Reinsurance market outlook: Margins Wear Thin

The global reinsurance market suffered its worst underwriting year in 1999, largely as a result of natural disaster catastrophe losses estimated to having cost the industry about US$24 billion. European reinsurers finished 1999 with an alarming 131% combined ratio, the U.S market with 114% and Canada at 105%. The stark rise in European reinsurance underwriting losses spurred rating agency Standard & Poor’s to recently issue a cautionary notice indicating that it will likely down-rate the financial security ratings of many of the global reinsurers. One of the prime concerns the agency has with the future course of the market is that the string of European storms which hit several countries in the last month of 1999 will only be felt in the current financial year. However, rising cat losses and excess capacity driving the ongoing soft market are not the only headaches facing reinsurers, the higher underwriting toll has seen several companies operating in the retrocession market withdraw, resulting in significantly reduced capacity and spiraling rate increases — this alone could provide the necessary impetus required to turn reinsurance rates around, reinsurers consulted by CU state.

Faced with a bombardment of poor 1999 yearend results from both European and North American reinsurers, international rating agency Standard & Poor’s recently committed a somewhat controversial action by issuing a cautionary warning on the future financial security of some of the major players in the global reinsurance market.

The rating agency has indicated it will likely downgrade the financial ratings of several reinsurers in wake of the string of poor underwriting results which have mainly arisen from the European market. In addition, Standard and Poor’s expresses concern over two factors likely to have a negative bearing on the financial performance of global reinsurers in the year ahead: the mega European storm losses incurred in the final month of last year, and the continuing high-level of capacity in the market. “Standard & Poor’s maintains a negative outlook on the reinsurance industry in general.”

Rob Jones, director of insurance ratings at Standard & Poor’s London office, points out that, despite a significant reduction in capacity of retrocession protection, there is a fear that the excess capital resident in the reinsurance market will continue to hold back reinsurance rates. “…the continued plentiful supply of reinsurance capital and availability of alternative protection methods, including capital market mechanisms, will temper rate increases. Economic levels of return [of reinsurers] to shareholders are likely to continue to prove elusive without the withdrawal of substantial reinsurance capacity, either by distributing capital to shareholders in the form of dividends and share buybacks, or to policyholders in the form of claims.”

Adding pressure to the woes of reinsurers is significantly higher retrocession costs, which reinsurers expect will have doubled by the end of this year. The heavy underwriting loses of the past two years, mainly on cat covers, has seen several global retrocession companies (who act as “insurers” to reinsurers) withdraw from the market in the second half of last year. In fact, a major player in the retrocession game, Australian-based Reinsurance Australia Corporation (RAC), recently closed its doors. Essentially, the reduction in retrocession capacity and the ongoing aggressive competition across the North American and European reinsurance boards has left many reinsurers with their backs “between a rock and a hard place”.

Some reinsurers contacted by CU are hopeful, however, that reduced retrocession capacity, combined with increased pressure on rates-of-return from global head-offices, could stimulate a withdrawal of several players from the reinsurance market. At the least, most reinsurers plan on displaying the “wear and tear” they have taken in the recent past when they engage in the current mid-year and yearend treaty negotiations with primary insurers — a critical time as many of the two-year “multi-year” contracts will be coming up for renewal. The question remains, however, to whether reinsurers will be able to bring about the necessary rate increases they need without sparking significantly higher primary retentions and “chasing premiums away” to the ever hungry alternative capital market competitors.

Canadian perspective

Although the Canadian reinsurance market survived the past year on a relatively healthy note with a combined ratio of 105% (1998: 118%) — at least after coming off of the Cdn$236 million underwriting loss reported for 1998 (primarily as a result of the ice storm) to last year’s underwriting loss of Cdn$76.5 million — the worsening global picture will have a significant bearing on primary rate adjustments, reinsurers promise.

