Reinsurance outlook: Low Rates & High Losses

Glenn McGillivray: Has the RAA expanded its membership to include reinsurers that previously did not qualify because of their size?

Franklin Nutter: Our membership structure has changed a lot in the last while. Historically, the RAA has been a body solely for U.S. property and casualty companies. However last November, our board changed the bylaws to allow for the inclusion of reinsurance brokers as affiliate members. They aren’t part of the RAA’s public policy decision-making process, but enjoy other benefits of being part of the association. In February of this year, the board made further changes to our bylaws to allow, for the first time, members in the life, health and accident reinsurance segments. Finally, the bylaws were changed to allow for the inclusion of non-U.S.-based companies. Some entities outside the U.S. have become important providers of capacity in America, so much so that such segments as Bermuda are almost an extension of the U.S. market. Also, a few major U.S. reinsurance players have redomiciled themselves in the Caribbean. We wanted to make it possible for them to enjoy the benefits of being a member of the RAA.

GMc: …What was the impetus for these changes in the membership structure?

FN: Good question. First of all, consolidation in the reinsurance industry has eroded our membership. Right now, there are about 21 member p&c companies in the RAA. Not too long ago, we had 36 or 37 members. So the association is currently at about 60% of its original size.

Secondly, we decided to allow brokers to join because of recent changes in several reinsurers’ distribution strategies. A few reinsurers, including Employers Re and Swiss Re, have moved to a dual distribution channel strategy by acquiring broker segment companies. So we thought it important to bring brokers to the table.

Third, the life and health reinsurance industry actually approached the RAA because it wanted to participate in our lobbying and public policy development efforts. We thought it a good way to grow the organization, so we changed the bylaws. Finally, we wanted to include non-U.S.-based players because of their growing importance in the U.S. market. About 40% of U.S. reinsurance premiums go offshore, and there’s an extraordinary foreign company presence in the U.S. So we decided to look at things on a more global perspective.

G.Mc: The plan for a U.S. federal government catastrophe reinsurer has fallen through. What was the reason for this proposed legislation, and what halted the project?

F.N: First, let me outline what the proposal is for a federal government-operated catastrophe reinsurer. For about 20 years, the RAA has supported the creation of such an entity, which could provide covers with high attachment points for areas in which both insurable values – and risks – are high. There have been a variety of proposals over the years. But current legislation calls for a two-point system. First, the U.S. Treasury would create an entity which would auction CatXL covers that an insurance company could buy for its own protection, or which a reinsurance company could buy and sell. The second part of the equation would have this entity reinsure, again at high attachment points, state-run cat reinsurance pools. The RAA is not enthusiastic about the second component, because we feel it could promote the creation of such state-run pools, thus depriving private-sector reinsurers from premium income. This legislation has been passed by the House Banking Committee, but it’s currently hung-up in the House Rule Committee, which basically decides which legislation makes it to the floor for a vote and which doesn’t. The senate has held hearings on the proposal, but that’s about where it ends.

Several companies and consumer groups have also worked to stymie the legislation, based primarily on concerns over the tax treatment of catastrophic loss reserves. So, in a word, the legislation is stalled. …there’s so much reinsurance capacity out there right now, why does the U.S. need a government-run catastrophe reinsurer? There is indeed a lot of capital out there right now. However for high-risk areas – such as hurricane-prone coastlines and earthquake zones – property values are high. In the event of a big loss, say a modern-day quake in the New Madrid zone, there might not be enough capital to cover the loss. Several companies could go under. But, again, we support a government-run entity that would provide capacity triggered only by very high losses. We’re thinking about capacity perhaps somewhere in the neighbourhood of 15% of the industry’s total capital – about US$50 billion.

G.Mc: What role can reinsurers play in improving risk modelling and management? Do reinsurers play an important role in promoting examples of “best practice” amongst insurers?

