Reinsurance Outlook 2006: Hunger for Premium

Canada’s reinsurance industry is experiencing somewhat of a cross-wind right now. Proportional treaties are evaporating, while excess loss treaties – particularly those related to catastrophe lines – have gained popularity. The two dynamics together create a future business climate both favorable and challenging to reinsurers.

Perhaps the most noticeable trend is the primary insurers’ move away from proportional treaties, which has in effect shrunk the pot of available premium volume for reinsurers. Taking advantage of surplus capital and strong returns, Canada’s primary insurers are ceding less of their premium volume to reinsurers and keeping that profitable premium – and hence retaining more risk and exposure – for themselves. Canadian reinsurers are there- fore watching their available premium volumes shrink, as their proportional treaties with primary insurers begin to evaporate.

The upshot of this is that the Canadian reinsurance market, while stable, looks increasingly like an excess of loss market right now. Catastrophes last year in both Canada and the United States resulted in new models that focus on increased capital requirements; the need to access additional capital for emergencies provided primary insurers with incentive to beef up their own financial security through the signing of excess of loss treaties with reinsurers.

Excess of loss treaties take effect when a primary insurer’s loss exceeds a specific, predetermined amount. For example, if a primary insurer is prepared to absorb or retain $1 million in losses, it may choose to purchase reinsurance to cover loss amounts beyond that point.

Typically, excess of loss coverage is provided in “layers.” A primary insurer will handle losses to a certain point; beyond that, a reinsurer would provide additional or excess “layers” of coverage. Sometimes different reinsurers will provide layers of coverage on the same policy, depending on how much of the risk the primary insurer wishes to cede. Typically, huge losses that would penetrate into the higher layers of reinsurance are not easy to predict. Excess of loss treaties are therefore often referred to as “non-proportional” treaties because the amount of premium the primary insurer cedes to the reinsurer is not proportional to the risk the reinsurer assumes.

In proportional or “pro rata” treaties, the reinsurer provides coverage to the primary insurer in exchange for a predetermined amount or share of the premiums charged by the ceding primary insurer. The frequency of these kinds of claims is generally higher, but the losses are more predictable as a result. That makes it easier to structure proportional treaties to limit aggregate losses from the contract.

In proportional treaty arrangements, reinsurers typically do not separately evaluate each of the risks contained in the contract, as SCOR Canada Reinsurance Company notes on its Web site. The reinsurer reviews the company’s general underwriting practices, but is basically dependent on the original risk underwriting decisions made by the ceding primary policy insurers. Typically, reinsurers will pay the ceding company a commission to cover the administration related to handing over that portion of its business.

When financial times are good for primary insurers, as they are now in Canada, they will often choose not to cede their profitable premium to reinsurers. “Over the past few years, insurance companies, the reinsurance buyers, have moved away from proportional treaty reinsurance coverage to excessive loss reinsurance coverage,” Cam Macdonald, the regional vice president of Transatlantic Reinsurance Co., says. “That’s definitely been a trend both here and in the U.S….

“Definitely companies have retained more of the exposure in-house. For reinsurers, it’s a good news-bad news scenario. The good news, I guess, is that we [reinsurers] are further removed from the loss. The bad news is, the premium pie for reinsurers is getting smaller. There is the annual struggle to maintain your top line and to grow your book of business. That’s difficult to do in a market that’s in essence shrinking.”

Steve Smith, president of Farm Mutual Reinsurance Plan, says three dynamics have made it easier for primary insurers to retain more risk. “First, the Canadian market has been very profitable for the last couple of years,” he says. “So there has been a real desire for the insurance companies to retain more of that profitable premium, obviously.

“The other thing that’s happening is this: through amalgamations and growth in surplus, there’s the ability to afford a higher retention. Companies have been growing their surplus or their capital for the last two or three years – to significant amounts. That strengthens their financial position and allows them to take more retention.

“So two things are taking place: a profitable business [that] is more attractive [to retain] and the profit itself is allowing [primary insurers] to take higher retentions.”

The next step, Smith observe, is amalgamations and mergers which are simply make companies larger and therefore offer the ability of acquiring higher retention.

“All three things are kind of working together to drive higher retentions.”

RISK RETENTION

Reliable statistics on retention levels are difficult to obtain. Anecdotal evidence suggests some Canadian reinsurers have seen their premium volumes drop by anywhere between 10% and 20% during the first quarters in each of 2003-04 and ’05. Conservative estimates suggest between CD$250 million and CD$300 million in premium volume has disappeared from the Canadian reinsurance market over the past year. Higher estimates climb up to CD$500 million. Whatever the actual figures may be, reinsurers don’t seem very concerned about the trend away from proportional treaties. In some specific situations, reinsurers have encouraged primary insurers to retain higher levels of risk (and therefore premium).

“As Canadian property and casualty insurance companies merge, and as they build up their surplus by making profits, they retain more risk and this makes perfect sense,” according to Pierre Michel, the chief agent for Partner Re Canada. “This was bound to happen. This was completely foreseeable.”