Patrick King, chief agent for Rhine Re Canada, is cautious in predicting the extent reinsurance rates will likely rise through this year’s yearend treaty negotiations. There is still ample capacity in the market, he observes, although reinsurers are less likely to use this writing capacity without getting the pricing right. “We’ve seen several new entrants [to the Canadian market] modify their approach based on actual underwriting experience.” One thing is for certain, King comments, “we definitely won’t see price reductions, those days are over”.

This sentiment is supported by Bruce Perry, vice president of marketing and underwriting at SAFR Partner Re, who believes that noticeably higher cat and liability related losses will cause many players in the Canadian market to shy from “chasing marketshare” at the expense of underwriting discipline. Although some of the new entrants to the Canadian market over the past two years have had their fingers burnt from rate cutting, Perry is not optimistic of any withdrawals from the market. “There are currently about 25 active reinsurers in Canada, and I’m not aware of any with plans of pulling out.”

While reinsurers will likely be cautious in applying their underwriting pens to potentially unprofitable business in the upcoming treaty round, Perry expects rate adjustments will be handled carefully with terms based on the particular experience of the primary companies involved. However, he is sure that the upward rate pressure being exerted by the reduction in retrocession cover, combined with the recent devastation on the cat front, will prompt a staunch stance by reinsurers in the yearend negotiations. “Cat events between now and the end of the year could see further pressure being brought to bear on rates.”

While the cost of retrocession cover has definitely increased, there is no definite signs that capacity has been withdrawn, notes John Phelan, president of Munich Reinsurance Company of Canada. He expects Canadian reinsurance rates will be impacted by global pricing pressures. “One should remember that ‘base rates’ should reflect underlying exposures. The Canadian insurance market has benefited from being part of the global market for many years. This is evidenced by the very low cost of catastrophe protection in the aftermath of the ice storm losses in Quebec and eastern Ontario when rates hardly moved. Now that costly catastrophe losses are also occurring in other parts of the world, rates are beginning to harden and we can expect that Canadian insurers will face significant rate increases.”

Swiss Reinsurance Company Canada president Patrick Mailloux says there are already signs of a hardening market, spurred by the rise in retrocession costs. This is being particularly felt in the cat lines which has seen a dramatic reduction in capacity over recent months. In that respect, he believes the global experience of the reinsurance market will have an impact on Canadian covers. Furthermore, he points out that Canadian losses are beginning to surface in company financials, “and this is attracting the attention of corporate head-offices”. And, although the capital inflow into the Canadian reinsurance market continued to rise through last year, Mailloux says, “I would not be surprised to see some companies leaving Canada this year”.

Although the combined ratio of Canada’s reinsurance market at 105% last year was significantly lower than that of the U.S and European markets, the true loss position when taking into account what was passed off into retrocession covers was most likely much higher, comments Peter Borst, president and chief agent of Employers Reinsurance Corporation (ERC). Borst was also recently appointed chairman of the Reinsurance Research Council. However, Borst does not expect that Canadian rate adjustments will be as severe as the U.S., given that Canadian results have not been as poor. In that respect, he feels there is more opportunity to tailor adjustments to the experience of the individual ceding company in this market. The U.S. market also has a greater number of mid-year treaty renewals now up for negotiation (which should act as a bellwether for what Canadian insurers can expect at the yearend).

That said, Borst believes there will be some “home office direction” this year in putting pressure on Canadian operations to focus on improving the bottom-line numbers. And, commenting on the negative report of the global reinsurance industry issued by Standard and Poor’s, Borst adds, “this downward rating merely affirms that we’re at the bottom of the cycle…it’s time for a correction”. Does the lower security rating of the major reinsurance players mean that any of the “Big Six” are at risk? “No,” Borst stresses, “but we could see some fallout among companies in coming years due to underperformance”.

Multi-year impact

A key factor leading to the current under-valuation of reinsurance rates was the reintroduction of multi-year, multi-line contracts in 1998 in a bid to relieve pressure on primary companies in transitioning over Y2K. As a result, less than half of reinsurance treaties came up for renewal at the end of 1999 when the full impact of reinsurance underwriting losses were being felt. This situation, however, will be reversed in the upcoming treaty discussions when the vast bulk of contracts will be subject to negotiation — the prospect of which has sent a shiver of fear through primary company ranks of significant and broad-based reinsurance rate increases.

