Will shareholders expect reinsurers to sustain the good times? With softening rates and new Florida laws, the opportunities aren't what they were in 2006. So is this when tax becomes important? asks Lindsey Rogerson.

Increased dividends and buybacks have been the order of the day as the big boys of the reinsurance world unveiled their annual results in the last month. Indeed it would not be an exaggeration to describe the current round of cash being handed back to shareholders as a veritable frenzy (see table 1).

Andrew Crean and William Elderkin, insurance analysts at Citigroup summed up investor pleasure. They said: "It is encouraging that capital return (in the form of either dividends or buybacks) and statements/communication in the area of capital management have been the key spotlight of the full year 2006 reporting season so far." But now that the cash is timetabled for redistribution, what will the demanding fund management industry be looking for next? And more crucially, does the reinsurance sector have another rabbit in its hat?

Nick Martin, investment analyst for the Hiscox Insurance Portfolio, believes the first thing fund managers will want to see is clear evidence that reinsurers are making good on their promises of share buybacks. He said: "It is all about delivery now. There are definitely some investors who want to see the money in their pockets first before they believe what they are being told. Because Amlin (previously) announced a share buyback and then pulled it post-Katrina, which was all very well and understandable, but now I think it is a case of 'show me the money' for most investors."

The main highlights of what has been promised include: Arch, XL Capital, Munich Re and Swiss Re all announcing share buybacks of $1bn or more. But the talk of returning money to shareholders did not end there. Renaissance Re opted for language more often seen in the UK investment trust sector in its annual results announcement - emphasising that it was increasing its dividend for the twelfth year running.

Managing expectations

Munich Re also hinted at a future of steadily rising dividends - a point picked up by Citigroup. In a note issued after Munich's annual results briefing it said: "The important point is that, for the first time in history, the dividend yield on Munich Re shares is a good reason to own the shares. This is a clear sign that the company is far more focused on tangible shareholder returns than it ever was in the past."

Citigroup is predicting that the average dividend increase for European reinsurers will be 13% in 2007. In fact, at the time of writing, only Hannover Re had resisted the temptation to jump on the "special dividend and buyback" bandwagon. The company instead is seeking to rely on the consistency of it profitability and the "lowest cost ratio" in the industry to woo investors.

The problem the reinsurance industry collectively faces now though is one of increased expectations. Analysts and fund managers are a demanding bunch and once companies produce record earnings they start demanding that money should be distributed to shareholders, a box of course which has now been ticked by most reinsurers. But they become somewhat trapped by their own success, with investors expecting at least more of the same going forward, if not continuous improvements.

Investors will now be expecting a continued improvement in profits - not only on the back of an exceptional year - but also in the face of softening market conditions. Making this situation even more difficult is the fact that performance is expected to continue in the immediate aftermath of new Florida legislation. And many reinsurers are already anticipating they will see a noticeable reduction in their Florida book of business come the mid-year renewals.

Devin Inskeep and Robert DeRose, insurance analysts at rating agency AM Best, admitted as much when they finally got around to upgrading the reinsurance sector from negative to stable, last month. They said: "The optimism for longer-term robust performance from the reinsurance sector is somewhat dimmed due to the resounding sentiment that market conditions will continue to deteriorate, particularly for non-catastrophe-exposed business lines. Additionally, many cedants enjoying the strongest industry results in decades continue to retain more risk, thereby reducing the overall demand for reinsurance." The pair singled out the near doubling of the Florida Hurricane Catastrophe Fund and the entry of so much new capital post-Katrina as the main reasons for reduced reinsurance demand in 2007.

When tax becomes taxing

So if reinsurers are faced with investor demands at a time of reduced opportunities, how can they continue to produce those all important profits? One of the most obvious tactics is by tightening up on costs. Hannover Re's annual results drew attention to one possible route to lowering costs when it highlighted the differing tax rates for insurers operating in different jurisdictions (see figure 2).

In what may even have been a thinly veiled threat to the German government to lower business taxes or else see the market lose out to other jurisdictions, it pointed out that it pays tax at a rate of between 15% and 25%, whereas reinsurers based in Bermuda pay nothing. Of course the exodus to tax free Bermuda is already underway, a point underscored by Omega's and Hiscox's recent departure to the sunnier climes and most recently by Kiln's announcement that it intends to up sticks and move from London to Bermuda as well.

Hiscox's Martin points out that reinsurers actually have a duty to their shareholders to consider the issue of tax. He said: "If nothing else changes, an easy thing to do is to lower your tax bill. In Hannover's case it sounds a little bit like 'do not forget about us - we have to compete against these people'. But if one company is paying 40% tax and a Bermuda company is not, then Bermuda can afford to charge a cheaper price and it will make more money out of the business, so eventually all the business will find its way to Bermuda. What we have seen in this reporting season is that Kiln has decided to relocate. Obviously Hiscox has done it, Omega has done it and I do think that shareholders quite rightly are asking management: 'should you really be domiciled in London?'"

Martin believes that with the exodus underway, the governments in high tax countries need to ask themselves if they are prepared to cut tax to stem the tide of departures.

He said: "From an investors' point of view I would hope that it (the departures) will get the government to think carefully about whether they want to level the playing field. Because at the moment Bermuda has a distinct advantage over London - and if that remains the status quo business will drift to Bermuda."

Lindsey Rogerson is a freelance journalist.