Last year's dark storm clouds may cast a longer lasting shadow over the Bermudian reinsurance industry than ever before, finds Lilla Zuill, with some of the view that fundamental changes to how the sector does business is the only way to go

The first real signs of hurricanes Katrina, Rita and Wilma's lasting impact can be seen in the Bermuda reinsurance market, say rating analysts from AM Best. And there is a cautious optimism from them that the changes, including a more conservative approach to business planning, may last. "Some of the risk management rhetoric is more believable now," said Matthew Mosher, group vice president of the agency's property/casualty rating division.

A wake-up call

The industry, which can generally count on being able to charge higher prices after costly events strike, now needs to take a more conservative approach, say the analysts, who have powerful influence given the clout their ratings carry with buyers. Reinsurers around the world are sometimes accused of taking a swashbuckling approach when market conditions ripen, as they often do on the heels of catastrophe, but the industry in Bermuda may have less of a swagger after the sobering experience of absorbing at least a quarter of an estimated $80bn bill from last year's deadly hurricane season.

"Bermuda, by and large, in terms of performance and capital, is in a relatively good place," said Robert DeRose, assistant vice president at AM Best, at its first annual briefing held for financial executives of Bermuda reinsurers in May. Indeed, the record storm season appears to have been the impetus behind a shift in underwriting practices for Bermuda reinsurers. "We have seen some companies affected by Katrina come in with some very smart moves," said Peter Dickey, a managing senior financial analyst with AM Best. The analysts also said that the "forward thinking" approach witnessed amongst the management of some Bermuda reinsurers sets the market apart, as there hasn't been a parallel response from industry players based in the US and Europe.

Hurricane Katrina, one of three deadly storms to hit the US last year, is expected to cost the insurance industry $40bn. This makes the storm the most costly natural insured catastrophes on record. The high cost is having a profound effect on the industry because it serves as a warning that the price tag for catastrophes can be severe. The weight of that message is likely to be compounded by forecasts of a heavy storm season this year, and the now pervasive pessimism that natural disasters could easily cost in the order of $100bn when they strike affluent urban areas.

The size of the 2005 losses "exceeded all expectations" said AM Best vice president John Andre, conceding that the rating agencies, modellers and insurance companies were all caught off guard. Modelling firms supplying systems to help underwriters assess the risk in contracts had projected as little as $10bn in total damage from a powerful hurricane swamping the Gulf Coast city of New Orleans, as Katrina did. After their gross underestimation, risk modelling firms are now increasing their storm-loss projections and are bumping up the number of factors that can trigger losses in a catastrophe, after Katrina proved there is a greater correlation between risks than previously thought.

An example of the increase in modelling options is modelling firm Eqecat's new gas and oil model, developed after Gulf Coast platforms were badly battered by Hurricanes Katrina and Rita. Of about 4,000 facilities in the area, three-quarters fell into the path of either or both storms, according to information from the US Department of the Interior. This left roughly 10%, or $8bn, of the record storm season's costs in the hands of oil rig and refinery operators.

While the cost was high, insurers and reinsurers willing to take another gamble can now sell policies to oil companies for up to 400% more than what underwriters were charging a year ago. But many are proceeding cautiously, realising that insuring high risks can tie up capital. "Catastrophes are the greatest single threat to capital adequacy," said Robert DeRose, an assistant vice president with AM Best.

All change

And companies are carefully considering the high costs perils can bear. According to Benfield's research division, in its quarterly report on the Bermuda market earlier this year, "companies reacted by reducing their risk appetite, changing their catastrophe models and underwriting assumptions and increasing reinsurance and retrocession protection."

Bermuda-based Aspen Insurance Holdings, for example, said it was reducing the number of risks it takes on in areas that may be hit by major catastrophes. The insurer also bought $400m in reinsurance protection, and was considering bumping that up to $500m. Ace, Bermuda's largest provider of insurance and reinsurance with a market capitalisation exceeding $12bn and operations around the world, said it was also stepping up its purchase of reinsurance protection. And PartnerRe said it declined more than 5% of the business it saw during the 1 January renewal period because it didn't want to be exposed to losses that exceeded the premiums that could be earned on policies.

"Bermuda's underwriters were chastened by the 2005 hurricanes," Benfield's Chris Klein wrote in the report, disclosing that the island's major insurers sustained storm losses in the region of $12bn. "Companies reacted by reducing their risk exposure, changing their catastrophe models and increasing their reinsurance protection," he added.

The rating agencies appear to be the biggest driver of the new conservatism setting in, with much stricter demands now on insurers and reinsurers to have sufficient capital to hand, as well as to keep adequate reserves to cover possible losses. After last year's wave of storms, the question of whether insurers and reinsurers have the financial strength to sustain more than one loss in a short period of time, arose. And this uncertainty drove property/casualty analysts to institute a change in the way they assess the sector.

