As European reinsurance shares remain on very low valuations, Tim Dawson asks if investors are being too pessimistic and whether the prospects are the same for everyone?

The shares of Europe's diversified reinsurers remain stuck on very low valuations (see figure 1). This is despite the excellent interim 2007 results that the groups have reported and the benign developments reported in their renewals updates. What are these valuations telling us and, more importantly, are investors missing something?

In discussion with investors, it seems that there are two overriding concerns: the prospects for the reinsurance cycle and growth. The very simplistic nature of the arguments for a return to a soft market with underpriced premium rates is striking. Investors argue that it has always happened before and that capital has built up in the industry.

These assumptions overlook several important changes that have taken place since previous cycles. The most obvious one is the greater understanding and focus throughout the industry on capital allocation, return on capital and the need to set (and hold) appropriate technical prices.

No one who has followed these companies through previous cycles can fail to be struck by the changes that have occurred in management thinking. The focus on shareholder value and the return on allocated capital are just two examples.

Reinsurers are generating strong returns and it is clear that the industry as a whole realises that not all this capital can be deployed in underwriting reinsurance risks. This is triggering substantial capital management activity with the market leaders Swiss Re and Munich Re acting as bellwethers with their share buyback programmes (CHF6bn and ?5bn respectively).

Shareholders are adding to this pressure - management teams are getting the message that excess capital should be recycled and not hoarded. The same influence is at work on capital that recently moved into the sector, for example sidecars. The owners of that capital want to see an investment return commensurate with the risks. If premium rates weaken, we will no doubt see that sidecar money leaving the market and returning to the hedge funds and other backers.

“The very simplistic nature of the arguments for a return to a soft market with underpriced premium rates is striking

Other disciplining influences are coming from the regulators and the rating agencies. In the Solvency II/Swiss Solvency Test environment, operational performance will be an increasingly important element underpinning oversight of the industry. When rating agencies publish their rating rationales, there is always a focus on whether the operating performance of the company is in line with what would be expected with a given rating.

What is particularly encouraging is that these forces are driving structural internal changes in the major groups that should help to embed responsible behaviour. The first big example was Swiss Re's decision to separate its technical pricing function from the market-facing parts of the group. This should mean that there is a clear "red line" in pricing that will prevent prices falling too far, even if there is a short-term cost in terms of volume. More recently, we saw Munich Re's "changing gear" programme, which includes the goal of being "the most profitable reinsurer worldwide" and included the capital management commitment mentioned above.

There are further examples that also point to good behaviour. So far market participants are not complaining of irrational pricing or competition from other quarters. There is also evidence of the start of some moves towards consolidation among the second and lower tier players (most recently, for example, between SCOR and Converium). Such moves help to keep the industry's capital aligned to the available business. In addition, reduced fragmentation is always a positive factor that reinforces market discipline.

Can reinsurers grow?

Reinsurers are in an unusual position. Currently their biggest source of competition is their own clients. The last few years have seen a dramatic improvement in the financial condition of insurance companies as figure 2 (taken from the US market) highlights. Capital adequacy has clearly improved but also the quality of the capital is much higher. The significant increase in the ratio of loss reserves to incurred claims points to a much-reduced risk that reserves will be deficient and therefore capital overstated.

In the short term, the impact of improved capital strength could well be supplemented by other factors, especially the Florida Hurricane Catastrophe Fund (at least until the time that the fund has to levy revenue-based assessments when its reinsurance cover turns out to have been not so cheap after all).

“If premium rates weaken, we will no doubt see that money leaving the market and returning to the hedge funds and other backers

In such an environment, the obvious first use of this increased capital is increased retentions by primary carriers and this trend appears to be playing out based on the comments that have accompanied reinsurers' renewals updates. Does this mean that reinsurance is destined to a future of no growth with profits simply being returned to shareholders each year through share buybacks and increased dividends?

It is here that we believe a clear delineation exists between those reinsurers that are well placed and those that are not. Simple capital substitution products such as proportional reinsurance would be likely to suffer the most. This appears to be reflected in the evolving business mix of the European reinsurers.

Conversations with reinsurance buyers suggest another trend: continued demand for reinsurance cover from the best-rated companies and those with a clear "added-value" to the insurance client. This has the knock-on effect of greater-than-average volume pressures on following capacity providers. This will undoubtedly drive yet more consolidation and capital management activity among the medium-sized reinsurers.

Implications

The market environment likely to evolve will look very different for the top tier and the rest of the market. The biggest groups with their strong financial strength rating, diversification, ability to take on the largest deals and the capability to access insurance-linked capital markets look well-placed to ride out pressures from the cycle. For such groups (and most of the quoted European names fall into this category), the stock market's pessimistic view simply looks wrong.

However, lower down the scale things will be less rosy. Volume pressures are likely (because less business is being ceded and a higher proportion of ceded business is snapped up by the market leaders) and pure providers of capacity could become exposed to competition from other sources of capital (for example, sidecars and insurance-linked securities).

Tim Dawson is an analyst for reinsurance shares with Helvea, an independent stockbroker based in Geneva, Switzerland.

Insurance-linked securities: Opportunity or threat?

Insurance-linked securities (ILS) continue to evolve in a very dynamic way. Early transactions were mainly concentrated in the areas of catastrophe bonds, usually offering protection against very severe but unlikely events. The last two years have seen a considerable broadening of the market with bonds being issued by reinsurers to cover, for example, extreme mortality risks and credit risks. There have also been some securitisations by primary companies (AXA, Zurich Financial Services) that have issued ILS as a direct substitute for traditional reinsurance cover.

As the market evolves, could ILS and similar instruments challenge the position of conventional reinsurance? There are some segments where this could be possible, especially in the direct securitisation of high frequency, low volatility portfolios such as motor by bigger primary groups.

However, such deals are unlikely to become the norm across the market because transaction costs are high and limit the viability of such deals to the largest portfolios. In addition, if the ILS market is to continue to develop strongly, this is likely to be on the back of parametric triggers or an industry loss index. This exposes the cedant to basis risk that would either have to be passed on to a reinsurer or would require considerable capital to back it.