Competition for Premium Pie

A quip in the early 1980s suggested that all that was required for a reinsurer to set up business was a telex machine and an expense account. Entry barriers remain low, but times have changed — particularly in regard to the need for increasingly strong capitalization in order to attract customers.

Today, reinsurers set up at seemingly lightning speed — and highly capitalized — when perceived opportunities arise. Witness the Bermuda phenomenon, as well as the waves of reinsurers established in 1987 (following the liability crisis), 1993 (Hurricane Andrew), 2001 (9/11 terrorist attacks) and 2005 (Hurricanes Katrina/Rita/Wilma). With each new wave, the time to establish a new reinsurer decreased while the average capitalization increased.

The nature of capacity has also changed. In the 1970s and early 1980s, we referred to ‘innocent capacity’ or ‘naive capacity.’ During that period, many insurers and reinsurers extended their operations into unfamiliar reinsurance areas to deploy excess capital and diversify operations. They often accepted business with a minimum of underwriting information. Mounting losses soon took care of excess capital and many lost their innocence. Several retreated to more familiar ground, dragging their tails of liabilities behind them.

Lloyd’s was not immune. Many names that had been lured by the expectation of easy profits later claimed to have been duped into joining syndicates. The result was financial hardship. Membership in the club came at a high price indeed.

Today’s new capacity is neither innocent nor naive. Some have long-term intentions and have invested in suitable vehicles to achieve their ends. Another segment, represented by hedge fund investors, seeks high returns in the short-term, with planned exit strategies. High returns are associated with high risk, and often this capital is deployed in concentrated areas of peak exposure, creating a calculated hit-or-miss proposition.

One such peak exposure is east coast windstorm in the United States. A significant portion of this market has recently been removed from the private domain through legislative initiatives in Florida. This ‘political solution’ puts Florida’s taxpayers at greater risk while significantly reducing the premium base that had attracted some of the new capital. The result? A knock-on effect on other business lines and regions, whether catastrophe-related or not, as newly established reinsurers attempt to otherwise deploy their capital and diversify their portfolios.

Global reinsurance premium volume peaked in 2003-04, and has steadily declined through 2006. The demand created by the natural hazard events of 2005 has already waned, as primary companies have increased net retentions on excess of loss business while ceding less proportional business. Prices have yielded to competitive pressures in many markets. Therefore, although the new capital may have been welcomed on peak risks, there is little demand for that capital in other areas, adding to the difficult task of portfolio diversification. A.M. Best has warned that the 2005 start-ups will be forced to seek alternative business opportunities in an attempt to fully utilize the capital raised. This may fuel additional merger and acquisition activity.

CLOSER TO HOME

It is no secret that 2005 was a particularly bad year for natural hazard losses while 2006 was relatively benign. This global perspective, coincidentally, is consistent with the Canadian experience. In Canada, 2005 was a poor year for reinsurers due to both man-made and weather-related losses. In the absence of major loss events, 2006 results improved, producing the first year in recent memory when the reinsurance industry posted an average combined ratio of below 90%. Despite stellar underwriting results, however, the average return on equity for Canadian reinsurers rested in the mid-teens — hardly cause for euphoria among shareholders, but better than an average year.

The reinsurance premium volume for risk assumed by licensed professional reinsurers in Canada (including Lloyd’s) appears to have stabilized at about Cdn$2.6 billion. This is similar to 2005, but a definite drop from the peak of Cdn$3.5 billion in 2003. Improved balance sheets of primary companies have allowed for the retention of more risk, reducing cessions to reinsurers. The long-term average ratio of licensed reinsurance to direct written premium is 10%, but the 2005 and 2006 ratios are just over 7%. Under current market conditions, there is no short-term expectation of a rebound in cession patterns.

The property line of business has historically represented more than 50% of all premiums to reinsurers in Canada, and 2006 was no exception. This line produced a loss ratio of about 44%, helping to drive reinsurance profits. The majority of this premium is produced by commercial property in Canada, where reinsurers only just now are beginning to feel rate reductions in the primary market.

The automobile line, previously the second major line for reinsurers, has slipped in status in recent years. Liability surpassed the auto line in 2005. The principle reason for this appears to be the reduction of automobile quota share cessions. Automobile premiums now represent less than 16% of reinsurers’ portfolios, whereas liability has grown to about 28%.

At first glance, this appears to be good news for reinsurers. The majority of reinsurance premiums for automobile stem from automobile liability and accident benefits, lines that have produced loss ratios far higher than property since the beginning of the new millennium. Unfortunately, liability has not fared much better, and loss trends are worrisome.

LOOKING FORWARD

Primary companies are retaining more risk, while competition is perpetuating the downward pressure on primary rates. After several years of decreasing loss frequency, there is anecdotal evidence of both increasing frequency and severity across several lines and geographic regions in Canada. But the impact of this trend on individual insurers is uneven. This is bound to affect the volatility and predictability of the primary results.

Reinsurance coffers have been replenished throughout 2006, but the restored capacity is facing a world of reduced cessions. There is increasing scrutiny of business strategies to maximize shareholder value, with an emphasis on capital management. The outlook is for a slow withdrawal of hedge funds and sidecars, further consolidation, especially among the 2005 start-ups and Lloyd’s syndicates, and continued share buybacks. Catastrophe bonds, however, will continue to play an important role in international markets as peak risks increase.

Amid predictions of an above-average Atlantic storm season and continued rate softening, a repeat of the strong performance of 2006 is unlikely. Broader issues such as terrorism, pandemics and climate change pose threats and act as a reminder of the market’s fragility and the imperative of enterprise risk management.

The current supply of reinsurance capacity, meanwhile, provides insurers with a wide choice of reinsurance partners. A key selection factor is the long-term security offered by a reinsurer. A reinsurer’s financial health benefits all stakeholders, particularly the health of its clients. To maintain health, reinsurers must be diligent in risk and capital management, and in ensuring that premiums keep pace with the growing risk exposures.