Despite record industry losses following last year's hurricanes Katrina, Rita and Wilma, many insurers and reinsurers managed to offset potentially devastating year-end results with strong investment returns, finds Ronald Gift Mullins

Investment income is to insurance and reinsurance as a life ring is to someone drowning. Without the bulwark of the invested billions generated from bygone premiums, the property/casualty industry would have long ago gone under in a sea of red ink.

In 2004, the US primary property/casualty industry actually made an underwriting profit, the first since 1978. Since 1984, the US reinsurance industry has never produced an underwriting profit, though it came close in 1997 with a loss of only $637m. Since 1986, it has produced a net profit (except for 2001 due to 9/11 when it and primary insurers had a net loss), thanks to investment income and capital gains. Obviously, how reinsurers and insurers invest and manage their assets has a powerful influence on net profits and greatly affects the companies' continued solvency and credit ratings. Only those insurance companies operated by governments can survive without the comforting cushion of investment income.

Getting the right mix

Because investment income encompasses diverse financial instruments - interest earned from government, corporate bonds and cash, dividends from equities, mortgage-backed securities, loans and finance receivables - insurers and reinsurers have to decide which investments to make, when and how. Selecting the precise combination of types of investments and maturities can make a substantial difference to how much investment income is earned, and, consequently, may often mean the difference between a net profit and a net loss.

The extended hard market has allowed the reinsurance industry to strengthen its balance sheets considerably, as Standard & Poor's recently noted in a report, and to "withstand the unprecedented losses of the 2005 North American hurricane season with its financial strength largely intact". The rating agency observed that since 2001, "The reinsurance industry has benefited from prices, and terms and conditions that represent a significant improvement on those that were experienced previously. As of 2006, this represents five renewal seasons in which the fundamentals of the industry have been strong. This is highly significant for the industry's prospects because some of the profits on business written in these years will be reported in 2006 and beyond."

The net underwriting loss for reinsurers doing business in the US, as reported by the Reinsurance Association of America (RAA), was $1.8bn in 2004 and, due to the catastrophic losses from the 2005 hurricanes, ratcheted upwards to $7.5bn in 2005. While the 2004 group reported a net profit of $3.1bn, what is really astonishing is that the 2005 group made $1.9bn in net profits, thanks to a substantial return on investments and realised capital gains. Investment income increased from $4.76bn in 2004 to $5.19bn in 2005 for reinsurers, according to the RAA accounting. "Investment balance sheets for insurers and reinsurers have been increasing over time, certainly pre Katrina," said Robert De Rose, assistant vice president, AM Best, "and by and large most companies still have more than ample assets to pay claims."

Eric Fitzwater, SNL senior analyst, insurance, reported that of the US companies classified by SNL as having major reinsurance operations, net investment income was $8.9bn in 2004 but jumped to $11.5bn in 2005. Adding realised capital gains of $4.3bn for 2004 and $6.4bn for 2005, this brings the totals to $13.2bn for 2004 and $17.9bn for 2005. Closer examination reveals that $3.37bn of these capital gains came from one reinsurer - National Indemnity, part of Berkshire Hathaway.

A summary of the investments held by Berkshire Hathaway's insurance group, according to its annual report, totalled $113.5bn in 2005, up from $101bn in 2004. Investment income after tax and minority interest for its insurance group in 2005 was $2.4bn and $2bn in 2004. "The increase in investment income in 2005 primarily reflects higher short-term interest rates in the US in 2005 as compared to 2004," the report said. It is quite an awesome feat to use short-term interest rates to increase investment income by 17% from 2004 to 2005, considering that the US bank prime loan rate ended 2004 at 4.34% and 2005 at 6.19%.

Curiously, according to a fairly sparse financial summary offered by National Indemnity, its total invested assets as of year-end 2004 were $47.7bn, but had catapulted by more than $11bn to $59bn by the end of 2005. Yet its net profit in 2005 was $4.1bn, up about $2bn from 2004, according to the RAA, and its surplus had grown to $30bn in 2005 from $27.2bn in 2004. A reading of Berkshire Hathaway's annual report, including chairman Warren Buffett's avuncular message to shareholders, reveals no explanation for this stupendous increase in assets. The Oracle of Omaha remains silent, a prerogative apparently of managing the company's $49bn "float" himself.

