Over the last 12 months, the property catastrophe reinsurance market has dodged a couple of life-threatening bullets and pricing is now gently softening across the board. So what happened? asks Peter Middleton.
A year ago, it was possible to describe a US catastrophe market in crisis. The prospect of a third disastrous hurricane season posed profound questions concerning the viability of the catastrophe reinsurance product. There was genuine concern in mid-2006 for the future of the business.
In the first half of 2006, reinsurers reassessed their coastal US exposures. Under pressure from recalibrated catastrophe models and enhanced rating agency hurdles, many reinsurers reduced their exposure to US property catastrophe risks. The reduction in capacity led to a sharp rise in prices.
Had 2006 produced another active hurricane season, there would once again have been serious questions about the viability of the cat models and the sustainability of the Bermuda business model. Investors might have opted for less volatile industries and rating agency hurdles would have been raised once again.
Thankfully, 2006 was a benign cat year, producing favourable financial results, allowing reinsurers to rebuild their capital bases and persuading investors to provide $40bn of fresh post-Katrina capital.
In January 2007 a new threat to the cat business model appeared in the shape of changes to the Florida Hurricane Catastrophe Fund (FHCF). This had a significant impact on the potential buying needs of Florida insurers. With Florida exposure representing a major peak zone for Bermuda cat reinsurers, any significant reduction in demand for their product in that key area would have a significant impact.
As it turned out, demand for catastrophe reinsurance at the mid-year "Florida book" renewals increased significantly, despite the FHCF changes. Reinsurers were still able to sustain their basic business model, albeit at weakened prices and reduced shares in programmes.
“The existence of cat reinsurance as a line of business drives the entire reinsurance industry model
The cat reinsurance market displays a remarkable resilience and persistence in the face of continuing adverse pressures. On the positive side, pricing is coming down from an all-time high. Furthermore, the existence of cat reinsurance as a line of business drives the entire reinsurance industry model. Without these volatile and potentially highly-profitable results, other lines would be unsustainable at historical combined ratios.
To counter this, there is a growing list of competitive threats besetting cat reinsurers and driving the market softening. The mono-line cat business has now been challenged by the rating agencies and this has forced almost all Bermuda reinsurers to diversify into the US casualty business and into non-US niche markets such as Lloyd's. No doubt this represents a trend that will continue in the near to mid-term with Bermuda reinsurers making further acquisitions in the non-US marketplace.
Insurers have found themselves squeezed between softening original insurance prices and a hard reinsurance market. They have sought to mitigate this by a variety of means. Coastal US exposures are being radically reassessed with significant reductions.
Insurers hoping to avoid the worst excesses of price volatility and credit risk have turned to the capital markets. The range of capital market products available tends to ebb and flow in response to traditional market pricing. Hence, if the current market softening continues, non-traditional products will be less important. Nevertheless, the long-term threat from the capital markets is palpable.
As we move away from the peak exposure zones, catastrophe pricing is proportionately weaker. Thus for the non-US peak zones of North European wind and Japanese wind and quake, pricing has been at best flat and is now showing single digit softening, although mid-year UK flooding will strengthen reinsurers' resistance.
Moving away further into territories that represent less exposure the pricing becomes weaker still, with rates down by double digits. However, this weakening follows a historical high pricing point and non-US catastrophe losses have been of limited financial significance to the reinsurance market over recent years.
“The long-term threat from the capital markets is palpable
Unlike the cat reinsurance market, both risk excess-of-loss and pro-rata markets have remained comparatively stable over the last year. Changes in pricing, commission levels and coverage generally directly reflect an individual insurer's risk exposures and loss experience.
The one area that has undergone significant change is risk excess-of-loss for US surplus lines and London market writers. Here, the continuing ramifications of Hurricane Katrina have led to the limitation or exclusion of nat cat perils coverage from programmes, with a consequent reduction in prices and a transfer of such exposure to the insurer's net account or to the cat reinsurance protection.
It is doubtful that any event, short of a major catastrophe loss, will affect the downward movement in reinsurance rates. Normal or average hurricane activity in the 2007 season is unlikely to alter this current direction and a loss-free year in 2007 will certainly increase the rate of decline in prices into double figures across the whole market.
At this year's Monte Carlo Rendez-Vous, we may be forced to confront the elephant in the room: the current downward cycle and where it will end.
Peter Middleton is managing director at Markel.