In this analysis of the US reinsurance industry, one thing rings loud and clear - yet more consolidation is on the cards, with virtually every reinsurer seen as predator, prey, or both. Ted Collins and Alan Murray fill us in on the details.

Entering 1998, the US reinsurance industry evidenced few outward signs of the market pressures that were bubbling all around it. Indeed, despite persistent talk of weak pricing of commercial risks and falling catastrophe reinsurance rates, the US-based reinsurers seemed to be able to defy gravity. Record earnings, volume growth approaching double-digits, falling combined ratios and unrelenting investment portfolio appreciation. All appearances suggested that it was the best of times.

Just below the surface, of course, a much different story had begun to emerge. This story, which continues today, is characterised by intensifying competitive conditions, rising shareholder demands, a changing market structure and the imperative of global expansion. These trends are more than influencing the decisions of US reinsurers today - they are forcing those companies to move in one direction or another, while at the same time, limiting the menu of choices. How US reinsurers respond to these developments will have significant, long-lasting implications for the industry's future structure and function, as well as for their own financial strength.

Overview of major trends affecting US based reinsurers

Changing market structure spurs struggle over value creation

As growth prospects have dimmed and competitive conditions intensified, reinsurers have become locked in a struggle with primary insurers, with brokers, and with new competitors over nearly every facet of the risk management function. At stake are questions of where in the risk management process value is created and who will reap the rewards of that value creation. Participants in the traditional market (insurers, brokers and reinsurers) have increasingly encroached upon each other's turf in their efforts to find new and profitable business opportunities. Making matters worse, new competitors without ties to established market paradigms, such as the US-based investment banks, have sought to re-write the rules of the risk management game. As the risk management function is divided into its component parts, first between risk transfer and risk financing - but ultimately into even finer pieces, such as risk origination, funding, transfer, and servicing - the competition for value creation at each step intensifies.

Shareholder value considerations are becoming key strategic drivers

The reinsurance industry is not immune to the general trend in business toward greater attention to shareholder value. In fact, as rising expectations about revenue and earnings growth have pushed US equity prices higher and higher - recent experience excepted - the sensitivity of many reinsurers' market values to shareholders' expectations has grown proportionally. However, as pricing conditions have deteriorated, pressures on growth and profitability have made it difficult to add excess value through underwriting. As a consequence, many reinsurers have sought to enhance shareholder value through other means, such as acquisitions or "optimization" of their capital structures. Some of these value-based decisions have added to franchise strength - thereby preserving or enhancing credit quality, whereas others - often part of defensive strategies - have been at the expense of reinsurers' financial strength. Balancing the often competing demands of shareholders and other stakeholders is proving to be one of the industry's most challenging tasks.

Insurance and capital markets are converging at the doorstep of reinsurers

Much has been made of the potential for convergence between financial and insurance markets, and reinsurers in the US have taken notice. As competitive pressures continue to alter the structure and function of (re)insurance markets, the reinsurers' position along the risk-transfer/risk-finance continuum has shifted. Several forms of alternative risk transfer are now established disciplines within the reinsurance market, and most US reinsurers have invested in this capability to some degree. The recent pursuit by investment and commercial banks of capital markets applications within this arena, is therefore a potentially significant threat to reinsurers' roles as capital providers. Although reinsurers should continue to benefit from their specific knowledge of insurance risk, the commoditization of this risk and the increasing capital mobility may erode their franchises. To date, successes in the capital markets arena have been modest, but the pace of development has accelerated. Reinsurers that possess strong financial and product development expertise may be able to capitalise on their unique capabilities; for others, disintermediation remains a risk.

Prominent features of the US reinsurance market

A mature market with developed products and coverages

The US reinsurance market is the largest in the world, based on premiums ceded by primary insurers. The US is also a mature market with significant wealth accumulation and private property ownership, privatised of industry, a developed concept of liability, and highly insured corporate and personal lines customer segments. Unlike most other world markets, the US reinsurance market is heavily weighted - at about two-thirds of net premiums - toward liability business, a mix that has remained relatively stable over the past two decades. Also unlike other markets, US reinsurers' premium volume is approximately evenly divided between proportional and excess of loss business; given the significantly more premium-efficient nature of excess business, the utilisation of reinsurance in the US market is therefore heavily weighted toward indemnity-based, rather than capacity-driven, coverages. Furthermore, the high proportion of excess of loss business suggests that the US market is considerably larger than a simple premium-based comparison with the other leading reinsurance markets would suggest.

