Nigel Allen takes a closer look at the stellar performers and the falling stars in the Hannover Re portfolio

To describe Hannover Re, as some have, as a reinsurer of two halves would be wrong. It is clear from the financial results of the last quarter, and of 2004, that there is a divide between the group's business divisions in terms of those earning sky high profits and those struggling to earn cost of capital. Hannover Re's recent results showed clearly who the star performers are, as both property/casualty and life and health recorded almost stellar results. In contrast, the group's program and financial reinsurance divisions have both experienced declines in profits and gross written premiums. However, the gains made on the property/casualty and life and health divisions have far outweighed these losses and it was with a clear sense of confidence that Wilhelm Zeller, chairman of Hannover Re, confirmed his belief that the group could "significantly boost our profitability in the year under review".

The shining stars

The top line growth experienced in property/casualty reinsurance in the first quarter of 2005 came as a surprise to some, a fact which "surprised" Wilhelm Zeller, as a 6% growth from renewals had already been forecast back in February, which he added was bolstered by "some spill-over of 07/01 and 10/01 renewals of last year which were also strong." The portfolio experienced premium growth of 11.8% to EUR1.3bn, while operating profit topped EUR108m, up 43% on the same quarter 2004, and recorded a combined ratio of 97.1%. This was achieved despite a hit of over EUR93m in the first quarter, resulting from winter storm Erwin, two large fire claims and a credit loss, which added 11% to the combined ratio (well above the 5% multi-year average). This was, however, countered slightly by the reserve release following the Central Fund settlement reached with Lloyd's earlier in the year, which had a 4% positive impact on the ratio.

Despite being a behemoth of the reinsurance world, Hannover Re's apparent cumbersomeness belies a quickness of foot and an ability to move swiftly to profit from changes in market condition. Citing the "sustained favourable state of the market" as the driving force behind its decision to increase business volume in property/casualty, Hannover Re was quick "to capitalise on the weakness of some of our competitors, including but not limited to the German market," explained Mr Zeller, and following the departure of a smaller reinsurer from the market was able to take over a number of its "attractive client relationships".

While property/casualty was lauded as Hannover Re's shining star, life and health was awarded the title of "rising star", with gross written premiums rocketing some 21.3% to EUR538.7m. This rapid growth was attributed to a new cedant brought on board at the end of last year, plus some spill-over premium from the very strong production of the German life insurers reported in the latter part of 2004 as a result of the changing tax environment. The division also reported a return to form in the UK. However, Elke Konig, the group's chief financial officer, made clear that, as part of this first quarter growth resulted from 2004 "spill-over", such premium level increases could not be expected for the remaining quarters of 2005, but forecast strong double digit growth of approximately 12% to 15% for the remainder of the year.

The falling stars

Hannover Re ranks in the top three largest providers of financial reinsurance products, and the division has reported strong profits in recent years, with 2003 recording an operating profit of EUR148.2m, up over 200% on the previous year. However, with financial reinsurance itself at the centre of the regulatory maelstrom which the international re/insurance industry is caught up in, the division's star is falling fast.

Hannover Re's financial reinsurance division experienced a year-on-year decline of 10.5% in its operating profit to EUR132.6m in 2004, while gross written premiums dropped some 27.6%. This trend continued in the first quarter of 2005, with the division reporting a 14.1% fall in its operating profit to EUR28m compared to the same quarter in 2004, although, Mr Zeller believes this is "a soft landing" as the decline equated to only two thirds of the decrease in the net earned premium.

"There were two major transactions last year which were not renewed," Mr Zeller explains, "and one transaction this year, obviously in the wake of the investigations that are ongoing in the US." With some 65% of Hannover Re's gross premium income from financial reinsurance in 2004 stemming from the US (32% Germany, 2% rest of Europe and 1% Asia), the sooner a resolution can be reached to the financial reinsurance problem the better. "Neither Mr Spitzer nor the SEC nor any of the other insurance regulators are saying that financial reinsurance is bad per se, or is no longer an acceptable practice," stressed Mr Zeller. "What they regard as unacceptable are disguised loans, reinsurance transactions that pretend to transfer risk but in reality don't, backdating, 'side agreements' and things like that. And we can only support the outlawing of such practices, which as per our underwriting guidelines have been banned for many years."

As Jurgen Graber, head of non-life reinsurance and a member of the executive board, explained during the Q1 conference call, "We still see increasing demand outside the US for financial reinsurance and we are constantly concluding new transactions. As far as the US is concerned, while we still have some demand, all of our customers are desperate for better guidance on how to account for these treaties and how these transactions are to be defined." Mr Graber added, "I would assume that demand in the US will pick up again for financial reinsurance by mid-2006, or early 2007 at the latest."

