Rising Fortunes

In a world buffeted by a record number of hurricanes in 2005, predictions of worse storms to follow in 2006, and worldwide claims last year approaching $US100 billion, it would be safe to say the global reinsurance industry was feeling somewhat on edge as hurricane season began again in April.

Catstrophe models were refined, capital models were adjusted, and the talk of the town was whether it would all be enough to maintain adequate capacity in the face of an even worse storm season in 2006.

But a funny thing happened on the way to 2007. Throughout the early half of this year’s hurricane season, storm forecasters started to adjust their predictions to reflect a milder season. All things going well, it appears the catastrophe damage losses in 2006 will not approach the astronomical figures generated in the wake of Hurricane Katrina’s destruction last year of New Orleans and the U.S. southern states.

In fact, primary insurers in Canada, buoyed by an influx of unexpected capital, have started to readjust their reinsurance treaties, using their capital to retain risk rather than to pay premiums to reinsurers. The insurance market in general appears to be reflecting sunnier financial climes ahead. What will all of this mean for Canada’s reinsurers?

As we approach the renewal season, we have asked nine reinsurance company CEOs to give us their insights into what they believe are the top issues facing Canadian reinsurers going forward in 2007. Their responses follow in alphabetical order by last name.

As is true of other markets, one of the key trends in the Canadian reinsurance market is the growing sophistication of modeling exposures requiring improved quality of data. Underinsurance and the evaluation of the non-modeled perils are also important issues.

The influence of rating agencies will continue to strengthen in the assessment of reinsurance security. They have taken actions such as increasing return periods of the PML reference and evaluating the internal processes of catastrophe exposure management. This has usually led to a requirement for more capital to maintain ratings. To support this capital increase, there will be pressure for price increases. How increases by class and territory are applied to individual markets will be subject to the usual market forces.

The Canadian market has many domestic and international forces influencing it. The absence of major losses so far this year, in addition to the returns generated thus far in both the domestic and international arenas, have helped the global market start the long recovery from the devastating 2005 losses. These losses reinforced the importance of reinsurance security to the reinsurance buyers, as well as the need to be diligent in analyzing their reinsurers. Buyers need to understand the rating agencies’ analysis, including reserve adequacy and methodology, and the makeup of any sidecar retro agreements.

Generally, reinsurance consolidations do not enhance market capacity so the industry is waiting to see what the impact will be of a recent, major acquisition.

We have in Canada a continued, adequate supply of reinsurance capacity for all main classes. Increasing reinsurance retentions might also continue.

The Canadian reinsurance market has become more of a “catastrophe” market for many classes, protecting against large infrequent losses that need to be adequately assessed and priced for eventual payout.

We expect to see a continually improving discipline for underwriting and corporate governance in Canada in 2007.

At this point in time, 2006 is looking good for most reinsurers in Canada. There have not been any catastrophic losses and no large single losses compared to 2005. It is expected there may be some softening in reinsurance terms for renewals. However, of greater concern is the softening of primary market terms – especially in property, but also in some of the other supporting lines. In theory, if primary rates are going down then reinsurance excess rates should go up to compensate. Sadly this may not be the case.

The Canadian reinsurance market is mature and the last two years have seen premium reductions of 17% and 13% respectively. This was caused mainly by primary companies cancelling their pro rata treaties and absorbing the difference into their net lines in order to achieve net growth. We may see a few more companies taking back their treaties again this year. Generating new products to make up for the loss of volume will be a challenge.

Lastly, the continual merger and acquisition activity will also reduce the potential buyers of reinsurance and change the reinsurance landscape in Canada.

The overall challenge for reinsurers is to maintain bottom-line profit in a quickly changing market.

The modeling changes and the more stringent capital requirements introduced by rating agencies following the 2005 hurricane season continue to impact the industry. Investors now give more credit to large and well-diversified portfolios. In addition, direct insurers are increasingly focusing on reinsurance security, namely the ability and willingness to pay claims, thus supporting the flight to quality.

The worldwide retrocessional market capacity has reduced significantly following the large losses incurred in 2005. Capital market instruments such as insurance-linked securitization and sidecar agreements are used more frequently, but this additional capacity is still insufficient to replace the shrinking traditional retro market. This capacity shortage is expected to impact primarily U.S. catastrophe-exposed business, but other markets such as Canada may also be affected to a lesser degree.

