Alan Murray and Ted Collins size up a downsizing US reinsurance market.

Looking back to 1998, the US reinsurance industry evidenced few outward signs of the market pressures that were bubbling all around it. Despite persistent talk of weak pricing of commercial risks and falling catastrophe reinsurance rates, US-based reinsurers' results seemed to defy gravity, with record earnings and capitalization, volume growth approaching double-digits, falling combined ratios and unrelenting investment portfolio appreciation.

Of course, like a cooling hot-air balloon, the industry has rapidly descended in the meantime, as many firms have been unable to sustain earnings in the current market. Times are indeed tough for the US reinsurance industry in 1999 and looking ahead to 2000. Real growth prospects are few, underwriting discipline is under strain, investment portfolio yields are in decline, and reported earnings are finally catching up with years of steady pricing deterioration. These stressful market conditions are affecting nearly all lines of business, grinding down reinsurers' earnings mercilessly. What's worse, the prospects for near-term resiliency appear dim. Partially offsetting the currently bleak state of affairs are the industry's overall high quality investment profile, its generally sound reserve valuations and risk management practices, as well as its strong capitalization. These mitigating factors have thus far enabled US reinsurers to maintain “Adequate” or better Financial Strength ratings.

From riches to rags: profits, once plentiful, now under seigeWeakened earnings strength and quality reveal impact of consistent price erosionFollowing several years of benign claim trends and robust investment gains - generated by steadily declining interest rates and surging equity valuations - reinsurers are now contemplating the transition from the crest of the wave to the trough. Persistent pricing erosion, previously masked by favorable reserve development, is now emerging to compress underwriting margins, perhaps exacerbated by signs of rising claim costs.

Investment returns also stand to weaken, as many firms that effectively front-ended their interest-rate related gains are now facing lower portfolio yields, and as interest and inflation concerns dampen equity market enthusiasm. Consequently, (re)insurers are looking to avoid severity losses to reduce volatility in their already weak profit margins. Paradoxically, however, earnings stability may actually be reinforcing weak pricing fundamentals. Adding a small measure of hope is the partial evaporation of retrocessional capacity, following recent catastrophic property and liability losses, which appears to be easing further downward pressure on rates, if not providing any significant upward movement.

Although reinsurers' surging capitalization and declining leverage has enabled the industry to build an incremental capital buffer to absorb deteriorating performance, intensified shareholder pressures, coupled with deteriorating earnings and weak prospects for future profitable business growth has spurred thinly capitalized and undifferentiated firms to merge or become acquired.

Struggle for growth blurring traditional lines of demarcation
Reinsurers fight over scraps of previously unattractive businessAs a seemingly mature market sector with a time-honored past, US reinsurers had developed, over time, a well accepted place within the insurance markets.

Reinsurers were defined primarily by their clientele (i.e., primary insurers) and by their method of distribution (i.e., direct vs. brokered). As market conditions have toughened, however, and as opportunities outside of the traditional reinsurance box have multiplied, these conventional definitions became strained.Perhaps the most alarming consequence of depressing market conditions has been the emerging tendency of reinsurers to scramble for growth by virtually any means. These initiatives often involve jumping - with both feet - into new and untested lines of business, expanding primary and reverse-flow operations - sometimes giving away the pen to MGAs/MGUs, and taking on new financial and underwriting risks in the process. In doing so, underwriting authority has often been transferred from underwriters to producers - a virtual recipe for disaster.

Direct and brokered markets - once enemies - now mix
The brokered and direct reinsurance markets have historically worked independently and, for the most part, in suspicion of one another. In today's intensely competitive marketplace, however, US reinsurers - both direct and brokered alike - are struggling for growth from any legitimate source. Consequently, direct reinsurers are increasingly appearing on brokers' slips, and brokered reinsurers are more often insisting on closer dialogues with their cedants, blurring once-pronounced distinctions between the two markets. Each form of distribution involves trade-offs between control of the customer relationship and control of costs. Today, neither group finds itself at a particular competitive advantage attributable to distribution, although direct-market firms - with their greater market heft and capitalization - are generally better positioned to hunker down for the continuing storm.