Hannover Re has also found itself embroiled in the ongoing HIH investigation. Following the recent disqualification of Raymond Gosling, former reinsurance manager at the now defunct Australian insurance giant, the Australian Prudential Regulation Authority cited Mr Gosling's failure to disclose changes which had been made to a "complex 'reinsurance' arrangement" between HIH and Hannover Re which altered the nature of the contract. But Hannover Re has been exonerated of any wrong doing confirmed Mr Zeller. "Two of our top people, Jurgen Graber and Henning Ludolphs have, on a voluntary basis, spent a couple of days in Australia in the witness stand of the Royal Commission," he explained. "No accusations have developed out of our role. So that situation is now behind us having had no negative impact."

One other former star of the Hannover Re portfolio that continues to fall is that of program business. Year-on-year the business witnessed a catastrophic 327% decline in its operating profit, reporting a loss of EUR129m in 2004. However, a major factor in this was the net loss experienced by Clarendon, the group's largest program operation, following the storms in Florida, which blasted some EUR90m off the company's books. Clarendon, it should be noted, writes property/casualty insurance exclusively in Florida. The first quarter 2005 saw a 16% drop in gross written premiums for program business, due primarily to some EUR50m of business being cancelled mainly by the US operations in the second half of 2004 and January 2005. With premium volume down substantially, the restructuring of the program portfolio continues, although the division did manage to generate sufficient net income to mean that it earned its cost of capital in the first quarter.

Clarendon is currently undergoing a strategic review of its operations, and has recently undergone an overhaul of its management team. The new team have been charged with "focusing the portfolio even more closely on profitable niche segments". Mr Zeller stated recently that as part of the portfolio restructure, it would "deemphasise" the Florida homeowners business, and at the time of writing Clarendon is planning to set up special reinsurance programs for its hurricane exposures on a proportional basis. Mr Zeller added, "It looks as if we will be able to cede it out to good quality reinsurers to the extent of 95%." Since the storms, Hannover Re has also moved to redeploy capacity from the program portfolio to the property/casualty reinsurance portfolio to avail of the stronger pricing position. "On the program side, after the storms, we realised that as a primary carrier you are much less flexible than as a reinsurer," said Mr Zeller, "because the Florida commission has declared a moratorium as of 1 October, and secondly rate increases are still not approved - so life as a fully admitted primary insurer in the US is cumbersome compared to reinsurance."

Clarendon is subject to a "target 10" profitability requirement, which means that only programs that have a profit potential of 10% gross after tax will qualify for its portfolio going forward. However, by increasing Clarendon's profitability levels, this reduces reliance on proportional reinsurance, enabling increased levels of retentions. While retention levels are currently well below 50%, improved profitability has the potential to push levels way over the 50% mark, which as Mr Zeller explained has two consequences. "On the one hand it makes you a standard US primary insurer which was not our intention. And secondly it requires additional capital. All of this needs to be carefully considered and that will be the subject of our final discussion." Hannover Re is expected to announce its plans for Clarendon in July.

Changing the trajectory

The "surprising" performance of Hannover Re's property/casualty division and the very strong growth in life and health are somewhat marred by the results of the program and financial reinsurance business. While the ability to change the trajectory of its financial reinsurance division is to a degree in the hands of the regulators, as US clients seek the reassurance of clarity on the accounting procedures for such transactions, on the program side stopping the fall is clearly in Hannover Re's hands.

FLEET OF FOOT

Hannover Re announced at the end of May that it had successfully issued a EUR500m hybrid capital bond via its subsidiary Hannover Finance (Luxembourg) SA. Existing holders of Hannover Re's EUR350m 2001/2031 hybrid capital bond issued in 2001 were offered an exchange into the new bond, which amounted to EUR211.85m and resulted in the issue of approximately EUR240.5m new bonds. The additional EUR259.5m of new cash was raised from the European capital markets.

Commenting on the successful issue, Mr Zeller said, "Given the extremely tough conditions in the capital markets in recent weeks, we are extremely pleased with the placement of this issue. With the exchange of our existing hybrid bond and the issue of additional new hybrid capital, we have used the current low level of interest rates to further optimise our capital base."

Speaking during the Q1 conference call prior to this announcement, Elke Konig, chief financial officer and member of the executive board, cited, "increasing quality of capital and locking in today's favourable market conditions for a longer period" as the main factors behind the transaction. "In addition," she continued, "the 2001 bond does not give us any regulatory credit."

HANNOVER RE WILHELM ZELLER

Wilhelm Zeller has been Chairman of the Executive Board of Hannover Re since 1996. Prior to that he was a Member of the Executive Board at Cologne Re, Cologne, for over 18 years. In 1995, additionally, he sat on the Executive Council of the new owner, General Re Corporation in Stamford/CT, USA. From 1970 to 1977 he was simultaneously Head of the Casualty and the International Department at Zurich Insurance Company in Frankfurt. Before that he started his career in 1969 within the Gerling Group, Cologne. Wilhelm Zeller holds a Diploma in Business Administration from the University of Applied Sciences in Cologne.