At the same time, the general need to rebalance reinsurance portfolios has increased the appetite for non wind-exposed lines and less catastrophe-exposed markets. The Canadian market is therefore likely to continue to attract some capacity from players seeking diversification.

Primary industry results in Canada continue to be strong. Balance sheets are healthy, fuelling growth strategies. As a result, we have seen a number of cedents increasing retentions or shifting towards non-proportional covers. This trend is partly offset by a growing awareness of catastrophe exposures, leading to higher limits of cat protection.

Canadian reinsurers are expected to continue focusing on earnings quality and stability. Rates need to be commensurate with the nature of the underlying risks that reinsurers assume.

For Swiss Re, this year was marked by the acquisition and integration of GE Insurance Solutions, and we are fully dedicated to our enlarged customer base. Our clients can continue to expect consistency in our approach to the market and underwriting behavior and a continued focus on long term relationships.

The insurance industry in Canada is reaping bountiful profits at this stage of the insurance cycle. The disciplined underwriting of risk and rate during the past four years has caused a most dramatic turnaround of the industry – akin to Chrysler and Iacocca’s K-car in the early ’80s.

But the increased profits have also brought out the inevitable – albeit healthy – competition for business. Although this competition has led to the expected price softening across all lines, most companies maintain their rates have not dipped below technical adequacy. Time will tell.

The reinsurance industry has also recovered well from the last soft cycle by posting decent returns, largely as a result of healthy underlying prices. Risk adequate premiums are being charged; nevertheless, the volatility of large losses and loss events, as well as the increasingly generous court awards from a progressively more litigious environment, has created a climate of considerable uncertainty.

Standard & Poor’s views the industry risk of property and casualty reinsurers as significantly higher than that of property and casualty primary insurers. The ratings agency said it is concerned about issues such as better financial strength not resultin
g in better pricing, exposure to unpredictable risks and low barriers to entry, to name a few.

This renewal season, we must focus all the more on risk adequate premium for exposure assumed. Catastrophe rates must reflect exposure: experience is an inadequate prognosticator of risk. We will have a devastating earthquake in Canada and we will have more weather-related storms such as last year’s Ontario rainstorm – timing is the only uncertainty. The latency risk in casualty is increasing, because courts are continuing to pilfer deep pockets as a societal entitlement.

We will stay the course of a common-sense approach to ensuring risk adequate pricing in our portfolio. Our business partners understand this and realize that long-term sustainability of earnings is the true measure of a healthy marketplace.

The two most important issues facing reinsurers today are: * The uncertainty regarding mutiple catastrophic events in given year. * The changing buying patterns of the primary insurance market.

As the global warming phenomenon continues, it is becoming increasingly apparent that the magnitude and frequency of losses is on the rise. In Canada alone, weather-related and man-made catastrophes totalled CD$2.5 billion dollars in 2005. Catastrophes in one form or another are seemingly regular events – or at least, they occur more often than history suggests. Reinsurers are continually revising their catastrophic exposures in large urban areas because the technical models used to calculate aggregate losses are being updated to reflect this trend. Recognizing this rise in frequency is an essential element in establishing adequate solvency margins for reinsurers.

* A conscious decision by many insurance companies toward higher retentions, excess of loss programs and less proportional coverage has meant fewer premium dollars for reinsurers. Taking advantage of surplus capital and improving return on equity, Canada’s primary insurance sector is clearly assuming more risk and ceding less premium to their reinsurance partners.

Ongoing consolidation within the primary market has resulted in larger entities requiring less reinsurance (at least at the bottom end of their program).

This trend may lead to continued mergers and acquisitions activity, or the departure of certain reinsurance operations from the Canadian market. As we move toward the treaty renewal season, the combination of achieving significant premium growth while maintaining adequate profit margins will be difficult for reinsurers.

Three dimensions contribute to the delivery of what PartnerRe holds to be the single most important value proposition a reinsurer can articulate for its clients: to ensure financial robustness, thereby securing the reinsurer’s ability to pay future claims and provide continuity of capacity.

First, exposures must be fully recognized, understood and priced. Catastrophe reinsurance is one example. Once the frequency and intensity distribution of significant perils is measured, the potential impact on the portfolio must be assessed. Underwriters will conduct a thorough analysis based on the geographical concentration of values, contract clauses and broader economic factors such as post-loss inflation. Only then will they make an intelligent – rather than a purely mechanical – use of pricing models.