F.N.: I think the role of the reinsurer here would be to provide modelling companies – or internal departments that do modelling – with “real world tests”. The cat modelling industry is quite young, and we haven’t had all that many disasters. So many of these models have not been tested in real-world terms. Reinsurers can help provide this reality.

As far as providing a role in promoting examples of best practices among insurers, I think reinsurers have an interesting opportunity to see many insurance companies in action, and view first-hand how things are being done. They can then pass this experience on to others.

G.Mc: During 1998 and 1999 some reinsurers chose to grow through M&As rather than organically. Will the consolidation process continue? Do you foresee a new wave of acquisitions from the largest reinsurers?

F.N.: I think we’ve hit a plateau. With little or no opportunity to grow organically, many companies have had to acquire in order to expand. So we saw a spate of deals over the last couple of years. Now, there are few opportunities left. For example, several direct writers went to a dual distribution strategy, buying broker channel reinsurers. So now, there are few suitable broker company targets left. This is not to say that we won’t see any deals in the next few months or years. We will continue to see reinsurers acquire, but these deals will be primarily for strategic reasons, and not executed for sheer growth. These deals may include acquisitions in emerging markets or in new lines of business. We may also see companies acquire the operations of those who wish to exit the reinsurance business altogether. All-in-all, though, I think there are more opportunities left in life and health than in property and casualty insurance.

G.Mc: In 1998 the combined ratio of the world’s 10 largest reinsurers ranked by premiums was 100% or more – are current pricing levels sustainable? What can reinsurers do to reach pricing adequacy in the current environment of excess capacity?

F.N.: Over time, reinsurers have been losing money as poor market conditions continue unabated. It appears that regular underwriting cycles no longer exist. And though there is some evidence that certain lines and rates have bottomed out, it’s unclear whether the corrections will be gradual or sudden. Even if they are sudden, it’s unclear whether primary companies will consequently retain more risk, or if they will flock to the capital markets for cheaper solutions. I think one thing’s for sure, though – companies that don’t have a major market presence will not survive. We don’t have a rising tide lifting all boats. Some will rise and some will sink.

G.Mc: Reinsurers cannot expect investment returns to bail them out for too long. Are market leaders expected to make a radical change in their business strategies? Is a reduction of costs and competition for quality business a viable solution?

F.N.: The progressive companies are making changes to their business strategies. Swiss Re is a perfect example of this, going with a dual distribution strategy in the U.S., expanding its life and health book and developing expertise in non-traditional and financial reinsurance. These days reinsurers are now that in name only. Really, they are risk transfer and risk financing experts. The y must always be progressive and forward thinking in order to provide clients – whether they are traditional cedants or Fortune 500 or 2000 companies – with solutions to their challenges.

As far as reducing costs, many reinsurers are looking at this. If your book is not growing, you have no choice but to look at things from the other side of the balance sheet. However reinsurers are under simultaneous pressure to meet new challenges that put pressure on their expense ratios. Right after having to deal with Y2K-related costs, for example, reinsurers must now develop their e-commerce strategies. Such evolutions don’t come cheap. The paradox is that while e-commerce is an expensive proposition, reinsurers will probably use such platforms to become more efficient – especially in the backroom – so they can ultimately cut their costs. It’s important to note that we’re in a transition period right now. Reinsurers, therefore, can’t just cut costs overnight. They have to address these rising – and expensive – challenges.

G.Mc: Do you expect that e-business strategies will have a positive effect in fundamentally altering the existing processes, standards and conditions of the reinsurance industry?

F.N.: Potentially. I think that for reinsurers, e-commerce projects will probably be directed more at making the business more efficient – improve backrooms and augment relations with clients. I don’t think we’ll see a lot of reinsurance capacity sold over the Internet. This will happen far more on the primary side, where products are simpler and prices are commoditized to a greater degree. If we do see reinsurance capacity sold over the ‘net, it will probably be with property cat covers, but even this is probably down the road some.

Business relationships between broker/cedant and reinsurer are more complex than they are on the primary side. Reinsurers must still very much take an advisor/consultant roll. The Internet likely won’t change this.