A consolidating market -

and for good reason

The maturity of the US market, combined with significant earnings strength and share appreciation in recent years, and the increasingly international scope of many commercial insurers and insureds, has prompted reinsurers to respond in several ways. These include, most notably, within-market acquisitions leading to consolidation, overseas acquisitions or joint ventures in an attempt to expand global reach. Today, the 10 leading US based professional reinsurers account for nearly two-thirds of business written, and the 25 largest reinsurers account for nearly 90%, compared to just over 80% five years ago. The number of active professional reinsurers has dwindled from a high of some 150 participants in the 1980s to 50 or so 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. Furthermore, many of the remaining firms are US based branches or subsidiaries of international insurance or reinsurance concerns, and have a modest presence.

At the heart of reinsurers' increasing concentration is the accelerated pace of consolidation among leading US primary property/casualty insurers, most notably the combinations of Zurich American with Home, CNA with Continental, Travelers with Aetna, St. Paul with USF&G and SAFECO with American States. As these and other firms have increased their capitalisation, 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, which has also led to a contraction of growth opportunities for reinsurers - particularly those with marginal capitalisation and with limited ability to create significant value for their clients beyond the lending of their capital.

As these conditions are likely to persist, the US reinsurance market can expect to see further consolidation ahead; the industry will continue to rationalise itself. The current year has seen ample evidence of this reality, with a large proportion of the 20 largest US reinsurers restructuring, making acquisitions, or being acquired themselves in 1998. Indeed, it is only because of the existence of a number of substantial obstacles that consolidation has not occurred more broadly and more rapidly. The most prominent hurdle involves the relationship between the market premium attaching to reinsurance firms and the excess value that can be derived from them by the acquirer. In many cases, these two factors do not line up, reflecting limited opportunities for cost-savings as well as uncertainty about the retention of in-force business. Another material obstacle to consolidation appears to be the divergent underwriting philosophies and quality among firms, as well as continued uncertainties associated with environmental pollution and other latent from prior years' operations. Despite these challenges, however, the environment is ripe for consolidation, and virtually every US reinsurer is seen as predator, prey, or both.

Search for geographic diversification and greener pastures fuels international expansion

Just five years ago, few of the leading US-based reinsurers had a meaningful presence in international markets. Today, however, most of the leading firms - both direct and brokered - have made overseas acquisitions or have expanded internationally through branch offices. Faced with classic buy-versus-build decisions, the largest direct writers - General Re and Employers Re - have both made large acquisitions in Europe, having concluded that meaningful growth in European markets could not be achieved organically. The acquisition of American Re by Munich Re effectively achieved the same end, but from the German perspective. Smaller, predominantly broker-market firms, constrained by their smaller capital bases and financial flexibility, have instead shown a preference for less capital-intensive acquisitions as a means of gaining access to business that they would not generally see in their domestic market. These acquisitions have generally been focused on Lloyd's and the London companies markets, which have emerged from several years of turmoil to compete vigorously for international reinsurance business.

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 in the US, 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 globalization is especially attractive.

Although US reinsurers' experience with liability lines has alternated between disastrous and lucrative, skills related to the pricing of long-term exposures is a competitive strength for US reinsurers seeking to leverage those capabilities in markets such as Europe, where the notion of liability exposure - particularly in corporate markets - appears to be increasingly taking 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.

Shifts in distribution and focus are challenging conventional reinsurer definitions

As a seemingly mature business 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 (that is, primary insurers) and by their method of distribution (that is, direct vs brokered). As market conditions have toughened, however, and as opportunities outside of the traditional reinsurance box have multiplied, these conventional definitions have been strained.

As US 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 business, most often in specialty property and liability lines. Often, the sponsoring reinsurer also assumes a significant level of insurance risk on underwritten transactions by providing reinsurance capacity, in some cases ceding certain exposures or excess layers to the broad reinsurance marketplace as well. These arrangements are sometimes referred to as reverse-flow transactions, because the business is generally promoted by the reinsurer, who also has a strong hand in the underwriting guidelines and takes significant risk. These efforts have opened new avenues of growth for US reinsurers, but not without some additional business risk; reinsurers need to take care not to jeopardise valued client or broker relationships by competing directly. Although this risk cannot be ignored, it is substantially mitigated by the efforts of both primary insurers and brokers to establish vehicles to compete directly with reinsurers in their own core business. In this regard, there are many sinners and few stones being thrown.