Insurers and reinsurers are now subjected to additional stress test risk analysis, to measure how they are likely to fare in the event of two costly catastrophes striking in a short period of time. This has prompted a general increase in the amount of capital rating agencies are requiring companies to have in order to hold onto a strong credit rating. Although AM Best says it doesn't have a one-size-fits-all requirement, and individually assesses how much capital is adequate for a particular company to hold, it concedes it takes a more favourable view of those who are conservative in their business planning. "We have to see this through a season or two," explained Andre. "We are going to have to see some of the risk management tools proven over time." And the analysts said companies have to be upfront on their financial condition, and risk management controls. "We need to feel a company is being straight with us," emphasised DeRose.

Closer scrutiny

Those underwriting coverage likely to be triggered in the event of another large natural catastrophe are being the most closely scrutinised. A company with concentrated exposures will need to hold more capital, said Andre, whether that is a geographic concentration, or a monoline property/catastrophe reinsurer. This is driving many companies to step up their practice of ceding risks onto other reinsurers, which spreads the risk out among several carriers. There is also a push to diversify into several lines of business, and to closely track how many policies are sold in any one area.

The drive to diversification can be seen even amongst a new breed of reinsurers formed on Bermuda after Katrina. While the Class of 2005, a group of ten insurers and reinsurers, was set up to take advantage of rising property/catastrophe premiums, most are also establishing themselves to sell other types of policies.

Another reason for companies to make sure they have the capital to cover losses, and that they tame their exposure to losses, is to keep investors happy. This may prove especially important for publicly-listed reinsurers, wary to cause any more concern amongst stockholders. Indeed, some reinsurers have yet to regain the ground their share prices lost after posting last year's losses.

Bermuda-based Montpelier Re is one example. Nearly nine months after Hurricane Katrina it was still watching its share price fall in mid-May to an all-time low of $15. Investors were likely reacting to concerns that the 2006 hurricane season, which officially begins in June, could lead to a new round of losses. Montpelier sustained losses in 2005 exceeding $1bn. In the months since, it has worked hard to make sure that doesn't happen again, actions likely spurred on by rating agencies and investors breathing down its back.

Most significantly, the reinsurer stepped up its purchase of reinsurance protection, a marked contrast to its track record of retaining most of its own risk from the time it formed in 2001. In the fourth quarter it wrote $106.8m in policies on a gross basis. However, in a departure from its normal business pattern, it bought reinsurance to protect it from losses on $98.5m of the business underwritten. Montpelier has also gone through a management shake-up, replacing its chief underwriting officer. Christopher Harris, who had been the reinsurer's chief risk officer, was also given the underwriting mantle. "It made sense to have the risk management side under the same umbrella as underwriting," said Montpelier treasurer William Pollett.

Endurance, a Bermuda-based provider of global property/casualty insurance and reinsurance, was another company to learn a hard lesson from the 2005 hurricane season. It too was left to bear the brunt of some $600m in claims filed in the aftermath of last year's hurricanes. Endurance was only able to pass on about 10% of its total losses to reinsurers, according to data compiled by New York-based industry group the Insurance Information Institute.

Endurance chief executive Kenneth LeStrange, after the company reported first quarter earnings in April, said the company had wizened up. "In the final quarter of 2005, we implemented key adjustments to our modelling technology based on the critical lessons we learned and the insights we developed from the 2005 storms," he explained. "We believe these insights and adjustments, coupled with the successful execution of our capital plan early in the fourth quarter, position us to improve our performance in both good and bad years."

While losses hit companies hard, investors more than replenished the capital wiped away by storm claims. By the end of the year, Bermuda's biggest insurers held 5% more, or $47.2bn, in shareholders' equity than at the end of 2004, after tapping capital markets for some $20bn to replenish balance sheets. To not do so would have been to court a downgrade from the rating agencies. "Access to capital is key," said Andre. But he added that it is not enough to be able to "reload" after one event. He said analysts will also be looking at reinsurers' ability to tap investors if there is another event.

And where there are concerns, the rating agencies have taken action. The now troubled fates of Bermuda reinsurers PXRe and Quanta Capital are poignant examples of what can happen when a reinsurer comes under a ratings downgrade.

Both companies were earlier this year downgraded into the "B" category after posting losses from last year's storms that greatly exceeded earlier estimates. In the aftermath of the downgrades, each reinsurer has seen a significant number of customers cut ties.

In the end, this may be the sector's starkest reminder that lax underwriting controls can, very quickly, send a company into a death spiral.

- Lilla Zuill is a freelance journalist.


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