Reinsurance Pricing: Out of Gas?

For reinsurance buyers, it is good news: all indicators from the global stage to the Canadian marketplace suggest that pricing peaked in 2003. For reinsurers, who individually remain adamant that underwriting discipline will be maintained going forward, the market environment looks less generous as the 2005 cover renewals approach.

While Canadian reinsurers saw their first double-digit return on equity at 12.7% for 2003 – with the previous five years having produced an average dismal 4.4% return – the warning bell sounding is the almost “hundred to zero” skid in the sector’s premium growth. After two years of 30%-plus annual growth in net written premiums, Canadian reinsurers produced a stale 4.5% rise in net written premiums for 2003, according to data collected by the Reinsurance Research Council (RRC). Notably, the sector’s net earned premiums for 2003 rose year-on-year by almost 14%.

With the property and casualty insurance industry’s premium growth since 2001 having largely been fueled by substantial rate increases – hence the so-called hard market era – the sudden stalling of premium growth at the reinsurance level (primary insurers generated 27%-plus annual growth in net written premiums over 2003) strongly hints at a flattening of pricing, most likely driven by price resistance. Reinsurer CEOs admit that the sharp drop in the sector’s premium growth is largely due to much higher risk retentions at the primary level.

Reinsurers suggest that such larger retentions are not only the result of insurers taking this option, but in some situations reinsurance companies have demanded higher risk retention to quell loss frequency. Nonetheless, lost business remains “lost business”, as many in the traditional p&c insurance industry have witnessed with the rise in popularity of capital market alternative risk solutions. Reinsurers also note that “net written premium” does not accurately reflect the true amount of premium taken on by the reinsurance sector, as this is net of retrocession costs. However, the RRC’s figures for 2003 show modest annual growth in “assumed premiums” of just under 6%, which for last year rose to $3.137 billion compared with 2002’s $2.963 billion (the RRC’s “assumed premiums” only reflect volume of licensed companies). Overall, the Canadian reinsurance results for 2003 suggest that the sector may have run out of gas in the hard market race – particularly the “established players”.

Furthermore, Canadian reinsurance market trends would appear to be in line with developments on the global stage – specifically the U.S. marketplace. Rating agency Standard & Poor’s (S&P) observes in its U.S. reinsurance company “mid-year outlook 2004” report that companies picked up a meager 5% increase in premium volume for 2003. In contrast, new sector entrants after 9/11, mostly being Bermuda-based operators unshackled by prior year loss developments, were able to “clean up” with premium growth of 50%-plus, which for 2003 totaled about US$47 billion. “Even at the height of this [current] pricing cycle, U.S. reinsurers remain fettered to their longstanding pattern of chronic underperformance. As Bermuda muscles in, and strong sustainable recovery remains an elusive dream amid ongoing reserve shortfalls, S&P is maintaining its negative ratings outlook on the U.S. reinsurance sector for the seventh consecutive year.”

S&P also observes in its “Industry Report Card: North American Reinsurers” that the traditional reinsurance sector continues to suffer from “diminished quality of capital”, “reduced financial flexibility”, “prior year liabilities” and the “overhang of reinsurance recoverables”. The report states, “…reinsurers have had a difficult time capitalizing on the hard market conditions of recent years…the ease of entry for new players and increased competition in the market have dampened the ability of existing players to recover”.

Canada’s reinsurance sector is also feeling the competitive impact of the new start-up players. While 2002 and 2003 saw the demise of several reinsurers, such as Alea, Gerling Re and HartRe, recent months have seen new licensed entrants such as Converium and Aspen Re. Several other global operators, primarily Bermuda-based, are expected to become licensed players in Canada over the next six to 12 months. Reinsurer CEOs CU spoke to in compiling this article were generally hesitant to comment on the new competition, but felt that the marketplace presented adequate opportunities for all companies “willing to act with responsible underwriting discipline”. However, as Bruce Perry , senior vice president at PartnerRe Canada, notes “there is ample capacity in the reinsurance market already, but several reinsurers are in the process of obtaining licenses for Canada in a market that is not currently growing. There may be more capital available than can be effectively deployed.”

