Reinsurance Perspective: 2004 Treaty Outlook

As the 2004 reinsurance treaty season draws nearer, the Canadian marketplace appears to be in a state of turmoil as global reinsurers evaluate their capital positions and effective capital use. The result has seen withdrawal of several known names from the marketplace in quick succession, while globally the reinsurance sector remains under pressure with most of the top players having being downgraded by the financial rating agencies. What does this mean for the upcoming treaty negotiations?

I vividly recall a meeting in our Toronto boardroom in September of 2001. The contention of the moment was that reinsurance rates were about to climb 40% and at least a handful of reinsurers would face inevitable demise. It was incumbent upon us, as reinsurance specialists, to counsel our clients to rapidly move their own rates to accommodate the impending spike in reinsurance costs. Yet, some around the table were vocal in their steadfast adherence to the soft market momentum, clinging to the only market conditions they had ever known.

Within weeks, the inevitability of the change was upon us. I saw the realities during a morose series of client meetings at Lloyd’s and a virtually empty plane ride home. We were in the maelstrom of a decidedly altered market. Today, almost two years later, there is value in retaining that perspective as I catalogue subsequent events and post 9/11 market influences. There is also merit in examining the fundamentals that carried the soft reinsurance market through the nineties.

My purpose is to provide some insight and to deliver a forecast for 2004 treaty renewals. The early 1990s were punctuated by the Hurricane Andrew loss which pushed prices to their peak and effectively depopulated the market. As Andrew’s loss was absorbed and new capital injected, we witnessed the emergence of the softest reinsurance market in history. Canada, in particular, led the way with a spiraling abundance of supply and a corresponding diminution of local demand.

In fact, during the period from 1993 to 2000, the number of insurance companies purchasing reinsurance in Canada dropped from 129 to a mere 55 in the wake of unprecedented consolidation. That virtually all of the thirty local reinsurers were foreign owned and that many were without sufficient critical mass in Canada was reason enough for an overwhelming focus on the top-line. Furthermore, investment income, especially for the European reinsurers that invested heavily in equities, was peaking at this time. These returns, in concert with the rise in reinsurers’ share value, had generated significant capital. Capital in this business tends to stick and is rarely reallocated. Reinsurers needed to reabsorb the capital with risk in lieu of earning less attractive risk free rates.

So, with all of these factors conspiring, local reinsurance rates had dropped by more than 40% in the five year period to 2000. Brokers and their clients were calling the shots with the full and enthusiastic support of local underwriters. The skill sets were diluted, and the demand for technical expertise in the broking and underwriting ranks was at an all time low.

Burst bubble

The bubble was bursting well before 9/11. Terms and conditions were clearly unsustainable. The equity markets were swiftly losing their luster. Nevertheless, on September 10, 2001, the global reinsurance market was leveraged with a healthy capital base of about $200 billion.

The next day a loss of at least $25 billion had been incurred. Within weeks an additional $50 billion had been withdrawn, largely in the form of diminished stock value. By yearend, the market had lost at least a third of its capital. Some reinsurers suffered more than others with hits that were totally disproportionate to marketshare and with similarly inappropriate net retentions.

All of this is well documented and I hesitate to dwell on what has become a tiresome focal point of industry discussion. That 9/11 hammered the reinsurance industry is a given. The consequences, however, are more subtle and the actual fallout has taken longer than expected to materialize.

There have been other contributors to our current market malaise. That the U.S. federal funds rate, for example, is one sixth of what it was in 2000 and fully one tenth of its 1990 level has certainly accelerated market hardening in view of the reality that reinsurers hold premiums for far longer periods than do their insurance customers. In 2001, European reinsurers lost just over $54 billion in equity markets. By the third quarter of 2002, these same reinsurers had lost another $56 billion. Simultaneously, the Enron and Worldcom debacles cast a shadow over global stock markets.

Asbestos reserves continue to grow. I recall reports in the mid-eighties that naively declared industry reserve adequacy with respect to Asbestos losses. In 1982, there were 21,000 identified asbestos claimants. In 2003, there are 600,000. In 1982, future asbestos costs were estimated at $38 billion. Today, we estimate future asbestos costs at a staggering $200 billion.

The pivotal issue surrounding asbestos loss is the growing gap between insurance companies’ gross and net loss reserves. There appears to be a $50 billion discrepancy in the balance-sheets of insurers and reinsurers. As insurers post massive increased asbestos reserves, they take simultaneous credit for equally massive reinsurance recoverables. To date, the reinsurance industry has not posted reserves that directly correspond to the recoverables. The disparity is disconcerting.

Two-speed

Not surprisingly, reinsurance withdrawals and a litany of rating downgrades have ensued. Who could foresee the demise of the Alleghaney Syndicate at Lloyd’s, Gerling Global Re, Hart Re or the S&P downgrades of both Munich Re and Swiss Re? There is unrelenting pressure on companies to perform in the wake of dramatic restructuring.

This brings me to the concept of the “two-speed market”. While the traditional players struggle under the weight of 9/11, asbestos, costly infrastructure and hostile tax environments, the new players emerging from Bermuda are operating without constraint. Highly capitalized, efficiently managed, and with no loss legacies, these new entrants are in an enviable position to reap the benefits for which their more established competitors have dearly paid. That these sophisticated markets may be a moderating factor on rates is no small irony.

Careful approach

So where are we going? I see the coming months leading to the 2004 renewal season as follows:

The focus will be on security and solvency and credit risk – not only as it pertains to recoverables from reinsurers – but also with respect to reinsurance brokers whose financials are often undeclared;

One or two reinsurance withdrawals before yearend are not unexpected. I cautiously add that Canadian licensed reinsurers, regardless of the precarious position of their parents, will have sufficient capital to support runoff in view of strong regulatory scrutiny in this country;

Reinsurance underwriting authority and autonomy will continue to migrate to centers outside of Canada. At this upcoming renewal, there will be less than a handful of local offices whose underwriters will be able to make an independent authorization;

Working layer auto/casualty capacity will be scarce despite the opportunities that result from dramatically compounded primary rates. Excess reinsurance rates in this class will continue to climb;

The reduction in proportional writings will continue as insurers spurn the cost associated with adequate reinsurance margins. Quota-share business, once an addictive top-line obsession, does not have the interest rate “fuel” to keep motoring; and

We are likely to see flattening in property catastrophe rates with no shortage of market capacity for Canadian exposures. Large authorizations from newly capitalized markets will exert mild downward pressure.

I will close with a few unavoidable platitudes. The reinsurance industry will come out of this period as a smaller collection of stronger players. Ins
urers should seek counsel from the most sophisticated advisors who are equipped with the strongest array of technical resources. In short, deal with the blue chip players and closely follow the flow of the reinsurance premium dollar. Make certain that every hand that touches it, from the broker to the reinsurer to the “retrocessionaire”, is meticulously vetted and fully disclosed. Remember that the cost of reinsurance is not the premium.

This September, when my colleagues and I sit around that same boardroom table, I know we will have a more cohesive strategy than we had in 2001. While the world has undoubtedly changed, the experience has thrust us into a far better position from which to navigate.