If "Katrina" was the word on everybody's lips at last year's Rendez-Vous, this year it is "capacity". With the gap between the hard and soft markets widening, Helen Yates considers what might be on underwriters' minds come this Monte Carlo gathering.

"The models are all being revised upwards, which leads to increased buying demand and a tremendous strain on capacity. It's creating the perfect storm that we're in the midst of right now." Brian Boornazian, head of reinsurance and president of Aspen Re America.

In its post-mortem of the 1 January 2006 renewals, Willis coined the phrase "Tale of Two Markets" to describe how rates had hardened on US wind-exposed lines, while elsewhere they softened. As the industry prepares for another renewal season, that trend has become even more pronounced, with the gap between the hard market and soft market getting ever wider. "The last two seasons have accelerated the 'crisis'," says Ernie Csiszar, president and CEO of the Property Casualty Insurers Association of America. "I think ultimately we would have faced the wall in any event."

Currently, this pattern does not seem to hinge on the outcome of the 2006 storm season, which (as underwriters collectively hold their breath) is shaping up to be a far less dramatic season than last year.

The challenges in this environment are many, and as the movers and shakers in the industry descend on Monte Carlo for the annual Rendez-Vous de Septembre, their discussions are likely to reflect this. With capacity as a common theme, other hot topics are likely to include capital market solutions, natural catastrophes (particularly if a hurricane does make landfall), new capital requirements, catastrophe model conservatism and the pressure to diversify portfolios.

Capacity strain

In the aftermath of 9/11, the effects were felt throughout the industry with premium rates soaring across all lines. A similar scenario was predicted this time last year, and yet the 2005 storm season did not end up being the industry-changing loss many had anticipated. Despite being the insurance industry's biggest ever loss at over $40bn, hurricanes Katrina, Rita and Wilma (KRW) had a massive impact, but only on those lines with direct exposures to US hurricanes.

Meanwhile, pricing and terms in other sectors continued to soften and this led to the formation of the two very distinct markets. These markets are moving even further apart according to recent reports on the 1 July renewals. "Once the underwriters have reached their aggregates, they are putting their pens down and ceasing to write any new business," explains Charles Cantlay, deputy chairman of Aon Re UK. "They have become more hesitant this year about writing beyond their means as the risk of being downgraded by the rating companies continues to be a serious threat."

This decision to reduce exposures resulted in a tough mid-year renewals for cedants with US hurricane programmes. Not only was there less reinsurance available, but premium rate increases massively outstripped insured values, leaving buyers with a lot less for their buck. "There was a difference between what people were intending on buying mid-year and what they could actually do with the price," says John Berger, president and CEO of Harbor Point.

According to Cantlay, US nationwide programmes with mid-term attachments purchased 75-80% of last year's limit. Property retro was tougher still, with only 50-75% of last year's limit available. He said Gulf of Mexico wind programmes had been completed but the amount purchased was down by one to two thirds on last year. "There is a capacity crisis for heavily wind-exposed business in the US right now," says Aspen's Boornazian. "Companies are not able to get catastrophe programmes placed from a reinsurance perspective and buyers are not able to buy the cover they want."

Many hurricane-exposed insurers have changed their stance towards reinsurance in an effort to reduce exposures. "Allstate never used to purchase reinsurance. Now they're one of the largest buyers," says Csiszar. Both Allstate and St Paul Travelers, with their substantial property cat programmes, have been forced to make cuts, both announcing they would cancel several thousand homeowner policies in Florida, Louisiana and other hurricane-prone states. "Insurers are cutting back," confirms Csiszar. "They're dropping policies in Florida, Cape Cod and Long Island Sound - that's a reality. They're not renewing, they're not taking on new clients."

According to the Willis Re-View, as of July 2006 wind-exposed business is experiencing its first truly hard market in over a decade. It identified five main causes behind the dual hardening and softening: hurricane losses, rating agency requirements, catastrophe model changes, capital market alternatives and retrocession shortages. While these causes can be identified separately, they are also very interlinked, as most of the current trends affecting the industry stem from the active storm seasons in 2004 and 2005. According to Re-View, the combination of these factors has produced an "uncertain and highly volatile" outlook for the immediate future.

Still reeling

Mark Boucher, chief executive officer of Endurance Worldwide Insurance, thinks that even if the current storm season turns out to be a quiet one, hurricanes will dominate the Rendez-Vous agenda again this year. "I think that the dramatic effect of last year changed all the constituents' view of risk - the world is now seen to be a much riskier place, with the likelihood of large losses increasing," he explains. Of those reinsurers that recorded large losses, many had enough in reserve to absorb them and/or exercised capital-raising to shore up balance sheets.

There's no getting away from the fact that Katrina dealt a hefty blow to the industry, but compared to Hurricane Andrew in 1992 when there were seven insolvencies in Florida, the feeling is the industry weathered the losses well. In total, Katrina has claimed four reinsurance victims, all Bermudian. Early on there was Alea and Rosemont Re, the latter going into run-off and having its infrastructure reincarnated as Ariel Re. In May 2006, Quanta, which also suffered massive storm losses, announced it was going into orderly run-off. And Katrina's final victim, one year on, looks likely to be PXRE. After it raised its storm loss estimate by $281m in February and lost its "A-" rating, CEO Jeffrey Radke announced the company was exploring strategic alternatives, including run-off.