Bermuda reinsurers blasted

About 500 miles west of the US, Bermuda felt the full destructive force of the major hurricanes that swept across the Gulf Coast during the summer of 2005. These hurricanes wiped out underwriting profits in 2005 for all but two (ACE and Arch) of the 16 Bermuda insurers and reinsurers tracked by the Benfield Group. Only a 22% increase in investment income and realised net gains of $5.8bn helped the reinsurers keep the net loss for 2005 at a reasonable $2.8bn. This was down from a net profit of $5.5bn in 2004.

With losses for 2005 totalling $11.3bn, Bermudian reinsurers were quick to replenish their capital in order to be well-provisioned for the expected sharp turnaround in pricing in early 2006. And the major rating agencies were worryingly fingering their letters and numbers, ready to lower ratings. But before the end of the year, $18.4bn of new capital entered Bermuda: 53% went to established companies, 40% to start ups and the remainder to side cars. At the end of the year, after the storm damage had been reserved, adding retained earnings and new capital, the Benfield group of insurers and reinsurers had remarkably boosted shareholders equity to $47.7bn, up from $45.4bn at the end of 2004.

Standard & Poor's observed that in 2005 the "largest European reinsurers performed better than many of the Bermudians, as the benefits of a global, diversified portfolio were made plain in a year of unprecedented catastrophe activity. Within the Bermudian population of companies, the more diversified players fared much better than those with a narrow property catastrophe focus"

European reinsurers hold steady

European reinsurers suffered greatly from the destruction of the 2005 hurricanes, yet persevered. Catastrophe losses amounted to $5.6bn for the five reinsurers (Converium, Hannover Re, Munich Re, SCOR and Swiss Re) tracked by the Benfield Group. Munich Re had the largest loss, $2.7bn, followed by Swiss Re with $2.1bn.

Yet having positive cash flow and favourable investment markets boosted the assets invested by these companies. None of them sought additional capital to cover losses, yet all had combined ratios over 100% in 2005; Hannover Re's 112.8% was the highest, followed by Swiss Re's 111.2%, whilst SCOR had the lowest with 106.4%. Munich Re was hit 2.7 points on its loss ratio when it was compelled to hustle about $1bn to its troublesome US affiliate, American Re, in order to raise its surplus.

Not to worry. Even with considerable underwriting losses, the five reinsurers reported net profits thanks to investment income and realised capital gains. Investment income for the five reinsurers increased slightly from $10.1bn in 2004 to $10.9bn in 2005. Total investments by the reinsurers rose from about $396.2bn in 2004 to $413.6bn in 2005. The major portion of the $17.4bn year-to-year gain for the group was the $16bn jump by Swiss Re. This increase came mainly from the addition of two new contracts within its Admin Re life insurance business.

But to ease their unprofitable underwriting results into the profits column, several reinsurers aggressively sought realised capital gains. Total realised capital gains for the five was close to $4.2bn in 2004 and $7.2bn in 2005. Most of the increase came from Munich Re's boost from about $3bn in 2004 to $5.8bn in 2005 when it sold percentages it held in a German bank and several European insurance companies.

While the financial wallop from the 2005 hurricanes sank almost all insurers and reinsurers in the US, Bermuda and Europe into underwriting losses, most ended the year with a net profit. Compare this performance with the industry's performance in 2001 when all sectors had a net loss and policyholders' surplus of US insurers fell $29.1bn from what it was in 2000, and tumbled another $2.9bn in 2002. But from 2004 to 2005, according to the Insurance Services Office, surplus of US insurers climbed by $35.8bn, or 9.2%, to $427.1bn. US reinsurers' surplus from 2000 to 2001 rose about $600m in spite of 9/11, but from 2004 to 2005 surplus swelled by $5.8bn, according to the RAA, to $67bn.

Such a stunning turnaround reflecting the industry's improved management of underwriting coupled with matching risk to investments and maturity, moved Standard & Poor's to revise its outlook on the global reinsurance industry from negative to stable, "because of the strong fundamentals of the industry and the resolution of some of the short-term uncertainties created by the unprecedented scale of the losses arising from the 2005 North American hurricane season." However, the rating agency warned that the stable outlook implies there will be little near-term movement in company ratings or outlooks, and that "the industry is in a period of transition and faces many challenges."

And if there was ever any question of how vital and powerful the meticulous investment of billions of assets is to the world of reinsurance, witness the net profit earned in 2005 by the industry while enduring never-before seen catastrophe losses of such magnitude.

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