James Vickers takes on the difficult challenge of predicting the future for reinsurers around the world.
Writing a forward looking article on the state of the reinsurance market when the 1 July placements have only recently been completed and we are only one-third of the way through the hurricane season could possibly be regarded as a futile exercise in crystal ball gazing. However, notwithstanding the huge potential uncertainty about potential catastrophe losses in the third and fourth quarters of 2006, there are a number of trends which can be observed and extrapolated with a suitable degree of caution.
Reinsurance market practitioners can sometimes forget that reinsurance is driven by the primary market and its terms and conditions offered to insureds. Historically, times of market change have coincided with primary insurers being in a position, either by choice or default, to alter their product. At today's point in the cycle it is clear that most primary insurance companies are still reporting very strong results.
Recent notable examples of this include ACE which recently reported second quarter results with a combined ratio on its property and casualty business of 88%. Similarly, XL Capital also reported very strong second quarter figures with a combined ratio of 90%. Allied with these good combined ratios, both companies also reported significant increases in their investment income.
Against this, it is understandable that most primary companies are not feeling any pressure to restrict coverage or increase prices. On the contrary, most are still seeking to expand and there is much talk about meeting budgeted income targets, which is never a good sign for underwriting discipline.
The only exception is the well-known difficulty primary companies have found in obtaining adequate capacity for their US Gulf and Northeast catastrophe-exposed covers. This shortfall was recognised well in advance and has led to dramatic changes in original underwriting as well as the complete withdrawal by some primary companies from catastrophe-exposed areas. Even those who have continued to write in these areas have been actively adjusting their underwriting to more closely match the terms and conditions of the reinsurance cover available.
The recent mid-year renewals have started to show signs that buyers with Northern European catastrophe exposures are facing an imbalance between supply and demand. The reasons for this are in many ways similar to the US: tighter control of catastrophe exposures by reinsurers; requirement to service reinsurers' higher capital loadings on catastrophe perils; new commercial models increasing loss exceedence probabilities for some companies; and growth in some companies' gross exposures through portfolio expansion. This trend is likely to continue through 2007 irrespective of whether or not the last half year of 2006 is impacted by major catastrophe losses or not.
Reinsurers losing influence
Outside the peak property catastrophe zones, and for all other classes, market conditions remain benign with primary insurers enjoying good results and many seeking to increase their market share. Whilst this trend may be unwelcome for many reinsurers, the stark fact remains that the influence that reinsurers can exert has diminished over the years with the move away from proportional treaty structures to excess of loss structures, where reinsurers negotiate prices for blocks of cover totally unrelated to the original pricing, the risk being protected. Reinsurers are therefore facing an awkward decision as to whether to continue to support the softening terms or reduce acceptances.
Balancing this are the different appetites reinsurers display towards the benefits of diversifying their portfolios. Some reinsurers believe that price adequacy is the key to success irrespective of whether this exposes their portfolio to greater volatility. A larger portion of the market places a greater emphasis on diversification, which in turn helps to exaggerate competition outside the peak catastrophe exposures and classes. The areas of current particular interest are casualty classes, commercial property per risk, non-correlated catastrophe risk and niche lines such as aviation, with its new players. In the foreseeable future it is likely that the pro diversification camp will continue to prevail and rates in the favoured classes will continue to come under pressure.
As in a tight market, retrocession capacity has been limited during 2006, particularly early on when many buyers found prices unattractively high. As a result, a number of reinsurers adjusted their underwriting so by the time additional retrocession capacity was available, mostly from capital markets, the buyers had adjusted their portfolios and were no longer interested. Whilst the retrocession market has been constrained there is no doubt the capital markets have stepped up their involvement in the catastrophe arena, particularly for peak zone exposures, and appear to be an increasingly permanent feature in the worldwide reinsurance landscape.
Regulatory pressure continues, both from a compliance angle but more importantly from the buying patterns of primary companies. The issues of Solvency II have been well aired but the most important trend being driven by it is the centralisation of risk management by many insurers with a much tighter analysis and control over reinsurance purchasing. And many forward-looking insurers are already implementing the conceptual thinking embodied in Solvency II. At a time when many primary companies' balance sheets are strong this does not bode well for reinsurers seeking to expand premium income for 2007.
One bright spot is that despite the disastrous 2005 losses, cash flow remains strong with actual cash payments still only being a modest portion of the overall loss. This will undoubtedly change eventually but on the back of increasing catastrophe rates in the US most reinsurers are maintaining positive cash flows. This is important in an investment market where interest rates are rising, although the downside is that rising interest rates have historically been linked to softening insurance rates. And it is unlikely that everyone has learned the lessons of the past regarding cash flow underwriting.
Turning to the three main reinsurance markets namely Bermuda, London and Europe. They are no longer as closely aligned as they were previously so the various scenarios which may occur over the next six months will affect each rather differently.
2005 was the first time the Bermudian market as a whole had been severely impacted by major natural peril losses. The differences between individual Bermudian companies' results have been marked with a small number facing severe difficulties. Simultaneously, rating agencies have called into question the business models of mono-line catastrophe writers. Some dedicated mono-line underwriters have sought to reject this and are resolutely sticking to their approach. Others, some of whom already have diversified portfolios, are seeking to expand further into other classes of business.
Should the second half of 2006 prove to be benign it is likely that the mono-line models will continue to be supported and those companies who have aggressively sought diversification may seek to moderate their models, bringing back more capacity to the catastrophe market. However, a 2006 season of major catastrophe losses will add extra pressure on the mono-line catastrophe model with the likelihood that even more capacity will be diverted to non-catastrophe classes.
The position of London and Lloyd's in particular not only differs from Bermuda but also from the past where large natural perils' losses have historically decimated certain syndicates. 2005 was the year that the Franchise Performance Board truly demonstrated its value. Through the enforcement of strict realistic disaster scenarios and tight risk loadings, Lloyd's 2005 hurricane losses have been contained within reasonable and sustainable limits. However the net effect was that syndicates have been constrained in their ability to accept more catastrophe risk in peak zones, despite the attractive rates. Should 2006 prove to be a low catastrophe year there is no doubt that many syndicates will have been forced to sacrifice some exceptional returns. But balancing this is that should 2006 perform poorly, Lloyd's should again emerge relatively unscathed.
The major European reinsurers also performed well in 2005 thanks to the strength of their diversified portfolios and comparatively modest exposure to US natural perils. Most reinsurers took the opportunity of the 2006 renewals to readjust their catastrophe portfolios so another poor US hurricane season should be comfortably absorbed. Where European reinsurers may face more demanding challenges is if there is a major natural peril loss in Northern Europe in the third and fourth quarters.
In summary, the tight catastrophe markets of the US are not being replicated in other territories or classes other than some early signs in Northern European catastrophe exposures. There seems to be little brake on the current softening of primary markets and the reluctant following support from reinsurers. Another poor US hurricane season is unlikely to be sufficient to arrest the general market decline as many insurers and reinsurers have reduced their peak zone catastrophe exposures to manageable levels. It is not yet clear what factors could arrest and reverse the current market softening other than unexpectedly poor investment returns and a deterioration in insurers and reinsurers loss ratios, which is unlikely to be seen for at least another 18 to 24 months.
- James Vickers is CEO of Willis Re International.
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