As stock markets fall, banks lay off personnel, insolvencies increase and economic growth falters, the symptoms of business success appear to have ducked behind the horizon. For the reinsurance sector, a market which has lurked in the doldrums for several years, there are undoubtedly tough times ahead, as poor underwriting results coupled with recent large loss events, adverse development on old exposures and low investment returns take their toll. This is not, however, a precursor to a collapsing market – far from it, in fact, according to analysts at Morgan Stanley Dean Witter (MSDW).

Instead, MSDW is predicting a powerful upswing in the global reinsurance market, lasting several years and most likely to benefit the strongest reinsurers. Already, MSDW has seen a massive shift in interest in the reinsurance sector; a conference call in mid-August logged around 175 investors interested in the business. During that conference call, analyst Espen Nordhus, based in MSDW's London operations, explained that several powerful forces are converging to push up the international reinsurance market in a sustained way.

With higher investment income comes lower underwriting discipline, he said, and as investment incomes are dropping, the implications of poor underwriting are increasing. But “when (the market is) in a downturn, forces come together and the whole balance of supply and demand shift,” as insurers become increasingly worried about their exposures. “Psychology, greed and fear should not be underestimated in this market,” he said, and these factors are contributing to a more risk-averse attitude. This contrasts sharply to the mid to late 1990s, when prices fell alongside a boom in the equity markets and distinct lack of catastrophes. “The late 1990s were characterised by one big party,” he commented.

Now, however, “the whole greed culture has been replaced by a more cautious outlook.” Insurance companies are increasingly finding themselves with weak capital positions, and adverse developments such as the need to strengthen asbestos-related reserves are having an impact on the bottom line. Reinsurers need to respond by increasing prices; in fact, global catastrophe prices increased by 1% last year, and recent adjusted estimates for this year show a 23% relative change in the pricing levels. “Post (tropical storm) Allison, the primary companies realised they retained more risk than they wanted,” said Mr Nordhus, and in the current climate “everybody will feel uncomfortable now – nobody will be bailed out by good capital markets. It is not an option this time.” Allison losses are estimated at $2.5bn with US thunderstorms adding a further $1.9bn to the recent insurance bill.

Mr Nordhus predicted a “bleak outlook” for small and medium sized players, and suggested several will go out of business. This will lead to an outflow in capital, which in turn inevitably results in rate increases.

As well as being hit by Allison, the re/insurance sector is facing under-reserving issues. MSDW estimates the broker market reinsurers are under-reserved by between $2.5bn and $5bn, and this cost is likely to be disproportionately shared by a few companies. “This combination of many things – capital markets, adverse development – comes back later as pain,” said Mr Nordhus. Recent examples include:

  • CNA corporate agreggate covers $236m ceded to stop loss reinsurers. Total of $707m ceded to CNA reinsurers;
  • CNA Re's $560m reserve charge and write-off of London operations;
  • Trenwick $51.6m loss reserve strengthening for D&O and PL book in US treaty and London/Lloyd's;
  • PXRE postponed Q2 earnings to restate results for revenue recognition from finite reinsurance contracts;
  • PMA Re's investment income down 18% due to stop loss reinsurance, giving away ‘float';
  • Overseas Partners suspends share repurchase program, cuts dividend and underwriting results shrink capital from $2.5bn to $1.6bn since early 2000;
  • General Re 2Q North American combined ratio 127.2% including 8.8 points of cats, 11.6 points of reserve strengthening on 1998-2000 accident years; and
  • Hartford Re 2Q combined ratio 119.4% on adverse development in 1998-2000 accident years.

    “The market is now driving looking in the rear view mirror,” said Mr Nordhus. That includes a view of long-tail business that is looking decidedly worse than it did a year ago. For 2000, MSDW estimates, based on AM Best research, calculate that just over 50% of asbestos-related liabilities are unfunded, and of the total industry reserves of $25bn, almost one-third is held by just five companies. Others are undertaking reserve reviews, and it is likely they will add to their reserves as a result. “We have reason to believe (asbestos) will create a lot of damage, particularly in the US,” he said, noting that last year Swiss Re entered into a major reinsurance commutation for its asbestos exposures. Loss cost inflation, with courts' “obscene” awards, mean that asbestos litigation will be settled at higher levels than it has been historically, commented Mr Nordhus, and under present calculations the industry may need a further $20bn to finance its asbestos exposures. “Medium-sized players may go out of business, and we may see downgrades,” he said. Loss cost inflation resulted in US reinsurers strengthening their 1998 accident year loss reserves by an average 11.1 points by the end of last year, and the average 2000 initial loss pick is 7.7 points lower than the current 1998 adjusted loss ratio and 13.0 points below the current 1999 adjusted loss ratio.

    Such indicators of market problems are reinforced by the wholesale withdrawal of retrocession capacity. With all this uncertainty, buyers are beginning the flight to quality.

    All these factors are contributing towards the upswing in the reinsurance cycle, said Mr Nordhus, an upswing he sees as being significant and which may last up to five years. “The competitive advantage in reinsurance is global diversification,” added to underwriting expertise and size. “The best players will make money out of the cycle,” though others will fall by the wayside. “It is a very concentrated business,” he said. “A few large giants dominate the reinsurance world.” It is these giants – including Swiss Re, Berkshire Hathaway, XL Capital and Aon – that are likely to be the winners in the upswing.