Stuart Shipperlee looks at the current market position, and where it is heading in 2004.
In our annual review of the global property/casualty reinsurance industry published last September, AM Best commented that the financial strength of reinsurers remained under pressure in spite of the hard market. This reflected a range of interacting factors which have either since continued or at least not materially improved. This has created an environment where structural change in the industry is taking place, with new (or relatively new) players becoming more important and relationship-based business under more pressure than ever before.
Balance sheet strengthBalance sheet strength in the industry has been materially reduced over the last two years, reflecting the combined effect of asset losses (especially equities), adverse development in loss reserves, and the World Trade Center (WTC) loss. Some significant capital raising has taken place, but generally not sufficient to fully restore former levels of risk-adjusted capital. A consequence of this is that reinsurers' balance sheets are showing a higher reliance on 'soft capital' deferred acquisition costs, goodwill, etc.). In addition, the degree of exposure to reinsurance recoverables has increased, partly because as gross losses rise so do recoverables, but also because both credit risk and 'dispute' risk have grown. Thus, the combination of reduced capital strength combined with increased reinsurance recoverables has caused a substantial exposure to develop in some companies.
High levels of capitalThe reaction of managements to pressure on their capital has highlighted the dynamic tension that can exist between shareholder and policyholder interests. For shareholders, an appropriate risk-adjusted return on capital employed is the goal. That is the measure they will apply to the managers of their business. Consequently, unless reinsurers can achieve a higher premium for the same risk sufficient to economically justify carrying the extra capital, the economic pressure is for them to run at lower capital levels and live with the consequent lower financial strength ratings. For policyholders, however, the maximum amount of capital relative to risk is the ideal position. Obviously for a reinsurer to successfully trade forward they need to find the relevant balance point for these conflicting needs. For most reinsurers, though, it seems unlikely that this point will be at capital levels necessary to achieve the highest Best's rating (A++).
Reaction to reduced ratingsThe reduced financial strength rating levels in the industry are highlighted by the fact that six of the top ten reinsurers have had their ratings reduced during 2003. That said, most continue to have ratings very comfortably within the secure range (see table 1). While there has been a lot of speculation about the potential impact of the downgrades, it is likely that cedants are now adjusting to financial strength rating levels that are at least somewhat below their former expectations. There has, however, been a growth in cedants looking for some form of protection (e.g. letters of credit) or exit clause (e.g. rating triggers) as well as diversifying their sources of cover. It should be noted that both these protection mechanisms and diversification by their nature reduce the importance of the 'relationship' component of their interaction with their traditional main reinsurers. This could have a profound effect on traditional practices in markets such as Europe.
New reinsurance capacityAny capital raised by a reinsurer against which it can underwrite technically constitutes new capacity. However, the primary point of interest at this juncture is the growth in capital in Bermuda. Outside of Bermuda, most capital raising by existing reinsurers has been to replace losses. Bermuda, in contrast, has seen both substantial new equity raised by start-ups and by several of the incumbents (see tables 2 and 3).The post-WTC loss pricing environment was critical to most of the start-up business plans. This allowed conservative amounts of business relative to capital to be proposed, which nonetheless still offered investors a high likely return on that capital. The combination of this modest underwriting volume relative to the capital base, low asset risk and no prior year tail led to high initial and prospective risk-adjusted capital levels. These, in turn were critical to start-ups achieving ratings from AM Best and to their general market acceptance. For example, for a start-up achieving an initial rating from AM Best of 'A-', initial and prospective risk-adjusted capital would be at the 'A+' or 'A++' level.For some of the existing Bermuda market too, the post-WTC loss environment, along with the pricing pressure in casualty lines driven by prior year adverse developments, has presented opportunities that have enabled them to raise fresh equity. While not immune to the problems of the traditional reinsurance market and particularly to adverse development on US casualty business from the late 1990s, recent investment in the Bermuda market has reflected investor confidence that businesses there have a reasonable degree of control over their adverse development potential. This is also helped by their general lack of exposure to asbestos-related claims.The consequence of the increased willingness of cedants to look for new markets, and the positive factors highlighted above, have meant that several new and existing Bermuda reinsurers are seeking to expand both by line and geography. Several have opened US and European operations and there is a clear move into casualty lines. However, this carries some risk. Entering casualty in any part of the world always runs the risk of adverse selection, and the development of new operations for a reinsurer is invariably a challenge to underwriting control. In addition to some of the factors highlighted above, a critical issue behind some of AM Best's recent reinsurer rating actions has been earnings quality. In particular, the apparent difference between the perception that the market is at a very high price level against the reality of reinsurer combined ratios during the first half of 2003 struggling to beat 95%.In essence, if the level of combined ratios in the mid 1990s is as good as it is likely to get (and this was during a benign period for catastrophe losses and prior to some of the second half recognition of adverse development), then even a modest overall softening could return the industry to underwriting losses.In practice it seems that, at least for the simpler risks, property is clearly softening. Perhaps of more concern though is that casualty rates seem to now be doing little more than mark time with loss cost inflation. Given the ongoing potential for new casualty exposures to emerge it is difficult to be confident that even current pricing levels are adequate. Moreover, if a further softening in property then accelerates the switch of capacity to casualty lines, this market may well turn too.There is a hope that, precisely because of the pressure on balance sheets, reinsurers will collectively hold the line on pricing and any soft market will be short and shallow. However, the point at which the market seems to have peaked does not bode well for that.Again, a significant exception is Bermuda. Although it should be recognised that since many of the Bermuda reinsurers have a higher than typical risk profile, earnings in the good years should be higher than average.
SummaryAM Best believes that the economic pressure on reinsurers to manage their capital efficiently will mean the highest Best's ratings in the future (A++) will be rare and likely to reflect special circumstances. Successful reinsurers will more likely run their capital at levels supporting somewhat lower ratings while still maintaining sufficient strength to be acceptable to cedants. This, in turn, will reflect an acceptance by cedants of lower ratings and a greater tendency to seek more diversified sources of reinsurance capacity.While the 2004 renewal season will be an important indicator of the market's ability and willingness to maintain pricing at healthy levels, the real test will most likely come in 2005. In the absence of a very large catastrophe loss, meaningful downward pressure on pricing is likely to emerge through 2004, and by 2005, this could be sufficient to mean underwriting losses if the market lets it happen. With the reduced ability of many reinsurers to do this it would put serious further pressure on financial strength.By Stuart ShipperleeStuart Shipperlee is Managing Director of AM Best Europe Ltd.