King confirms that, where less than 50% of Rhine Re’s contracts were renegotiated at the end of 1999, nearly 90% of them will be subject to renewal at the end of this year. “From what I’ve heard, most reinsurers are not going to renew multi-year arrangements.” Should insurers be concerned with facing harsh and across-the-board rate increases? “No, I don’t believe so,” King comments, but pricing will most likely be applied on a strict basis to match the level of experience reinsurers have had with clients since the last renewal. However, multi-year arrangements are likely to become a fashion of the past, he adds, “multi-year contracts were unheard of before Y2K, and those reasons don’t exist anymore…There is more volatility in pricing reinsurance because of cat trends, which is why reinsurance has always been negotiated according to one-year contracts.”

Mailloux notes that several insurers have expressed concern over the extent of rate increases likely to be applied by reinsurers in a hardening market and especially after a multi-year lock-in rate. “I’ve heard of a concern that a hardening will see everyone being treated the same. However, as we always do, Swiss Re plans to rate every client and treaty independently…We have to ensure that rates [increases] take into account the client’s own experience.” Mailloux says Swiss Re has always tried to discourage clients from multi-year contracts. “Multi-year contracts recently became very popular for Y2K to create stability, and there was some merit to this logic…but I don’t see how multi-year arrangements can help anybody going forward because of the risk of facing heavy corrections after having been locked into contracts of up to three years.”

Borst adds his voice to the growing support-list of reinsurers keen to see an end to multi-year contracts. As a result, he expects to see considerably fewer multi-year arrangements being negotiated at the end of this year. “We weren’t keen on multi-year, and a number of markets [reinsurers] are looking at revising these terms for the upcoming [treaty] renewals.”

Increased retention risk

The risk of a “broad brush” reinsurance pricing increase could drive business out of the market, says Tom Hopkinson, president of reinsurance broker Guy Carpenter (Canada). In particular, the “type of business” likely to take flight from the primary market in the wake of unduly harsh reinsurance treaty terms will be those companies with “superior results”, comments Hopkinson. “…that same ‘broad brush’ mentality seldom generates enough extra premium to reverse the results of accounts that have hurt treaty reinsurers. Therefore, unless we properly recognize each account’s historical results, we run a very real risk of losing good business and keeping the bad stuff,” he warns.

This is a concern several of the reinsurers surveyed by CU for this article acknowledge. As a result, most expect rate increases in the yearend treaty renewals will be dealt with caution, unlike the past hardening of the rate cycle which saw primary company retentions rise considerably and opened the door for investment bankers to enter the market foray. However, the excess capital surpluses retained by many primary insurers will no doubt see a rise in some retention levels, says Borst. “Insurers realize that the reinsurance product has become underpriced… Retentions on the primary side will perhaps rise because some companies now have the ability to do so. But, despite the strong surpluses, insurers are dealing with their own volatile results [which may discourage higher retention levels].”

Although the issue of “higher retentions being sparked off” through the upcoming treaty negotiations will remain a question mark until the day of reckoning, Perry does not expect the threat of higher primary retentions will result from the upcoming discussions. “In the past, when there has been an unduly adjustment to rates, primary company retention levels have increased. But, I don’t see any great movement in this regard for this year.”

Phelan is also skeptical of higher primary retentions, at least at any significantly higher level. “Rates are currently so low that increases, on their own, would have to be very large to create the kind of economic stimulus necessary to increase retentions or to attract alternative market instruments. Naturally, cedents will continue to systematically increase retentions to more effectively use their own capital and this may become more attractive as reinsurance rates increase to appropriate economic levels. On the otherhand, there is no attraction for us [reinsurers] to retain business which can only be written at an economic loss in the short to longer-term.”