Reinsurers enter primary markets - the customer as competitor
As pricing conditions have deteriorated and growth opportunities in major insurance markets have dwindled, both primary insurers and reinsurers are seeking new opportunities for growth in order to more fully utilize their capital. In doing so, these firms - historically business partners - are occasionally finding themselves in adversarial positions. Increased utilization of self-insurance and captive insurance vehicles has stripped primary insurers and, to a lesser degree their reinsurers, of a portion of their revenue base. In response, insurers have rushed to retain their client base by providing risk management services and direct excess covers, encroaching on reinsurers' traditional domain. Furthermore, as primary insurers have steadily decreased their reliance on reinsurance, most leading US reinsurers have sought to protect their business sourcing by establishing subsidiaries to participate in primary insurance - or so-called ‘reverse-flow' reinsurance business, most often in specialty property and liability lines.

Some US reinsurers remain protective of their traditional client relationships, while others seem more than willing to cannibalize their existing business, believing that if they don't, someone else eventually will. The resolution of this competitive struggle remains far from clear. However, reinsurers will need to carefully balance the preservation of their core business relationships with the need to confront pressures from new competitors and shareholders.

Consolidation marches on - but to a quicker beat
A long term process continues and accelerates
The trend toward consolidation in global reinsurance has been underway for more than a decade, and continued in 1998 and the first half of 1999. Moody's expects that this trend will continue at an accelerating pace among the brokered reinsurers, as better capitalized firms seek growth through acquisition, and as weaker-positioned reinsurers are increasingly marginalized. As always in this business, new, innovative, and highly-focused specialty reinsurers will continue to emerge, seeking to capitalize on market opportunities.

Consolidation continues to be driven by several factors. Many weakly positioned or undercapitalized firms have been placed in runoff, or have become insolvent, thereby exiting the market altogether. Increased risk retentions, heightened financial security concerns and a preference among insurers, insureds and reinsurance intermediaries to deal with fully committed and financially stronger reinsurers have reduced the number of names on cedants' and brokers' slips, marginalizing weaker and strategically unfocused firms. Merger and acquisition activity has accelerated as reinsurers seek to secure their competitive position and to achieve growth in the face of saturated markets. More recently, the compounded effect of pricing deterioration, the prospect of reduced investment yields, and a reversal of favorable claim trends in several major markets has prompted increasing numbers of smaller reinsurers to merge or be acquired.

US reinsurance market becoming increasingly concentrated
Today, the three leading US reinsurers (based on NWP) - American Re, General Re, and Employers Re - all predominantly direct writers - write more than one-third of business written by US reinsurers, and the ten largest firms account for nearly three fourths. The number of active professional reinsurers has dwindled from a high of some 150 serious participants in the 1980s to fewer than 50 such firms today, as a result of mergers, acquisitions, and as a growing number of firms - particularly reinsurance subsidiaries of primary insurance and non-insurance enterprises - have been sold or placed into runoff.At the heart of reinsurers' increasing concentration is the accelerated pace of consolidation among leading US primary property/casualty insurers. As these and other firms have increased their capitalization, operating scale, and risk diversification, they - like their corporate insured clients - have increased their premium and risk retention levels to improve the efficiency of their operations, thereby removing business from the reinsurance market. Furthermore, both primary insurers and brokers have reduced the number of reinsurers they deal with in an effort to improve the efficiency and credit quality of their ceded reinsurance portfolios. This, in turn, has led to a contraction of growth opportunities for reinsurers, particularly those with marginal capitalization and with limited ability to create significant value for their clients beyond the lending of their capital.

Following direct writers' lead, brokered reinsurers begin to tie the knot
Following rapid consolidation among the direct reinsurers and brokers in the early 1990s, the pace of consolidation among brokered reinsurers has accelerated in the past year. Whereas broker market reinsurer acquisitions were once seen as unattractive - due to the lack of franchise typically enjoyed by those firms - such transactions have become increasingly commonplace with the deterioration of market conditions and the deflation of share prices. Many smaller firms are running quickly for cover, seeking refuge through mergers and acquisitions to ensure near-term survival - if not long term success. Moody's expects that consolidation among US broker market reinsurers will continue over the next year or two, as shareholder pressures intensify and growth opportunities stagnate.Yet despite this unmistakable trend among the smallest players - most of which generate less than one-tenth of each of the three largest direct writers - the process of consolidation among larger broker market reinsurers has been slow to proceed. Constraints in this process have been uncertainties regarding latent liability exposures - particularly on casualty excess of loss business written in the 1970s and prior years - as well as reinsurers' strong reported earnings and high market valuations in recent years. Additional concerns of potential acquirers have included the stability and retention of premium flow and divergent underwriting quality and philosophies among firms.

