Only three years have passed since Hurricane Katrina sent three Bermuda reinsurers into run-off. Amanda Atkins considers what impact another major catastrophe could have on the market in 2008.
In a recent report, Aon Re predicted that it would take a catastrophe loss in the region of $60bn to halt the current inexorable downward slide in (re)insurance pricing. The question is, if the catastrophe reinsurance market needed to re-capitalise rapidly would there be sufficient sources of funds, given the current lack of liquidity in the equity and debt markets, to enable the industry to get back on its feet?
Pricing in the catastrophe reinsurance market has always been sharply cyclical – with rates increasing dramatically after major catastrophes only to fall again as new capital looks to take advantage of the harder market. Despite the losses suffered in 2005 (the losses from Katrina currently stand at $43bn in today’s money), prices started to turn down from the middle of 2007. In today’s market it is by no means certain that a single significant loss would be enough to halt falling prices, let alone lead to rate increases.
So what are the key factors that need to be considered if the industry did have to face up to the challenges of a significant catastrophe loss? In 2005, Hurricane Katrina led to the run-off of Alea, Rosemont and PXRE. In the event of an industry-changing loss – or series of losses – in 2008, could we see further run-off in Bermuda?
Picture of good health
Bermuda represents the largest single concentration of catastrophe capital in the world today. Total assets in the insurance and reinsurance industry on the island have reached more than $500bn generated by $130bn of annual written premium. Since 2005 both catastrophe and claims frequency experience has been exceptionally benign, so companies are enjoying well-capitalised balance sheets and excellent results.
While most Bermuda reinsurers were created primarily as catastrophe writers, pressure from ratings agencies and investors has meant that many have undertaken significant programmes of diversification in the past 18 months. This has either been through writing a wider range of classes of business, including casualty, or through acquisition – particularly in Lloyd’s, the US excess and surplus lines market and Europe.
The development of more robust risk management techniques over the last ten years, combined with increased external scrutiny from regulators and ratings agencies, also means that companies are better prepared to deal with losses should they occur. Enterprise risk management, risk-based capital modelling and more timely management information mean that companies are much less likely to be taken by surprise.
Back to the future
So, if such a catastrophe were to occur it is likely that the vast majority of the Bermudian companies would be operating from a very firm base. The issue may be less about losses resulting from one single catastrophe and more about the aggregation of a number of sources. These include attrition losses, increasing claims frequency and a poor investment outlook. It is likely that a reasonably serious economic downturn in the coming years would bring about losses in the all these areas.
This is a scenario the market has faced before. In 1999, there were nine catastrophe losses (though not in the US), D&O claims from the dotcom failures, losses arising from inadequate rates during the 1990s (particularly in the casualty classes) and poor investment returns. Despite this, there was no significant shift in pricing until 2001 when the World Trade Center attacks acted as a radical catalyst for change.
When times get tougher, more buyers tend to claim on their insurance. Cash flows will continue to become less robust as premium income falls in the softening market. In the short term, this is likely to continue despite the increasing claims frequency. At the same time, companies are seeing a reduction in the rate of growth in investment income. Reducing cash flows are coupled with falling interest rates and stagnating stock markets. Investors will need to be persuaded that price rises, resulting from whatever catastrophe gave rise to the need to raise funds, is sufficiently serious to offset all of the above and more.
Geography is also fundamental in assessing the ramifications of catastrophes. As we have seen this year, catastrophes in developing countries tend to have very high death tolls but proportionately, the claims bill is much smaller in terms of property damage etc. Economic losses from the recent Chinese earthquake are already being estimated at up to $20bn. However market commentators believe that only a small proportion of these losses will fall onto the insurance industry. Double-digit growth rates are however being recorded for the sale of insurance and life insurance products in Asian markets, so it is only a matter of time before catastrophe events in these regions start to translate into substantial insured losses.
The public failure of many of the catastrophe risk models post-Katrina has led to significant improvements. Nevertheless, actual events that fall outside the modelled scenarios may well have considerable repercussions for expected losses, and may create some surprising losses for catastrophe reinsurers.
The effects of an accumulation of losses will also vary depending on where in the insurance cycle they fall. The losses from the terrorist attacks on the World Trade Center came at the end of a seven-year down cycle in which billions of dollars had been lost. This had the effect of tipping a number of underwriting businesses over the edge even as it hardened rates across all risk classes. Should disaster strike in this calendar year, most companies would be reasonably well insulated by the reserves built up from prior years. The story could be very different in two years time if the effects of the credit crunch – on both the investment markets and in claims from D&O policies for example – take longer to resolve than first thought.
For a complete business failure to occur from a catastrophic event it would need insurers and reinsurers to incur both unexpected losses and to be unable to raise the additional capital required to bolster the balance sheet. Post KRW around $10bn was raised in Bermuda alone with Aspen raising an additional $600m in three days in New York. Considerable sums were also raised through mechanisms such as sidecars, designed to give investors the ability to profit from the rapid upswing in prices but not tie their investment into the longer-term insurance cycle.
Capital market muscle
So how might the capital markets respond if called upon again in such circumstances? The severe and ongoing writedowns of asset prices by the investment banking community leads one to wonder how much capital there is actually out there for longer-term investments.
The good news is that insurance and reinsurance businesses – whether live or in run-off – retain an appeal for the investment community because of their very low correlation to other investment classes. Current evidence is that there is capital available for deals. The question is whether it would be available in sufficient quantity if there were significant catastrophic losses in 2008.
The post KRW period shows that capital is becoming increasingly short term. Recent experience of underwriting businesses closing down sidecars would imply that the vehicles had done their job. They were designed to give investors the ability to underwrite defined, short-tail risks for a finite period, and to exit as prices turned down. There is no doubt that these structures can be easily revitalised if certain lines of business turn sharply in response to changing circumstances.
Many reinsurers are also looking at cat bonds as a way of accessing funds. Approximately $7.7bn of non-life cat bonds were issued during 2007 as an alternative to traditional reinsurance. In time, it is estimated that insurance-linked securities could represent 30% to 40% of total reinsurance limits placed. There is also a move towards the use of indemnity triggers for cat bonds rather than the typical industry loss or parametric triggers. This will make such capital market solutions act in an almost identical way to traditional reinsurance covers.
There is no doubt that the world is becoming an ever more complex place and it remains almost impossible to consider every eventuality. Despite this, the reinsurance market in the main is infinitely more capable of recording risk accumulations, analysing potential loss exposures and devising the risk management and reinsurance protection needed to survive pretty much all but the most extreme series of events.
As companies have grown they may have become more resilient to catastrophe losses but they still need to provide a return on equity (ROE). Active management of the portfolio to maximise ROE will continue to grow. Individual companies will withdraw or refocus their portfolios as a strategic underwriting decision. Unlike serious losses of previous years, which led to an entire business going into run-off or even insolvency, it is more likely that catastrophes today, even those falling outside modelled parameters, will instead lead to portfolios or parts of an organisation entering the run-off market.
Amanda Atkins is CEO of Afinia Capital and was previously chief financial officer of Alea.