Reinsurance: Extreme Makeover

Reinsurance is more than 350 years old (Lloyd’s itself has been around for almost 320 years), but most industry observers recognize there has been greater change in the past 25 years than in the previous 250 years. In fact, this rate of change has accelerated since the events of 9/11, and reinsurance now shows signs of a transformation that will affect every underwriter, reinsurer and reinsurance buyer in Canada over the next few years.

Traditional reinsurers are being challenged in a new market created by young upstart investment bankers. Long-standing relationships are being supplanted by short-cycle strategies. Canadian reinsurance licensing requirements may soon be relaxed, and new alternative risk transfer mechanisms are appearing almost daily.

Two forces are pushing this remarkable change: 1) the new “fast” money funding today’s emerging reinsurers; and 2) the sea change in attitude toward the relationships that underlie reinsurance conduct. To put it simply, change is being driven by both the new principals behind reinsurance and the new principles underlying it.

When these forces are juxtaposed with the current market realities of increasing regulatory control, a flood of aggressive capital, embattled rating agencies, competing catastrophe modellers, enterprising climatologists and dedicated geologists — not to mention ham-fisted politicians and strident consumer advocates — one can imagine an impending confrontation that threatens the very capacity available to Canadian insurers.

LOOMING CONFRONTATION

The following chain of sequential events ultimately brings us to a dilemma:

* we have increasingly concentrated populations of affluent consumers locating themselves in the paths of expected weather events, producing the most costly series of catastrophic losses in insurance history;

* the resultant attention to changing weather patterns and catastrophe modeling dramatically accelerates research into — and leads to an increase in funding for — atmospheric and even seismic catastrophic event forecasting;

* due to this new research, public awareness and heightened demand for underwriting capacity, fund managers, investment bankers and other entrepreneurs identify the brief investment “window of opportunity” that is reinsurance; and

* in order to meet the increasing demand for underwriting capacity, insurers redirect what would traditionally be long-term reinsurance relationships to new-capital reinsurers who have publicly professed their short-term view, complete with exit strategies.

To fully appreciate the impending problem, one must stop and consider why insurers buy reinsurance. What, exactly, is reinsurance supposed to do?

In the simplest possible terms, insurance companies buy reinsurance in order to spread atypical underwriting experience over time or markets, or both.

This explanation is so basic that it needs closer attention. Insurance companies buy reinsurance in order to spread, over longer accounting periods, adverse experience created by exceptionally severe losses, a frequency of large losses or a period of intense loss activity. Even the largest insurers buy protection against truly catastrophic loss events in the knowledge that the catastrophe losses of a few markets must be spread among the many insurers worldwide.

Surplus treaties, facultative cessions, risk excess, shock loss and catastrophe treaties are all intended to do this one thing: spread adverse experience over time and over markets.

Thus, a prerequisite for traditional reinsurance is staying power.

Early professional reinsurers in Germany, Switzerland, Great Britain and elsewhere could be described as “traditional” reinsurers. Some of the oldest disappeared or were absorbed into other reinsurance companies only in recent years. Nevertheless, when someone talks about traditional reinsurers, they mean those with a history. And by history, they mean those companies that expected and were expected to be around for a long, long time.

Not surprisingly, reinsurance has always been thought of as a business that is relatively easy to get into, but very hard to exit. Reinsurance liabilities might last for a lifetime. Commitments are not forgotten; transgressions are rarely forgiven. If large losses must be spread over time, then time (and long-term relationships) become an integral part of reinsurance.

BRIEF HISTORY OF NON-TRADITIONAL REINSURERS

Today, not all reinsurers can be described as “traditional.” In the early 1980s, the market saw a gaggle of new reinsurers — capitalized by various unrelated businesses such as bus lines, steel mills, photocopier and sewing machine manufacturers — who thought they knew how to expand into capital/financial markets. Unfortunately, these new markets helped to precipitate a soft market. These reinsurers came to be known as “nave capacity.” They lost hundreds of millions and ceased reinsurance operations.

In the early 1990s, insurance companies twigged to the idea that they could leverage their return by writing a portfolio of reinsurance on the back of their existing capital. Unfortunately, they helped precipitate a new soft market. These insurers soon realized that, not only were they providing underwriting capacity to their competitors, but they were subsidizing those competitors with cheap reinsurance. They too lost hundreds of millions, and discontinued their reinsurance operations.

In the early 2000s, we saw the growth of a totally new breed of reinsurance investor: offshore reinsurers, having made their first appearance immediately following Hurricane Andrew, were entering the reinsurance market and relying on a strategy of timing.

Prior to 2001, Hurricane Andrew was the largest loss in insurance history. It wiped out a number of insurers and reinsurers, and created a new urgency for secure reinsurance capacity. Not surprisingly, a lot of smart money got the idea: “What better time to enter the catastrophe reinsurance game than post-loss, when the rates are soaring?” And so they did.