BOTTOM FOCUS

Canadian reinsurers boosted net taxed income for 2003 by more than 5.7 times to $310.8 million compared with the $53 million profit posted the year before, according to the RRC. Last year also saw the sector generate an underwriting profit of $91.5 million against underwriting losses recorded in the two preceding years of $226.3 million and $312 million respectively. Last year’s underwriting improvement was achieved on a significant improvement in the combined ratio which fell year-on-year by more than 14 percentage points to 96.3%.

As such, reinsurers argue that the sector’s premium growth, or top-line performance, is less important to its bottom-line growth, which presumably benefited from a hard-line approach to underwriting discipline. Reinsurer CEOs say that discipline remains intact. In fact, the RRC’s chairman Cam Macdonald observes in the council’s 2003 industry financial review that last year’s combined ratio – although significantly improved – remains inadequate relative to the potential risk of future catastrophe losses.

Although 2004 will likely present an even better financial return than last year, the reinsurance sector’s ROE remains inadequate, says Perry. “We need a few more years like this [2003 and 2004].” Notably, the 12.7% ROE made by reinsurers last year was achieved at the height of the hard market, and in the current poor investment return environment, such a return is unacceptable, he adds. “Reinsurers’ combined ratio of 95% [for 2003] is the lowest in over 20 years, yet produced an ROE of only 12.7%…reinsurers must continue to lower their loss ratios below 95% in the current investment environment to produce the returns demanded by shareholders…The improved result for 2003 should continue for 2004, and must extent to 2005 and beyond if reinsurers are to maintain the confidence of investors.”

As a result, Perry says, “I don’t mind losing business that is under-priced”. This view is supported by several other industry leaders. Gerald Wolfe, chief agent for Canada at General Reinsurance Corp., says the focus has to remain on the bottom-line. “I don’t think getting premium growth is that critical. What is important is to achieve an adequate and sustainable underwriting profit. A 99.9% combined ratio is not adequate, given the volatility of the reinsurance business…with emerging issues and both natural and other catastrophe exposures. Growth is secondary, though.” Brian Gray, president of Swiss Reinsurance Co. Canada, firmly stands behind the need to protect the bottom-line. “The market cycle over the next two years will be interesting. Certainly on the reinsurance side, we don’t believe that investors will be satisfied with 18 good months after several years of weak underwriting results. We therefore expect that reinsurers will remain firm – probably firmer than the primary Canadian markets.”

PRICING MOMENTUM

While upholding the virtue of sensible, and therefore profitable, underwriting practices is commendable, this does not guarantee a “confluence” with the reality of market conditions. Reinsurers admit that a large slice of the premium pie was lost over the past year due to higher primary company retentions. At what point does “market and su
pply demand forces” dictate a reduction in pricing?

“While there have been substantial price increases at both the primary and reinsurance levels, at some point it is not possible to continue raising rates as it [pricing] reaches a point where the economic sense of buying is questionable. For instance, some reinsurance covers have already reached the point where cedants have had to make tough buying decisions. This has lead to a restructuring which in some cases has meant the disappearance of some underlying layers,” observes Roy Vincent, senior vice president of Canadian treaties at Hannover Re. This means that there has been less risk transfer to the reinsurance sector, but not necessarily a weakening in pricing, he adds.

Insures are now absorbing most of the “bottom end frequency”, confirms Perry. If you look at the aggregate of all business lines, then growth based on volume premiums has lost momentum in the Canadian marketplace, he says. “Property is the line that has fueled the recovery [in Canada], and there are already signs that reinsurance terms have stabilized.” While reinsurance assumed by licensed reinsurers escalated by 64% between 2000 and 2002, growth in premium has flattened over 2003/4, he notes. “This would appear to be the result of some primary companies reducing their dependence on proportional reinsurance arrangements, and others retaining more risk in their non-proportional (excess of loss) programs.”

Henry Klecan, president of SCOR Canada Reinsurance Co., says pricing in some lines of business has peaked. This, plus the fact that primary companies have taken higher retentions, accounts for the stalling in the reinsurance sector’s premium growth, he notes. “But, they [cedants] need to be careful that their capital base can support this [higher retentions].” Klecan supports the camp favoring ongoing underwriting/pricing discipline in the reinsurance sector, but adds, “I think reinsurers are committed to maintaining underwriting discipline, but it remains to be seen. It’s been the ‘talk’, but come November/December, the message from head-offices could be very different.”