The caveat, Michel adds, is that “it is happening quicker than some people had thought…. We don’t know for a fact but we can’t help but think that only time will tell but in that in some cases it might have been too fast.”

David Wilmot, the senior vice-president and chief agent for The Toa Reinsurance Company of America, believes Canada’s primary insurers may ultimately revive – rather than abandon – the use pro rata reinsurance treaties in the future. He notes the financial strength of the nation’s primary insurers has led in part to a softening market over the past few years – particularly in heavy commercial property and auto lines. Brokers have commented publicly on the reduction of some premium prices across the country.

“I’m going to suggest to you something [other reinsurers] may not have said,” Wilmot said. “If the prices continue to drop, there’s a tendency to use the pro rata more often. Reinsurers would be well-advised to pay more attention to the use of pro rata as the original policy premiums go down.

“Suppose, for example, I’m writing this book of commercial business; competition is getting fierce and I know the pricing is getting a little keener. Fortunately, because I’ve had such good results for the past two years, I have very attractive commission terms. I’m getting a really good commision from my reinsurer.

“Well now, I know that I’ve slashed my rates by 20%. I’ll tell you what I’m going to do: I’m going to keep my commission the same way, but I’m going to start using the surplus more. I’ll start feeding that treaty more, which I can do. The treaty will let you write five times as much into the treaty as you keep net.

“Well on average, you’ve only been feeding 50% into the treaty on the biggest risks. But now you start fee ding 60%, 70%, 80% … 200% into the treaty and keeping less. So you get great commissions.”

GROWTH MODELS DICTATE IMPORTANCE OF PREMIUM

As far as shrinking premiums go, Michel says reinsurers probably don’t have much to worry about, depending upon their business model. If reinsurers’ growth models are based on mergers, acquisitions or size increases, then obviously premium volume – which is required to raise enough capital to support such strategies – would be of concern if it started to dissipate. But if reinsurers base growth models instead on return on equity (ROE), then they would be more resilient to the loss of premium volume. “Volume will start to matter if we reach too small a size that our risks are not well diversified,” Michel noted. “We are very, very far from that today.”

Some note shrinking premium volumes may become problematic in the future, should they happen in concert with increased merger and acquisitions activity in the Canadian market. M&A activity among primary insurers would only shrink the premium pie even further, according to Swiss Reinsurance Company Canada president and CEO Jean-Jacques Henchoz.

“The main issue I see [for reinsurers in the future] is related to this growth discussion,” he says. “Since a number of companies have quite some cash to deploy, there will be an active search for acquisitions. I would see consolidation as one trend on the primary side.”

This is significant, Henchoz says, because “any merger and acquisition [activity on the primary side] reduces overall the available premium for reinsurance, that’s for sure. Short-term, it could be that the acquirers need us to provide some capital support, so it might lead to some one-off deal opportunities for us. But as a general trend, if you see a consolidation in the primary sector, obviously the overall reinsurance capacity shortly after is less. There is a reduced pot.”

ASSIGNING VALUES TO RISK

All of this is happening at a time when Canadian reinsurers are paying out a hefty number of catastrophe claims. In 2005, weather storms and the explosion of the Suncor plant in Alberta (producing more than CD$1 billion in losses), Toronto’s August 19 rainstorm and tornadoes (another CD$400-500 million in losses) and other events have all combined to produce one of the worst financial years on record for Canadian reinsurers. They saw their combined ratios skyrocket from 92% in 2004 to 102% in 2005. The combined ratio is a measure of financial success and is based on dividing claims costs or expenses by premium revenue. Insurers and reinsurers need ratios to be well under 100% to make a profit.

At a PCUC luncheon in Toronto Andre Fredette, vice president and general manager of Caisse Centrale de Reassurance, noted that Canadian reinsurance results over the past several years have not been “stellar.” The industry saw good combined ratios in 2003 and 2005, he said: “The other years before that were not that great.”

To mitigate this trend, reinsurers say, it’s important for the insurance industry as a whole to assign proper values for each insured risk. In other words, if a risk is CD$500,000, then a policy shouldn’t be written for CD$250,000. This may be easier said than done in a competitive, softening market.

THE ROLE OF NEW CAT, CAPITAL MODELS

Nonetheless, the emphasis on assigning proper value to risks is especially important in light of the new, recalibrated catastrophe models. These models are being developed in the context of increasing frequency and severity of catastrophic events. Reinsurers note the old models were undervaluing losses by up to 20-25%. That could be both because of the limitations of the models as well as the data being input into the models, reinsurers say.

“What we’re seeing now, of course, is the fact that there has been an awful lot of pressure over the course of the last few years for making sure we have proper values assigned to the exposures that are out there,” David Green, vice president of underwriting at the Toronto office of Odyssey America Reinsurance Corp, says. “We saw that with [the 2003 fires in] Kelowna [B.C.], where there were problems with valuations because certainly reconstructions that had to be done at costs that were far and above what the houses were insured for. This created a replacement cost crisis out in Kelowna.”