Recent reinsurer earnings and share value deterioration, opportunistic plays by some capital-rich acquirers, and the prospect of persistent pricing weakness, as well as the pressures exerted by rapid consolidation among insurance and reinsurance brokers, have combined to accelerate the pace of consolidation among brokered reinsurers. Most notable among these have been the acquisitions of NAC Re by XL Capital (which also owns XL Mid Ocean Re), of TIG Re and Skandia America Re by Fairfax Financial (now forming part of the Odyssey Re Group), of Winterthur Re America and SAFR US by PartnerRe, of Constitution Re by Gerling, of Chartwell Re by Trenwick America Re (in process), and of USF Re by Folksamerica Re. Another transaction, Employers Re's acquisition of Kemper Re (renamed GE Reinsurance Corporation) raised some eyebrows as the first large acquisition by one of the leading direct writers of a broker market firm. And in the direct market - perhaps most unexpected of all - was the acquisition of the largest US player, General Re, by Berkshire Hathaway for nearly $22 billion, serving as a reminder that even the largest and best positioned firms are not immune to market forces.

As challenging market conditions are likely to persist over the near term, Moody's expects that the US reinsurance market will see significant further consolidation and rationalization ahead. The environment is now ripe for consolidation, and virtually every US reinsurer is seen as predator, prey, or both.

International expansion - the search for greener pastures
Weak domestic growth, pursuit of geographic diversification fuels expansion overseas
Less than a decade ago, few of the leading US-based reinsurers had a meaningful presence in international markets. Today, however, most of the leading US firms - both direct and brokered - have made overseas acquisitions or have expanded internationally through branch offices. For the large direct companies, these acquisitions have focused on building a strong European base, while the efforts of brokered reinsurers have generally centered on Lloyd's and the London company market.

On one level, the international expansion of US reinsurers can be seen as simply an exercise in good client service: domestic clients are writing more business overseas, and reinsurers are following them abroad. This explanation, however, tells only part of the story. US reinsurers' overseas expansion is fundamentally a response to weakening domestic market conditions, the expectation of higher growth rates across product lines in less mature reinsurance markets, and expectations of rising demand in established international markets for expertise in excess of loss and liability exposure underwriting. The pursuit of sheer premium volume in an effort to ensure long-term viability and market prominence is another rationale that cannot be discounted. The appeal of new clients, and the ability to geographically diversify exposures - particularly property risks - has made globalization especially attractive.

Although US reinsurers' experience with liability lines has alternated between lucrative and disastrous, skills related to the pricing of long-term exposures are a competitive strengthfor reinsurers seeking to leverage those capabilities in markets such as Europe, where the tort liability concept - particularly in corporate markets - is beginning to take hold. The same can be said for US reinsurers' experience in excess of loss underwriting, which is, by all accounts, poised to garner increasing market acceptance over the medium term. As regulatory barriers fall and national boundaries lose relevance in Europe, primary insurance markets are becoming more intensely competitive, and the economic efficiency of excess reinsurance coverage will become more appealing over time. Cultural and operational challenges, as well as financial risks, should not be ignored, however, as US reinsurers seek to apply their skill sets abroad. The lack of familiarity with foreign risks and with local market norms in overseas markets can have potentially disastrous underwriting consequences.

The looming Y2K threat: are reinsurers whistling in the dark?
The scale of potential disruption that may arise from the Year 2000 problem is enormous, and insurers and reinsurers may be among the most exposed if Y2K issues are not properly addressed. Their unique challenge lies not just in squashing the “bug” within their own computer systems, but in facing the prospect of claims and coverage litigation associated with a number of business lines (re)insured. Reinsurers' attempts to mitigate exposure with exclusionary policy language and/or coverage sub-limits have been largely rebuffed by ceding companies that have little such language in their underlying policies. Regardless of whether claims are ultimately successful, many insurers and reinsurers will certainly face large legal defense bills. Coverage disputes relating to recent efforts by insureds to seek payment for Y2K remediation costs under “sue and labor” clauses within the standard property policy serve to illustrate this point. At this time, most reinsurers - like the ceding companies whose fortunes they will surely follow - are wed to a Y2K strategy best characterized as “whistling in the dark.”

Alan Murray is vice president and senior credit officer and Ted Collins is managing director in Moody's Property/Casualty Insurance & Reinsurance Group (New York office).