Looking at the current financial picture of the Canadian p&c insurance industry, some reinsurers may think there is some “fat” in their pricing, comments Wolfe, “but I think this is illusionary, particularly when you take into account the current interest rate environment”. He concurs that higher primary retentions have impacted on reinsurance volume growth, but holds the view that pricing remains firm – at least for the time being. “Pricing remains firm [in the reinsurance sector], there’s no question. Pricing went up across-the-board in 2003, now in going forward, the challenge will be to maintain underwriting and pricing discipline going into 2005. This isn’t a ‘softening cycle’, but yes, there are some signs of price flattening, particularly on the property and property cat side.”

The biggest impact on reduced reinsurance premiums came through on quota-share arrangements, which declined significantly in the 2004 renewals, Wolfe says. “One huge deal I’m aware of was not renewed.” There were also increased primary retentions on auto, due to the rate increases demanded by reinsurers in light of the emerging losses in lower layers (within the $1 million retention), he notes. And, reinsurers also demanded increased retentions by their primary clients in certain lines because of the loss exposure, he adds.

Gray also refers to the increased primary retentions being the cause of reduced premium growth, specifically regarding proportional business. A number of cedants converted proportional to excess of loss covers in the last renewals, he notes, which saw a significant chunk of premium move out of the reinsurance sector. “I think the 2003 [reinsurance] numbers didn’t show a decline in pricing. For 2004, I believe there’s going to be more pricing stability, pricing [at the moment] is probably appropriate in giving shareholders a reasonable return.” Over the short to mid-term, Gray is a believer in reinsurers sticking to their underwriting guns. “There will be a lot more discipline this time.”

WEAK LINES

Auto and the liability lines in general remain weak in pricing, says Perry. Auto, based on 2003 results, is running at a loss ratio of 92% and liability at 83%, he notes. “Automobile and liability, however, have been problematic. Rate freezes and rollbacks at the primary level do not help the situation. Most of the proposed changes to provincial automobile legislation are aimed at reducing the small and medium claims, but do little to curtail the severe claims that flow to reinsurers.” Perry points out that, in addition to the high combined ratio attached to the liability classes of business, there is the issue of the “tail cost” associated therewith. As such, he expects there will be resistance by reinsurers against any price softening in this arena.

Wolfe also sees general liability as being a line of business that remains problematic. “I don’t think we’re out of the woods on general liability. There’s specific concerns with U.S. exposures, particularly long-haul trucking, and then there’s directors’ and officers’ (D&O) which we need to be vigilant about…There is also the likelihood of further adverse development from older accident years.”

The potential loss exposure associated with casualty/liability is the prime issue at stake this year, confirms Vincent. Specifically, reinsurers are leery of the exposure they might face in this regard through auto. “Most covers in Canada combine automobile…with third-party liability…While the number of potential losses for automobile is reasonably and quickly established, the quantum of loss takes longer to establish. Further losses for general third-party liability and the other classes that may be covered can and often do take longer to surface.”

Gray expects that the upcoming renewals will deliver similar terms to those presented in the 2004 treaty negotiations. But, there will be upward pricing pressure in some segments, like lower layer auto and other areas within the liability class. “This will depend on a per client basis.” However, he also feels that certain specific areas in liability, such as D&O and errors and omissions (E&O) remain under-priced in Canada. “We expect that commercial liability and lower layer auto excess covers will continue to be particularly firm. Working layer auto excess in particular, will likely see [renewal] rate increases because the rates apply to a premium base that has been eroded by primary market rollbacks and reductions.” However, overall, he expects there will be few new underwriting conditions demanded by reinsurers for 2005 renewals. “…but we expect the market [reinsurers] to be unwilling to give up progress made during the last two years”.

The casualty/liability side of the business will attract further rate strengthening, predicts Klecan. This will be particularly evident in auto, with the losses incurred in Ontario and Alberta likely to attract attention. However, he does not believe that the 2005 renewals will present any “hidden surprises” in terms of a ‘brand new, hot button”. On a per risk basis, he notes, there is probably sufficient margin in the current pricing of the Canadian reinsurance sector. “But, we could be fooling ourselves, because there really hasn’t been any [substantial] cat loss. We [reinsurers] shouldn’t be intoxicated by a single year’s performance.”