Chris Waterman assesses the overall stability of the reinsurance sector in light of recent events
In 2004, the reinsurance sector was hit by the worst insured property catastrophe losses in history, continuing adverse reserve development, negative pressure on rates, the Spitzer investigations and then the most horrific natural disaster in living memory on 26 December. With all these negatives you could be forgiven for thinking that Fitch jumped the gun in being the first agency to change its outlook for the reinsurance sector to stable from negative back in July 2004.
However, an important distinction must be made between a rating outlook and an outlook on the sector's fundamentals. Fitch's stable rating outlook reflects our view that there will be fewer rating changes over the next 12 to 24 months than in recent years, and that the number of upgrades and downgrades is likely to closely match during this period.
So why do the sector's fundamentals appear to be at odds with this view?
During 2005, reinsurers are expected to report continued adverse reserve development on prior underwriting years and premium rates will likely continue to experience downward pressure. The simple answer is that these are all largely factored into Fitch's current ratings and are therefore neutral for our rating outlook.
However, a permanent shift in the length and depth of the soft market could change Fitch's rating outlook on the reinsurance sector. We would view a sustained soft market followed by a short hard market negatively, whereas a shorter and less severe soft market followed by a longer hard market would be viewed positively. We view the latter of these two scenarios as unlikely due to the ease with which capital can enter the reinsurance sector. As a result, the reinsurance sector rating outlook is likely to fluctuate between stable and negative, with a positive rating outlook over the medium-term relatively unlikely.
The most significant factor influencing Fitch's decision to revise its rating outlook to stable in July 2004 was the improvement in the reserve profile of the sector.
Adverse reserve development continued through 2004, but at levels significantly below those reported in 2002, and Fitch believes this trend will continue in 2005. The additional losses resulting from these reserve adjustments are expected to be manageable from a capital perspective following strong capital formation in the sector over the past three years.
When considering the improved reserve profile of the reinsurance sector, it is important to highlight two fundamental drivers. Firstly, reinsurers are reliant on ceding companies to report claims in a timely fashion and are largely dependent upon ceding companies establishing their own reserves accurately. Fitch's analysis of the US primary insurance market concluded that although still under-reserved by between 12% and 17% of the industry's surplus at the end of 2003, this represented a major improvement on 2002 when the under-reserving range was between 16% and 27% of surplus.
Secondly, the reinsurance sector's reserve profile has also improved through reserve surpluses recorded in recent underwriting years (2002 to 2004), which to some extent have mitigated the deterioration seen in older years.
Figure 1 illustrates the decline in adverse reserve development reported by reinsurers required to file with the US Securities and Exchange Commission.
Although limited to a sub-group of the global reinsurance sector, the trend shown by these reinsurers can be extended to the sector as a whole, particularly as the majority of adverse reserve developments reported over the past four years relates to US-domiciled risks.
Rates remain adequate
Given normal catastrophe experience over the next 24 months, and subject to the continued decline in adverse reserve development, negative pressure on premium rates is expected to intensify. However, near-term premium rates are likely to remain technically adequate and therefore supportive of reasonable, although declining levels of profitability. Despite current premium rate pressure, reinsurers' underwriting results over the next 24 months will continue to be lifted by profitability generated on 2002, 2003 and 2004 underwriting years that will earn out during this period.
Although we continue to believe that premium rates are on average adequate across balanced books of business, the reinsurance sector can now be considered a risk selectors market. The ability of reinsurers to maintain underwriting profitability will be determined by the classes of business underwritten and the level of discipline shown by these companies in the implementation of their cycle management strategies.
Even though the major reinsurers have yet to make their 2005 renewal season analyst presentations, our expectation is that premium rates will on average be flat. This compares to rate increases of approximately 5% achieved during the 2004 renewal season.
The five hurricanes that caused widespread damage to the Caribbean and the East coast of the US this year (Charley, Frances, Gaston, Ivan and Jeanne) and the three Pacific typhoons (Songda, Tokage and Chaba) will collectively result in insured losses in excess of $30bn. Property catastrophe losses in 2004 are likely to ultimately be greater than those sustained in 1992 following Hurricane Andrew, thus making 2004 the worst year for insured property catastrophe losses in history.
