Reinsurance Outlook: 2003 CAT Rates

The Canadian market was fortunate in that, for the second year in a row, it experienced no significant catastrophes in 2002. In addition to the benefit in terms of human cost, this unusually good stretch has allowed insurers and reinsurers to refill the coffers from the last significant Canadian catastrophe – the 1998 Ice Storm.

In a year when the industry endured its worst performance on record, the relief from major catastrophic loss was a welcome respite. The 9/11 terrorist attack had a significant impact on catastrophe reinsurance pricing and terms for 2002 renewals, and continued to influence 2003 programs. Terrorism exclusions or limitations have become the norm. Instances of positive terrorism coverage being purchased are few, and most large commercial risks in Canada now operate without terrorism cover. While the enactment in the U.S. of the Terrorism Risk Insurance Act of 2002 (TRIA) will have a peripheral impact on some Canadian treaties, most Canadian exposures do not have access to a government-supported or mandated mechanism.

Fire-following

There has been a push by reinsurers to update regulations pertaining to fire-following a nuclear incident or following terrorism, in order to align primary insurance policies with protection that international capital and reinsurance markets are willing to provide. This will continue to be a topic for 2004 renewals, as reinsurers – who do not provide fire-following cover in most countries – determine whether this is a risk to which it can justify exposing its capital.

Beyond terrorism and nuclear, other risks emerged over the past year. While asbestos dominated casualty lines, mold was a topic for property coverages. Most primary markets were already set to incorporate updated mold exclusions into their policies, recognizing that this exposure was more likely to face a frequency of claims, rather than severity, and therefore most likely to be carried within the net retentions of most carriers.

Beyond pricing and terms, the quality of markets and capacity availability both played a role in 2003 renewals. A sharp drop in industry capital – in the range of 25% resulted from the combination of equity losses, the terrorist attacks, asbestos run-off, a normal year of global storm losses (including the European floods), and the remnants of soft market underwriting.

Solvency quest

As global reinsurance capital disappeared, clients placed more emphasis on reinsurers’ solvency. The demand for top quality claims-paying ability grew, as more clients realized the true cost of reinsurance is not just the premium paid, but the sum of the premium plus any uncollectable losses.

At this year’s annual Swiss Re “Statistical Breakfast” seminar, Paul Kovacs, the chief economist at the Insurance Bureau of Canada (IBC) reported that investment returns dropped from 7.6% to 5.8% for 2002 – a 40-year low. Return on equity (ROE) fell from 3.1% to 1.6% – the worst two-year performance ever recorded for the industry in Canada.

While capital erosion caused clients to focus on reinsurance security, reinsurers sought to deploy their scarce capital more selectively, and at terms and conditions needed to generate an acceptable return and strengthen balance-sheets.

In our 2002 Catastrophe Rate Comparison article, we noted: “While often in our industry changes seem to take place with a top down approach, the primary market must take responsibility to return to underwriting basics, and to take measures to improve their rates, in order to effect a bottom up correction in the marketplace.” There is evidence that the industry is improving from the bottom up. Overall premium growth is clearly having an effect, although claims growth in liability – and especially in automobile outside Quebec – continues to make profitability in these lines elusive. Despite the positive movement in prices, the primary industry still recorded its worst year ever.

And reinsurers? Companies reporting to the Reinsurance Research Council (RRC) showed a combined ratio of 110% for 2002, despite the catastrophe-free year we noted. It is in this context that companies went into their 2003 renewal season.

The analysis

Charts 1 and 2 show how rates have changed for the three categories tracked by Swiss Re for the Canadian market. The category into which a layer falls is dependent only upon the limit and deductible for the layer. A small company’s entire program may be categorized as low, conversely a very large company’s entire program may be categorized as high. The graph charts the simple average of rate changes, not weighted by premium.

Note that the sample includes all comparable covers for which Swiss Re knows the terms for two consecutive years, and hence includes many layers on which Swiss Re does not participate.

