The direct and facultative market is getting softer, but demand is up and capacity cutbacks should prevent a freefall. Senior insurance figures say it will take a sizable loss or a series of significant losses to turn the market

While rates in the facultative reinsurance market have been under downward pressure for some time, there are mixed feelings about where things are heading as the industry approaches 2011. Some feel prices will fall dramatically, while other experts think direct and facultative (D&F) players will pull back on capacity, allowing underwriters to hold their lines with more success. The recent decision by Chaucer to exit US D&F suggests that players are willing to pull back where the market is too soft and competitive.

Integro Insurance’s managing principal, international insurance and reinsurance division, Ron Whyte, says: “I don’t think we’re going into freefall because I do think some people will cut back. I’m not going to be saying to some of our major US retail clients, ‘we should target 25% off’. I think we’ll start by saying for those that are cat-driven you need to try to hold your renewal.

“If we can get something off that’s fine, but I am worried we might bleed some capacity overall from the market. If and when rates push up, new capacity will come in, so it’s never going to go up too much or for too long.”

More activity

Whyte says: “If you look at the D&F market when rates are softening, it’s the area that comes under most scrutiny. If people don’t think the market is in a particularly good situation, they’re going to start easing back.

“If they’re looking at allocation of capital, syndicates take a hard look at what capacity they need for next year. I fully expect some of the Lloyd’s ones to cut back. The area they’re likely to cut back first is the D&F side so they can control their treaty writing a bit more.”

Traditionally, facultative reinsurance has been bought to fill gaps in cedants’ treaty programmes. In times gone by, a soft market would have presented arbitrage opportunities. These, however, are fast disappearing, according to Whyte. “Generally speaking, as the market softens there’s more activity on the fac side because there’s more available capacity,” he says. “For a while now there has not been a naïve fac market so the opportunity for a straight arbitrage has largely gone.”

Whyte does not see massive softening because he thinks there will be a clear out of capacity, which will bring some discipline into the market. “You just don’t find those ridiculously cheap deals out there anymore,” he says. “On the cat side, I don’t think there’s necessarily going to be more capacity around, so those looking to buy fac on cat risks may struggle – with rates where they are I think that a number of syndicates will be cutting back on capacity. Some have pulled out of writing North American property business.”

Prices might be low but demand for fac cover has increased dramatically as the treaty market has softened. “The amount of trades is up 25% on the prior year. We expect a significant amount of that to stick, even if the market terms improve,” Aon Benfield Fac chief executive Elliot Richardson says. “More people are buying facultative to allow them to get through this cycle. I would say we’ve got at least another 18 months, if not two years, of that left, barring a large event.

“People will avoid the word arbitrage because they don’t like to be accused of doing that, but every fac deal is an arbitrage position,” he continues. “You should be improving your net treaty position on that account. I’m looking forward to another tough 18 months where you can really show the value of fac. I think it will hold fac in great stead come the market turning.”

Property portfolios

The major European treaty renewal at 1 January is a good indicator of what is likely to happen to prices in the facultative reinsurance arena. Both markets tend to be influenced by the same macro-level influences when it comes to pricing. Overall, as the industry prepares for the Baden-Baden Meeting, all the indicators are that rates are going to fall again. This is despite some losses in 2010 – including the Chilean earthquake, Deepwater Horizon spill and New Zealand earthquake.

While the losses – particularly in Chile where economic losses are expected to reach $30bn and insured losses about $8bn – will dent earnings for the year, they were not sizable enough to turn the market. “Do we expect rates to go up as a result of the Chilean earthquake? Not really,” Whyte says. “I think it will have affected people’s overall property portfolios, so maybe there will be a little cutting back on where they put their capacity.”

BP has set aside $20bn to pay claims from the Deepwater Horizon explosion and resulting three-month-long spill, during which 53,000 barrels of oil a day leaked into the Gulf of Mexico. The insurance industry has avoided exposure to the worst of the disaster, with Lloyd’s anticipating it may see claims of $300m-$600m.

In the third quarter, typhoons in Asia and the New Zealand earthquake have added to the loss register. A magnitude 7.0 event on 4 September is likely to cost NZ$1.5bn-NZ$2.5bn (US$1.14bn to US$1.9bn) in insured losses, with the bulk falling to the New Zealand Earthquake Commission. As at Q3, insured losses globally are about $36bn – $12bn more this time last year – with 42 incidents over $50m, according to statistics from Aon Benfield.

“It’s attrition, it’s cat and it’s been constant throughout the year,” says Richardson. “It’s a pretty bleak picture. There’s too much capacity and the combined loss ratios are still allowing underwriters to make money. We’re at around 101% for the combined loss ratio and traditionally the market doesn’t turn until the loss ratios exceed 115% combined.”

