioration in casualty losses, or if investment values fall further. This may be good for prices but it's unlikely to comfort the owners of the companies who suffer.

Therein lies the rub. As investors, we have now lived through two years of `kitchen-sinking' of incumbent reinsurers' loss reserves. Combined with investment market falls, these have more than erased the earnings of most global reinsurers. These players have done little to demonstrate that current reserve levels are adequate. What confidence can we have that 2003 earnings will not be further tainted by charges? While in theory reserve charges should drive the hard market, the equation breaks down if fresh capital can enter and undercut prices quickly. Once an incumbent reinsurer has priced itself into a problem, the market dynamics work against the ability to price itself out. The coming hard market may not be profitless overall, but the main beneficiaries will be those who avoided the excesses of the late 1990s.