As the lines between primary and reinsurer are blurring, so too is the demarcation between those US reinsurers who place business directly and those who use brokers. This distinction, which has long served as a key point of reinsurer taxonomy, is steadily losing its relevance. Increasingly, direct writers are seen on brokers' slips, often as lead underwriters with a significant participation and influence over the terms and conditions. Conversely, broker-market reinsurers are increasingly insisting on the ability to develop closer working relationships with their cedants, as they are increasingly becoming aware of the bottom-line benefit of developing a stable clientele. This in part reflects the changing roles of both reinsurers and reinsurance intermediaries, as well as the universal need for growth in a marketplace that is uniformly difficult.

Financial results belie difficult market conditions

In spite of challenges to the core business of US reinsurers, the market has managed to report relatively attractive returns in recent years. Although premium growth of the US companies has fallen dramatically, realised capital gains and the rise in earnings from foreign operations have combined to double the return on premiums earned by the market over the last two years.

These favorable market returns have also been distributed in a relatively even-handed manner across the industry. Both the largest firms and the smaller reinsurers have achieved similar returns (about 10%-12%) on written premiums over the past few years. This experience runs counter to Moody's long-term expectation, that the largest reinsurers, on the strength of their substantial franchises, should outperform their more marginal peers. In this regard, the performance of all US reinsurers should be watched closely for the years 1998 and 1999. In more than a few cases, Moody's expect that thinly capitalised and undifferentiated US reinsurers, will become pressured into run-off or become acquired, having lost their fight against brutally competitive US reinsurance market conditions.

As the impact of low growth and weak pricing becomes manifest in the financial results of US reinsurers in the coming years, these companies may find some benefit in the incremental surplus buffer they have built in recent years as investment markets have risen. The industry's operating leverage has declined slightly each year since 1994 (declined substantially, if the highly-capitalised National Indemnity is included in the analysis), offering the industry some additional capital to absorb deteriorating performance.

A deterioration in performance would represent a stark departure from recent industry performance, which has been marked by a decade of fairly stable loss patterns. Except for 1992, when the US reinsurance community was ceded substantial losses from Hurricane Andrew, and 1998, when pricing on liability coverages had rebounded from cyclical lows, the industry's loss ratio has fluctuated within a fairly narrow band, between 70% and 75%. In fact, moderating loss experience in recent years has been at least partially responsible for pressuring US reinsurance rates down.

How will all this shake out?

Moody's expects that the trends outlined above will pressure the financial strength of the US based reinsurance companies, although they will affect each firm differently.

The largest of these reinsurers - which tend to possess sophisticated financial and risk management skills, large limits of underwriting capacity, global service capabilities, and unparalleled product design and distribution - are well-positioned to meet the challenges presented by changing market forces. Their substantial resources will enable them to fund the research and development necessary to stay competitive, but their heavy investment in the status quo will make it difficult for them to make meaningful change quickly.

There will continue to be a role in regional markets for highly client-focused generalists - because of their proximity to local cedants and intermediaries, and for specialty firms - because of their focused knowledge and their ability to bring innovative solutions to the market. Such firms, however, may be challenged to remain independent over the long term, given their relatively modest scale and limited financial flexibility.

Smaller, generalist firms with undifferentiated capabilities whose business rationale is predicated primarily on providing capital in small increments to syndicated reinsurance programs are at risk. These firms may be compelled to accept greater levels of underwriting or financial risk to compensate for fundamentally weaker competitive positions.

Ted Collins is a managing director in the Finance, Securities and Insurance Group of Moody's Investors Service, the global credit rating agency. Within this group, Mr Collins leads a team of professionals devoted to the analysis and ratings of property/casualty insurance, reinsurance and brokerage companies.

Mr Collins is a certified public accountant and holds a Masters of Science in Professional Accounting degree from the University of Hartford in Connecticut. He graduated with a Bachelors of Arts in Mathematical Economics from Colgate University in New York.

Alan Murray is vice president and senior credit officer in the Property & Casualty Insurance Group at Moody's Investors Service. He oversees ratings on a portfolio of US and international (re)insurers, and is the principal author of Moody's Global Reinsurance Report. Mr Murray has also been involved in the analysis of the capital market initiatives such as catastrophe risk securitization, insurance derivatives and other alternative insurance risk transfer and financing structures.

Prior to joining Moody's in 1990, Mr Murray was a member of the corporate actuarial group at American International Group (AIG) in New York City. He holds a degree in physics from Cornell University.