Recalibrated cat models have been designed to take into account phenomena such as storm surge and demand surge. Assuming these models and valuations are more accurate in the future, new catastrophe models are expected to spit out results that call for much higher capital requirements.

At the same time, new capital models are also calling on companies to reserve more capital for future events. Wilmot noted the new capital models are the second part of a double-whammy. “At the very same time these higher PMLS [probable maximum losses] are being generated by the [catastrophe] models, the rating agencies – A.M. Best, Fitch, Standard & Poor’s – are putting more emphasis on insolvency in relation to weather PMLs,” he says. “So there’s sort of like a 1-2 punch.”

In fact, it’s kind of a triple-whammy, when factoring the increasingly unstable weather conditions predicted for 2006, as well as increasing population densities in U.S. coastal areas.

“Clearly the frequency and the severity of the hurricanes in certain areas of the world are increasing,” Christophe Colle, the president and CEO of XL Re Canada noted. “That’s the first variable of the equation. The second variable of the equation is that the density of the sums insured is increasing in the world. The fact is, the sums insured are very well-concentrated. So when you’ve got a concentration of sums insured in an area where frequency and severity of the hurricanes are increasing, it leads to a situation we are facing right now.”

All of these events are leading up to a kind of ‘Perfect Storm’ that may be related to the recent emphasis on excess of loss treaties. Although primary insurers are pulling out of their proportional treaties, they are still obviously counting on reinsurers to support them in the event of future natural catastrophes.

“The insurance companies are continuing to buy catastrophe protection and increasing some of that coverage at the upper levels,” Bruce Perry, the senior vice president of underwriting at Partner Re Canada, said. “They’re really just retaining, thinking of the frequency of the smaller claims that’s being held in-house. But they’re still protected against The Big One.”

CANADA ‘INSULATED’ FROM U.S. REINSURANCE MARKET?

Canadian reinsurers note with interest that the Canadian reinsurance market appears to have emerged relatively unscathed from the global impact of the U.S. hurricanes in 2005. Damage estimates for Hurricanes Katrina, and Wilma alone are estimated at between US$60-80 billion. Traditionally, Macdonald noted, “when there have been large cats in the past, that coverage was considered a [global] commodity and everybody would pay the same. If catastrophes went up, catastrophe rates would go up generally worldwide, whether [or not the catastrophe] was [in] London, Bermuda, the States, or here [in Canada]. Everybody would pay for the US$50-70 billion dollars of losses.”

And yet, while some local insurers in Florida were seeing reinsurance rates skyrocket anywhere between 30% and 300%, insurers in Canada were paying much more modest catastrophe-related rate increases.

“Last year around, that [global apportioning of the catastrophe losses] didn’t happen to the same degree,” Macdonald observes. “It did happen. I think our cat book went up by marginally – 7% or 8%, or something like that – whereas in the past it might have gone up by 20-25%.

“But cat rates did go up [in Canada] because, although we weren’t terribly affected by the hurricanes in the United States, Canada did have some of its own large cat losses… But it was more the activity locally that drove the price up than it was the effect of the [U.S.] hurricanes.”

Even so, another bad year for U.S. hurricanes in 2006 means primary insurers “might be paying more for cat cover no matter where you are,” Macdonald predicts.

Reinsurers might be able to make up for some of the lost proportional treaties through excess of loss catastrophe covers, but will it be enough?

“I guess that’s good for reinsurers, but that will more than likely be at the top end of the program,” Macdonald says of the trend towards excess of loss treaties, particularly as they relate to buying catastrophe covers. “So if [insurance companies are] buying CD$400 million now [in excess of loss treaties], they might buy CD$450-$500 million [in the future]. The rates up there are fairly thin, so it’ll be some additional income but it won’t make up what we’re missing on the bottom end or by losing the proportional programs that have been in the market.”

How the twin dynamics of fading proportional treaties and the emergence of excess of loss treaties will pan out in the future is anybody’s guess. But most reinsurers are satisfied the Canadian reinsurance market is now “stable,” even if it is unpredictable. There’s still more than enough worldwide capacity for the Canadian reinsurance market, which absorbed more than CD$1.5 billion last year in claims. As one observer noted, this compares favorably to the U.S. experience: out of the US$60-80 billion in losses for Katrina alone, about 50% – or about US$38 billion – was ceded to reinsurers. Plus, the capacity of new Bermuda reinsurers that started up in late 2005 should be coming online sometime in 2006, Wilmot notes.

“Overall, I see it as very stable for Canadian reinsurers,” Smith says. “I think you’ll see the Canadian market considered very attractive for international reinsurance players, because of the relatively modest catastrophe activity and insurers’ efforts on insurance-to-value, which is improving the premium to risk or the subject premiums. I think overall in many of [Canada’s primary insurance] companies right now, they are really focusing on quality of risk management and loss prevention to really protect the loss frequency. I think that all serves to create a stable, attractive market for reinsurers in Canada.”