Despite the benefits of globalisation, Latin America is stilll as vulnerable to financial and social instability as it ever was but it possesses a unique potential for insurers and reinsurers willing to invest in a long-term strategy, say Luc Albert and Thomas Holzheu.
The competitive environment in non-life insurance has changed dramatically over the last few years.1 The soft market, high losses, lower investment returns and the decline in equity markets have combined to reduce the industry's capital base in all major markets, and turn excess capital into a tight capital base - particularly in commercial lines and reinsurance. As a result, insurers and reinsurers on average have lost more than half of their market capitalisation since the end of 2000.
Although September 11 clearly accelerated this trend, the hardening of the property and casualty (P&C) insurance market began in late 2000. Commercial lines and reinsurance rate increases led the market, while personal lines lagged by one or two years. The catastrophic results of 2001, coupled with the fall in capacity, accelerated the price increases in the commercial insurance and reinsurance market.
In addition to the financial impact of the largest loss in insurance history, the September 11 attack added a new dimension to insurance risk - substantial terrorism loss. Consequently, threat scenarios differ substantially from those of the past.
Because of its role as a player in the global financial and insurance markets, Latin America has felt - and continues to feel - the impact of these changes. This can easily be illustrated by the high catastrophe exposure in the region and the strong dependency on international reinsurance markets, making the local price trends follow closely the cyclical price swings in global reinsurance markets.
In addition to global issues, the Latin American insurance industry has also been challenged by recent local macroeconomic developments. The financial crises in Argentina and Uruguay, the unstable political and social environment in Venezuela, as well as the recent uncertainty surrounding Brazil's future, resulted in significant currency devaluations, higher inflation and the slow-down of foreign investment. Further, Colombia remains entangled in a spiral of violence, and the country's political and socioeconomic future depends highly on a positive solution to this problem.
Market hardening required
Over the past years - as has been the case around the globe - primary insurance and reinsurance rates in Latin America have been far from adequate, producing significant losses among insurers and reinsurers. The best therapy for Latin America - and for the rest of the world - is to remain profitable in the current low-yield investment environment and to maintain underwriting discipline. Premiums have to be sufficient to cover losses without relying on capital gains. It is paramount for the industry to go `back to the basics' and rectify the non-profitable environment for the benefit of all parties involved.
This situation presents a Herculean challenge for all players in the market. Although every company is responsible for its own success, insurers and reinsurers have to join efforts and look for a constructive team approach in order to withstand this difficult situation. Core business focus, technical underwriting, integrated risk management and solvency-awareness are just a few catchphrases worth mentioning.
Efficiency must improve
Efficiency is yet another critical factor, as cost ratios are still comparatively high in most Latin American markets. In fact, while cost ratios in European markets average less than 25%, some Latin American markets - such as Argentina and Chile - show ratios exceeding 40%. Some steps have been taken already, and distribution has become a lot more innovative in recent years in order to reach a broader range of clients.
However, there remains wide room for improvement: distribution systems can be made more efficient by reducing the number of parties involved; fixed costs can be reduced by achieving economies of scale; production processes can be shortened and made more efficient; redundancies, like those found in re/insurance accounting, can be eliminated; and reinsurance programmes can be restructured and simplified.
Selection of long-term partners is crucial
Although recent renewals have resulted in price increases and limitations of terms and conditions, most Latin American markets need further hardening in order to pave the way for a sustainable future. Many insurers need several profitable years to restore the strength of their balance sheets.
In this respect, it is extremely important to select the right long-term partner. Primary insurers must now pay more attention to the capital strength of their reinsurance partners. Under the current circumstances, it is clear that only market players with strict underwriting discipline and adequate capital management will be successful.