The graph and the chart show the upswing in average rate increases over the last four years, when the market began to turn in 1999. Significant increases took place in 2002 with further increases in 2003 such that current rates have begun to surpass the last peak in 1994 that occurred as a result of Hurricane Andrew. In 2003 increases clearly continued, but at a much slower pace than the year before. Caution should be taken to note that this comparison does not take into account that “equivalent layers” are now more exposed than in 1994, since the underlying portfolios have typically grown. These numbers have not been adjusted for inflation and are not directly comparable over the long term.

This study focuses exclusively on excess catastrophe coverage. However casual evidence also indicates clearly that catastrophe coverage provided in proportional covers saw substantial price increases in 2003, in the form of higher margins and lower reinsurance commissions. This correction began to make the cost of cat cover on an excess and proportional basis more comparable than in prior years. Charts 3 and 4 show the data in terms of percentage rate changes from the prior year.

The two most significant changes in rates followed the two largest insured events in history: a 49.5% increase in 1993 following Hurricane Andrew, the most costly natural catastrophic event, and a 44.1% increase in 2002 following the terrorist attack on the World Trade Center (WTC), the most costly man-made catastrophic event. Simply measuring the average change in rate based on gross net premium income (GNPI) is only one part of the picture, since the reinsurance rate alone does not fully reflect the premium charged per layer. Another measure is the premium as a percentage of the limit, or “rate on line” (ROL).

In charts 5 and 6, the changes to the ROL since 1999 are shown, both as a simple average and as an average weighted by the premium charge for each layer. Also included is the year over year change using 1999 as a base – the year in which the market finally turned from its low, and catastrophe rates began an upward trend.

The simple average changes in ROL are larger than the changes to the rate on GNPI, reflecting the impact of growth in the underlying portfolio. This portfolio premium growth may result from two factors: true growth in the portfolio’s size (which increases the exposure to the reinsurance cover, and may result in more cover being purchased), or rate increases at the primary level (which increases a reinsurer’s premium, but not exposure). When looking at the average weighted by premiums, the increases are significant. The implication is that bigger, more exposed programs (with more premiums) were subject to proportionately larger increases than programs with a smaller GNPI.

The conclusion

The rise in catastrophe premium rates from their 1998/99 lows (from the client’s perspective), and the rise in natural and man-made exposures (from the reinsurers’ perspective) have focused attention on the cost of catastrophes. To manage these significant exposures economically, it is important that reinsurers understand the exposures well on every program, particularly to storm and earthquake. This requires good client data systems, and accurate reporting of aggregates by i nsurers.

Consistent, high-quality data helps the client in two ways. First, it allows them to understand their level of aggregate risk, and therefore to build the true cost of the different exposures into their product pricing, so as to compete effectively in the market. Secondly, credible data helps control the cost of catastrophe cover, by allowing reinsurers to avoid price buffers to compensate for uncertainties in the true level of exposure. At Swiss Re we focus on the reporting of aggregates for Vancouver earthquake risk, both in proportional and non-proportional covers.

The Swiss Re study shows that catastrophe pricing continued to rise in 2003, albeit at a much more moderate pace. Are the increases enough? We reiterate that with the increases, we are only now reaching the price levels seen almost a decade ago. If there is a normal catastrophe burden in Canada in 2003, then the combination of primary market and reinsurance rate increases should be enough to allow reinsurers to see improved combined ratios at yearend. Whether the result will be good enough remains to be seen. The industry’s results have not yet attracted a meaningful amount of new, external capital to our business. That leaves internally-generated earnings as the only way to rebuild balance-sheets. In the words of the Swiss Re publication, “The insurance cycle as an entrepreneurial challenge”, the only alternatives, “..are to increase share capital and/or to improve technical results. But increasing share capital itself will ultimately require better technical results. Thus, the only options are reducing expenses, better selection of risks and higher prices. Everything indicates that reinsurance is going to be very expensive for the foreseeable future.”

As always, Swiss Re’s study compares average changes in market rates. There is, and should be, a considerable range of increases depending on an individual client’s book. Portfolio growth, line-of-business shifts, regional shifts, primary pricing, earthquake deductibles, and inuring reinsurance changes all play a role. Swiss Re Canada will continue to price every layer of every program.