Many reinsurers were hit with substantial catastrophe losses in 2004 and 2005, and the impact from this continues to resonate. As recently as 16 June, White Mountains reinsurer Folksamerica increased its pre-tax KRW loss estimates by $203m, net of reinstatement premiums. Folksamerica had been expecting to cede $143m of its storm losses to its sidecar Olympus Re, but this would have exhausted the sidecar's capital base, despite it having raised some fresh capital at the beginning of the year. To keep it in business, White Mountains was forced to reimburse Olympus by $137m of the ceded amount.

AM Best promptly downgraded the rating of Folksamerica from "A" to "A-". The ratings remain on review with negative implications but there are signs the reinsurer is making tracks to appease the rating agencies. In its half year results, White Mountains Re CEO Tom Hutton said the unit was now benefiting from underwriting changes. "We have reduced our exposure to natural catastrophes," he said, "including withdrawing from the marine and offshore energy business in the Gulf of Mexico."

Rebalancing act

White Mountains is not the only reinsurer looking to reduce its aggregate exposures in peak catastrophe zones. Another subject likely to be discussed at length at this year's Rendez-Vous is how new capital requirements from the rating agencies and more conservative catastrophe models have put pressure on reinsurers to rebalance their portfolios. "For companies to achieve profitability within the new rating agency and catastrophe model environment do they chase premium in non-cat exposed businesses or increase rates in all areas in order to get true underwriting profitability?" asks Boornazian.

Property cat reinsurers have been forced to reduce exposures or diversify their writings. But according to John Berger this is not always straightforward. "The biggest non cat market is casualty - and it's not for the fainthearted - people have lost billions writing casualty business," he explains. "The rating is critical in that business ... you have to be an 'A+' reinsurer. Well guess what? There are not a lot of those floating around in Bermuda. People say 'well lets diversify' but it's just not magic, you have to find other well-priced business and be able to access it."

A knock-on effect of increased diversification is that it has accelerated and deepened the hardening of the wind-exposed sector while also accelerating the softening of rates on other lines. Increased competition on non-wind-exposed lines, due to more diversification, has further depressed prices in these sectors.

Capital market capacity

For some sectors of reinsurance there is simply not enough capacity at any price. "In the offshore markets some major energy groups chose not to buy offshore cover for the Gulf of Mexico because they felt that the pricing and the terms were too restrictive," explains Boucher. Similarly, retrocession has disappeared off the radar. If anyone is offering it, it is at a price that few can afford - not that Torsten Jeworrek, member of the board of management of Munich Re, is overly concerned. "The retrocession market is subject to stronger cyclical fluctuation than the traditional reinsurance market. But usually retrocession capacity increases again after a relatively short period, owing to the higher prices."

It is in the current environment that capital market solutions become even more important. "In the past, major natural and man-made catastrophes did not lead to a significant reduction in available reinsurance capacity," says Jeworrek. "Katrina changed this picture. For the first time, a real lack of capacity for a certain risk class (US hurricane) was apparent. No wonder risk carriers with hurricane exposures were looking to the capital markets as 'a lender of last resort', resulting in a record issuance of hurricane cat bonds of $2bn." While cat bonds, risk swaps, ILWs and sidecar arrangements still only account for a small proportion of total available capacity, their influence is growing rapidly.

Special purpose vehicles - otherwise known as sidecars - have been given a makeover and are growing in popularity. Sidecars will no doubt be one of the buzzwords on the Rendez-Vous agenda, having become a popular resort for reinsurers unable to get their hands on retrocessional cover. Most sidecars are fully-collateralised vehicles that take on a specific risk in an insurers' or reinsurers' portfolio, although the structure does vary. "The sidecar is able to attract investors to an extremely focused risk strategy, which enables capacity to come into the market. That's got to be a good thing," says Boucher.

While sidecars have been hailed as one of the answers to the capacity crunch, along with ever-popular cat bonds, questions are likely to be raised at the Rendez-Vous as to their long-term viability. The problems experienced by Folksamerica with its sidecar Olympus Re, and the commitment of capital market investors, are some of the issues likely to be raised. "If you get a frequency of very large claims, that could exhaust the capital in the sidecar - and then that exposure comes back to you," explains Berger. "It reminds everyone that this is not a perfect match of exposure and capital. There is a risk that the sidecar runs out of money and the exposure goes back to the ceding company."

With the appetite of hedge funds seemingly relentless, the opportunities for reinsurers seeking capital market solutions are improving all the time. But without better education from the industry, Boornazian thinks capital market investors could lose some of their enthusiasm. "The capital markets are somewhat cautious in their approach to providing capacity as the downside risk has proven greater and less predictable than they originally though" he warns. Whether their commitment can withstand another active storm season has also yet to be demonstrated. "These funds are quick to come in, but let me tell you, they're also quick to pull out," warns Csiszar. "Ultimately a lot this year will hinge on how the storm season shapes up."

Hurricanes on the brain

"We won't be able to get away from the US wind season," predicts Boucher. Not that the hurricane season has so far given us any reason to expect another KRW-like pounding. But it's still early days, and it could all look very different in the short space of time between press deadline and the eve of the Rendez-Vous.

Even with a below-average season, most believe rates will continue to harden on wind-exposed lines. "The key is to try and have a game plan that weathers all market conditions," advises Berger. "Many people are going to make predictions and at the end of the year somebody's going to be right. Were they really right or were they just lucky? Nobody knows in the short term." Boornazian advocates a return to good old-fashioned underwriting expertise: "This is a time when the reinsurers who have true intellectual capacity in the form of experienced underwriters will outperform those who rely exclusively on the models."

- Helen Yates is editor of Global Reinsurance.

GLOBALREINSURANCE.COM

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