A different risk landscape
The evolving risk landscape for all players has implications beyond the Latin American market, however. In fact, since September 11, traditional measures of loss severity - including probable maximum loss (PML) and estimated maximum loss (EML) - are currently under discussion. Terrorism risks stress the limits of insurability. The insurability of the risk is assessed according to its ease of quantification, lack of correlation with other risks, mutually shared interest of insurers in the risk and the economic feasibility of placing it with private insurers. As September 11 showed, terrorism risk does not conform to several of these criteria. Consequently, primary insurers and reinsurers can only offer terrorism cover on a limited case-by-case basis.
Innovative solutions - which may involve pools and/or the financial markets - are required to achieve a broader spread of risk. However, this type of risk makes the capital markets uneasy. Thus, the price is high. Managing this new risk is therefore a challenge for the insurance and reinsurance industry - the entire industry must learn more about it and be creative in finding solutions.
Stock markets have been declining on a worldwide basis, since peak levels were reached in early 2000. In addition, default rates on corporate bonds rose sharply in 2001, contributing to the general stock market decline. Worldwide, government bond yields have also reached all-time lows and are not expected to increase in the near future.
As a consequence, above average annual investment returns - similar to those achieved in the second half of the 1990s - are unlikely in the years to come.
Distress of insurers
By 2000, solvency ratios had already started to decline in most markets. The US non-life industry's capital funds registered a decline in 2001 of $27bn or 8.5%. In 2001, non-US insurers are estimated to have lost approximately $60bn in capital funds due to losses in their equity portfolios.
As a result, worldwide non-life capital decreased by about $90bn in 2001. Similar or larger losses have to be expected for 2002, if the current state of stock markets continues. Worldwide, all these losses add up to an estimated decline of currently $180bn or 25% from the peak of global non-life capital funds of $700bn reached at the end of the year 2000.
Focus on corporate governance
The recent surge in highly visible corporate defaults - such as Enron and WorldCom - has caused a re-evaluation of the industry's credit exposure. This, in turn, has affected both insurers' bond portfolios and the credit risk embedded in their products, including credit and surety insurance, derivatives, and the credit risk in finite re/insurance deals. Credit risk was frequently not adequately compensated for during the last soft market.
Some insurers will reduce their exposure to credit risk even though the reward, compared to the risk, is probably rising now. Others, who have the expertise in evaluating credit risk and the capital to back it, will continue to take on credit risk.
Another visible consequence of the accounting scandals are rate increases in directors and officers (D&O) and errors and omissions (E&O) coverage, as well as a change in the general attitude towards complex financial transactions with earnings-smoothing propositions. In fact, corporate clients and banks are finding off-balance-sheet earnings smoothing less acceptable, given the current climate of accounting transparency. The current hardening of the commercial market, however, triggers demand for non-traditional solutions.
The insurance industry needs to contribute by actively managing its exposure and meeting reserve and equity requirements. Active risk management can reduce capital needs. Primary insurers and reinsurers need to carefully control underwriting, improve risk modeling, do asset/liability management, improve risk diversification and take the right decision concerning which risk to keep and which to transfer.
Latin America is part of a larger picture
Globalisation has resulted in a synchronisation of the reinsurance cycle at a global scale. Latin America has not been spared from this process and can no longer be perceived as an isolated market. Although financial and social instability continue to jolt the region, it possesses a unique potential for insurers and reinsurers willing to invest in a long-term strategy.
1 Swiss Re; sigma 4/2002, Global non-life insurance in a time of capacity shortage.In addition
Recently, Zurich-based Swiss Re decided to concentrate its Latin American underwriting activities in three main centres: Armonk, NY, the headquarters for its P&C operations for the Americas, Mexico City and Bogota. In addition, it maintains a group of professionals in its Sao Paulo office to take advantage of an eventual opening of the Brazilian reinsurance market.
By Luc Albert & Thomas Holzheu
As Swiss Re's head of Latin America, Luc Albert is responsible for the development and implementation of Swiss Re's business strategy in the region. He is also a member of the Swiss Re Management Board. Thomas Holzheu is a senior economist and deputy head of the New York office of Swiss Re's Economic Research & Consulting unit.