However, given the pattern of the hurricane losses, ie, several medium-sized events rather than one large event, we believe that the US primary market is likely to retain a disproportionate amount of the losses. In addition, many US primary insurers will have only purchased limited reinstatements on their property catastrophe programmes and may have been forced to purchase additional cover for the remainder of 2004. This demand for reinsurance capacity may ultimately have proved a positive for property catastrophe reinsurers in 2004.
We do not view the 2004 catastrophe losses as a large negative for the credit quality of the reinsurance sector as these losses have largely resulted in a drag on earnings rather than eroding the capital bases of reinsurers.
It was notable that in their first half 2004 earnings calls, reinsurers were warning investors about the pressure they were experiencing on rates.
However, third quarter results and forecast adjustments following the US and Caribbean hurricanes and Pacific typhoons certainly leads us to believe that rates may hold up for longer than most commentators had previously expected. Hence, our view that rates are likely to remain flat for 2005 rather than showing an overall decline.
The tsumami that devastated many costal areas around the Indian Ocean on 26 December was highly significant in terms of human and economic loss, but is unlikely to result in insured losses that will have a material impact on the credit quality of the reinsurance sector. In particular, the event occurred too late in the year to impact many 2005 reinsurance programme renewal negotiations.
At present there are no reliable estimates of the total economic and insured losses arising from the tsunami, although there has been some speculation that the insured loss could range between $5bn and $10bn.
A catastrophe of this magnitude and in this region has not historically been modelled by the catastrophe modelling firms, nor is there relevant historic data on which to base an estimate. Consequently, unlike the hurricanes referred to above, it will be some time before an accurate assessment of the loss can be determined. However, a large proportion of the residential property loss is unlikely to have been insured due to the very low insurance penetration rates in the countries affected. Initial thoughts are that commercial property, business interruption, life insurance and travel accident claims will form the bulk of insured loss.
Predicting the underwriting result for 2004 has been a difficult task with so many catastrophes during the year. However, Fitch is currently forecasting an aggregate combined ratio for the reinsurance sector of approximately 100%, of which, 3% to 4% is reflected by the Q3 storm losses and the Q4 tsunami.
We believe that the calendar-year combined ratio for the reinsurance sector bottomed out at 97% in 2003 and will come under increasing pressure as the earning benefit from the hard market runs off and a more moderate premium rating environment returns. (See figure 2).
New York Attorney General's investigation
A growing investigation by a number of state attorneys general and by the US SEC into underwriting and insurance marketing practices and the use of non-traditional, finite reinsurance products has received much attention since October 2004.
Although reinsurers may become increasingly involved in this investigation as it unfolds, Fitch does not believe it is likely to negatively impact the credit quality of the reinsurance sector as a whole. However, as the investigation into financial reinsurance products develops, this may have an impact on reinsurers that underwrite this line of business and demand for financial reinsurance products themselves may decline.
Fitch believes that the most likely affect of the NYAG's investigation on the global reinsurance sector relates to instances of alleged 'tying'.
This involves situations where brokers agree to place an insured's business with a primary carrier, as long as that primary carrier agreed to use the same broker to place its reinsurance business. Eliminating such tying arrangements would be unlikely to produce a dramatic shift in the distribution channels for reinsurance business.
Reinsurance companies' reputations have suffered less from the NYAG's investigation than those of re/insurance brokers' and primary insurers.
From a franchise and market perception perspective, it is important to note that reinsurers have generally not been implicated in any allegations of breach in fiduciary duties, allegations that are viewed among the NYAG's most serious. Although some of the companies mentioned in the complaint were either reinsurance operations or have reinsurance affiliates, these were not included in the suit's more serious allegations.
It is likely that the investigation, and its subsequent fall-out, will put downward pressure on primary insurance premium rates and modestly exacerbate existing downward pressure on reinsurance rates. However, this is unlikely to add materially to the negative rating pressure already being experienced by reinsurers.
Chris Waterman is senior director at Fitch Ratings.