Property rates continued downward in the third quarter, according to Aon Benfield, with US cat-exposed accounts seeing a drop of about 10%; overall, North America fell by roughly 13%. Rates in the London market fell by 7.5%, while prices in Asia Pacific were down by an average of 11%. Globally, casualty rates were down by about 5%.

“This is pretty bad bearing in mind how much they’ve been softening in recent years. There’s no sign of that stopping in Q4,” Richardson says. “We think it will be an even more competitive landscape coming out of the end of the year.”

“We are in a soft market and we don’t expect it to change in the immediate future because there is still a fair amount of excess capital in the market,” says Massimo Reina, head of international facultative business at Guy Carpenter’s facultative reinsurance unit, GCFac. “There have been quite a few losses – the first half of the year was particularly busy with some large losses. Realistically, we don’t expect that these losses will have an effect on a global basis.

“The Chilean earthquake has had an effect on facultative property rates in Chile,” he says. “But if we are looking at the whole of Latin America the effect has been very limited because the insurance and reinsurance market is in quite a healthy financial state at the moment – certainly healthier than last year – and we don’t expect this to change in the immediate future unless we see some particularly large losses and probably more than one.”

Predictions of a more active hurricane season in 2010 did not result in major landfalling storms or sizable industry losses. At the time of writing, the season is not over, but the USA appears to have escaped the worst of it. Cyclones Earl, Hermine, Karl, Igor, Matthew and Nicole led to some instances of heavy flooding, but losses are expected to be in the hundreds of millions rather than billions. Total losses in Mexico from Hurricane Karl could reach $4bn.

“The areas where it’s more difficult for insurers and reinsurers to compete is in the main cat areas,” Reina says. “So we’re talking about US exposures or northern European wind – the rates

will probably hold a little bit firmer than in other classes. It doesn’t mean they will increase or even stay stable but it will be more difficult to reduce prices in those areas.”

Eating away at profitability

The glut of capacity and lack of major claims activity will make it difficult for most reinsurers to prevent rates from sliding further at 1 January. “In general, rates will continue to fall – by how much I don’t know,” Whyte says. “Non-catastrophe property rates will come off again. In major catastrophe areas they’ll be looking for maybe 5%-10% off next year – so I don’t think they’re falling off the map.”

“There have been a number of events this year, such as the Chile earthquake which have eaten away at people’s profitability,” he says. “It looks like it’s going to be a non-cat year in the US but results won’t be as good as people would have hoped because Chile surprised them. If we suddenly do have a big windstorm or a California earthquake or something, you might get a sudden post-Katrina type reaction – maybe for a while – but my view is when you get these events the hard cycle is a lot shorter than it used to be because capital can flow so quickly into the market.”

While there has not been any major loss on the underwriting side of the balance sheet, on the investment side, returns are slowly improving. For 2009, global reinsurance capital made a remarkable recovery, totalling $396bn at the end of the year, bringing it close to the record levels of 2007. Shareholders’ funds even surpassed their pre-credit crisis level for the 30 largest reinsurers, reaching $210bn, according to Aon Benfield’s aggregate index. This was attributed to a low catastrophe year and the improvement of investment returns.

“There has been a mismatch between the direct and reinsurance side for some time and there is one now,” Reina says. “The reinsurers are normally the first to react to try to turn the trend and to increase rates. At the moment, there is the willingness to try to stabilise or increase rates but with the amount of excess capital, they are finding it very difficult. It’s difficult for reinsurers because at a time of diminishing investment returns they need to make sure they make a profit on the underwriting side.”

Knee-jerk rate increases

The consensus of opinion is that it will take a sizable loss or series of significant losses to turn the market at this stage. That could be two or three Katrina-size losses, thinks a senior D&O underwriter.

“That would certainly get people thinking. The market is the softest I’ve ever seen it and the influencing factors are that there have been no losses since Katrina really,” he says. “The Chilean earthquake provided an uptick in D&F pricing for a while but it seems to be settling back down now. BP went pretty much self-insured so it didn’t really affect the market – there were a couple of knee-jerk rate increases on deep-water drilling but it didn’t affect the market really.

“In the financial institutions market there’s an oversupply of capacity, which just drives rates down,” he continues. “The brokers don’t need to broke because there’s this surfeit of capacity.

“That’s why the market needs losses because people come in speculatively and rates get driven down. Then there’s a couple of big claims and the newcomers run away. Then people who are in the market and have always been in the market will pick up a big increase in premiums. It sorts the wheat from the chaff, certainly.”

It will take blood on the carpet for the market to turn, thinks Miller Insurance head of facultative reinsurance Mike Papworth. “When will the market turn? When combined ratios all begin with a one again! At the moment, they’re not there yet. Nobody is losing money yet: there have been no casualties; business plans have not collapsed, and most are still posting good results. With this situation, it’s very difficult to tell your buyers that prices have to go up.” GR