Next, the reinsurer should establish quantitative risk tolerances and acceptance limits for various classes of risk – including, but not limited to, the underwriting risk. In so doing, the degree of diversification embedded in the reinsurer’s unique portfolio should be closely monitored, with a view to preserving at all times a significant spread.

Thirdly, PartnerRe believes clients are entitled to detailed, quantitative data on their reinsurers’ resilience to shock losses, their investments and reserves. In keeping with our conviction in this respect, our latest initiative has included the voluntary publishing of loss development triangles and the value of the discount in our reserves.

It is perhaps more in the execution – as opposed to the enunciation – of its strategy that a reinsurer differentiates itself, enabling it to offer its clients sustainable and consistent capacity.

Very early on in 2006, the insurance industry was continuously bombarded with the prophesies of climatic experts predicting a “a year filled with more severe storms than 2005.” Fortunately for the insurance industry, the weather prognosticators held true to form and missed the mark. Very fortunately…

As I’m sure we have all heard, ad nauseum, the 2005 storms collectively – and specifically Katrina – represented market-changing events that put severe pressure on reinsurance renewals at the beginning of 2006. This was particularly realized in the U.S., where the supply-and-demand effect was constantly front and centre. Not only did the 2005 losses represent extraordinary and unexpected loss severity, the credibility of the catastrophe models was thrown into serious doubt. The demand for significant increases in capacity is now guaranteed.

I think most insurers and reinsurers alike are beginning to feel a little more optimism as the hurricane season (hopefully) heads into the tail end of the storm season. If the balance of 2006 continues to be “loss free,” the 2007 catastrophe renewal season should prove to be relatively favourable and even generate some reduction in rate in the Canadian market.

At the reinsurance level, the casualty experience – particularly in auto – has not been quite as favourable. The frequency of severe auto losses has continued to escalate; this is putting the reinsurance experience under further pressure. The pressure comes as a result of primary rates steadily decreasing over the last few years, while reinsurance losses are increasing. If this trend continues, there will be inevitable reinsurance rate increases in order to effect correction.

From the perspective of Canadian Farm Mutuals, 2006 has been relatively calm. There have been some cat losses, primarily in Western Canada, but they have been comparatively minor in nature. The result is a generally favourable year so far. Risk quality and insurance to value will continue to be the key to stability and profitability at both the insurance and reinsurance level.

As we move into the renewal season for 2007, the main discussion will be around pricing. Over the past year, reinsurers have learned that models are not foolproof pricing tools (not that they were ever meant to be). This lesson has been learned at great cost to the industry south of the Canadian border. The question that arises in Canada is this: Will we also have to learn this lesson the hard way? Are we really modelling for storm, wind and hail – not to mention a whole host of other perils that do not even generally raise their heads above the parapet? More importantly, are we receiving premium for this additional exposure?

It is extremely important for reinsurers to maintain underwriting discipline as we move into this new renewal round. As of press deadline, the relative absence of hurricanes in the 2006 season is a positive for the industry. But this should not be used as the starting point for a discussion about the pricing of natural catastrophe covers. We need to show all of our stakeholders that we have a healthy market; this is a good starting point to meet the other issues and challenges that constantly arise in our industry.

Let’s look at the relationship between market share and market timing. Sound advice tells the underwriter to grow into strong markets and pause during market downturns. Yet invariably reinsurers seem to get their timing exactly wrong. Following one or two decent underwriting years, it hits the underwriter: time to increase market share!

I risk making the obvious seem profound by saying that we can’t all grow our market share at the same time. Historically, however, we appear hell-bent to do just that. We can all rationalize such efforts as “superior stra
tegy,” because “we’re smarter than the competition.” Or call it “a growth directive from head office that cannot be ignored.” Or perhaps, simply call it “unbridled optimism.”

Of course there are intelligent ways to grow market share. However, they tend to require planning, long-term commitment, good execution and … well … intelligence. Short of these qualities, the cyclical underwriter can only hope to buy market share, thus weakening credibility, capital, security and, while he’s at it, market stability.

Perhaps for these very reasons, I am increasingly confident the historic pattern of mismatched market timing will be less pronounced in 2007. Inflationary factors such as Canadian building indexes and medical expenses are again on the rise. Primary policy pricing itself has declined. Legacy reinsurers have yet to fully recover from the events of past years. At the same time, rating agencies and regulators have become increasingly vigilant in the oversight of reinsurers who ignore the short and long-term damage caused by aggravated market cycles.