They located themselves in a small, tax-friendly island off the east coast of the United States, and quickly wrote volumes of business. Ironically, they received excellent financial security ratings: after all, they didn’t have to pay for Hurricane Andrew — or for asbestos losses, pollution losses, products liability or a thousand other commitments currently being borne by historic reinsurers. And by “historic” reinsurers, I mean the traditional or legacy reinsurers who had been supporting their client insurers over many years and through many tribulations.

Never mind the support they received in the past from traditional reinsurers, many buyers, during the years following Hurricane Andrew, reduced or ignored their long-term relationships in favour of competitive new reinsurers that had clean balance sheets and unfettered capital.

In the months following 9/11, a second wave of Bermuda reinsurers (the class of 2001) quickly raised capital and began writing billions in catastrophe and short-tail property premiums.

To no one’s surprise, a third wave, the class of 2005, followed promptly on the heels of Hurricanes Katrina, Rita and Wilma. Today, Bermuda is one of the largest reinsurance centres in the world.

FAST MONEY

In fact, this new market capacity is needed. The capital raised in Bermuda and elsewhere has actually been less than that lost to the catastrophic events that spawned them. However, this money comes with expectations of high return and early exit strategies. Investors have been told to anticipate 30% returns; they do not anticipate being in the reinsurance business once these returns are no longer forthcoming. Characterized as “fast money,” there is nothing long-term about these investors. No baggage and no historic loss portfolio. No regrets, no payback, no promise to remain in the game.

If we were to describe
a typical class of 2005 reinsurer, the story might go something like this: Created after Katrina in the final days of 2005, the newly capitalized reinsurer writes its first several hundred million of cat premiums before the office furniture arrives. Support staff is added. The anticipated storms of 2006 do not materialize; substantial profits are realized. For this reason, the scheduled initial public offering (IPO) is pushed forward to early 2007. This IPO goes well, but now that the reinsurer is publicly traded, it must offer a business plan. The reinsurer, created to capitalize on short-tail property catastrophe, announces to its new shareholders that it will enter additional lines and new markets. The new owners, encouraged by the returns of 2006, now watch the weather in 2007 as they have never watched weather before…

LONG-TERM PRODUCT, SHORT-TERM MONEY

An interesting example of the exiting ability of new money is something called a “sidecar.” In the current context, a sidecar might be defined as a company created expressly to augment, by reinsurance, the capital of one of the newly capitalized markets. Like a sidecar, this temporary reinsurance vehicle can be quickly and easily jettisoned.

It would appear that reinsurance need no longer be a long-term commitment. Catastrophe bonds, risk or loss portfolio securitization, hedge fund entry into — and exit from — specialty reinsurance entities, sidecars, and other examples of Alternative Risk Transfer (ART) mechanisms allow the new capital to play at reinsurance and then move on when the returns are no longer there, or when better investment opportunities present themselves.

There are a number of problems with this new reinsurance model, not the least of which is that it cannot endure. Traditional reinsurers, prepared and willing to endure the ups and downs of market experience because the risk is spread out over time, watch the fast money scoot in for the financial kill following each major loss event. New capital markets expect and demand returns of 30%, whereas traditional reinsurance has tended to produce returns closer to 9% to 10%.

Traditional reinsurers may well conclude the game is rigged; indeed, signs exist that they are catching on. One of the largest of these reinsurers is cautiously moving toward direct underwriting, while several others have begun to play the securitization cat bond ART game. One of the most astute investors to become a reinsurer has recently announced that cat writings will be halved in 2007; several others are struggling to find ways of putting closure on older, long-tail business, such as by commutation.

Another significant problem lies in the apparent success of many of these new markets.

The demanding hedge funds and other investors behind these reinsurers draw off substantial returns that, under the old model of reinsurance, would have remained within the industry. Such returns, if they remained within the industry, would allow reinsurance capital and capacity to grow organically, strength ening reinsurance solvency needed for the inevitable future catastrophes. Now much of this profitability is lost to the industry, and buyers are poorer for the loss.

There continues to be a shortage of capacity in particularly hazard-prone regions. Some of America’s biggest personal lines insurers are announcing curtailment of underwriting in key regions. Not surprisingly, there has been public outcry, followed inevitably by government intervention such as in Florida.

If the Canadian insurance market is no longer amenable to long-term partnerships, in which reinsurers are able to price and spread risk over time and markets, then reinsurance is no longer workable. Reinsurance, or whatever reinsurance becomes in the next few years, will necessarily become opportunistic and, to the extent that it tends not to reinvest its returns in the industry, expensive. Coupled with a growing foreknowledge of future weather cycles, the product will become even more volatile than it is today — assuming it will be available at all when the wind blows.

As we continue to see examples of extreme weather, and as aggregate liabilities grow in Canada’s earthquake zones, it has never been more important that we recognize reinsurance as something that will only continue to work effectively if it is bought and sold as a long-term solution.