The Reinsurance Glass: HALF FULL or HALF EMPTY?

One might think that after two consecutive years of healthy returns, excellent combined ratios and decent after-tax net income, the Canadian offices of reinsurers would be raising a toast to market conditions and the performance of the p&c industry in general. However, reinsurers are by nature, a cautious lot. It comes with the territory of acting as a backstop for large losses and trying to put a price on uncertainty.

In Canada, reinsurers are watching the underwriting discipline in the primary market closely for signs of change. They are also taking a careful look at specific lines of business, namely liability and auto, for price adequacy and adverse reserve development on large claims that hit excess layers. Changes in these conditions could spell the difference between consistently good performance and a deteriorating bottom line.

WHAT GOES UP…

Last year’s rosy results saw a combined ratio of 92.4%, a 4% improvement over 2003. In 2004, the 19 reinsurers that form the Reinsurance Research Council posted an underwriting profit of $166 million, which was a considerable gain from 2003’s $91 million. Overall, after-tax net income also improved to $376 million from $310 million the year before.

While these are respectable numbers there are voices in the reinsurance community who question whether it is enough to restore capital and regain the strength to withstand massive losses.

“The fact is that we have a weaker reinsurance community than we did five or 10 years ago,” David Wilmot, senior vice president in Canada for Toa Reinsurance Company, says. “It has made a little bit of money in 2004, it will make some more in 2005. That is nothing against the losses that have been suffered. The new money going into the reinsurance community has not gone to the reinsurers who paid the freight, who carried the losses. There is still capacity and competition, but there is no longer the resiliency to take a really big hit.”

Reinsurers in Canada also witnessed a premium decline for the first time since 1998. Net written premiums decreased to $2.1 billion from $2.5 billion in 2003. While the overall premium pie may be shrinking, sources say this is nothing radical or unexpected. “That trend has continued in the first quarter of 2005,” Bruce Perry, senior vice president, marketing and underwriting in Canada for PartnerRe, says. “It goes through stages. In the hard market when rates are going up, reinsurers are naturally taking more premiums. And then at some point, you get the slow movement from proportional to non-proportional reinsurance and primary companies increase their retentions, keeping more risk in-house.”

Andre Fredette, senior vice president of CCR Canada, says another reason for the premium decline is the ongoing consolidation in the primary market. “The market is not growing because the number of insurance companies has been gradually diminishing every year through mergers and acquisitions,” he notes. “When an acquisition happens, the amount of reinsurance placed in the market reduces because the new entity gets more capital and keeps a bigger net retention. Once that is done, companies usually don’t go back.”

RUNNING HOME TO RECOVER

In addition to the shrinking premium pie, reinsurers are monitoring other trends. One of the foremost concerns is the uneven nature of the insurance industry’s recovery. The improved results of the hard market were mainly made on the back of property business.

“The market is retreating a little from some of the long-tail classes of business,” Wilmot says. “Reinsurers are finding the property risk excess easier to write.”

Indeed, the low loss ratio for primary property business, at 51% in 2004, has fuelled much of the profitable portfolio business for p&c insurers. Sources say that leading up to the renewal season in January 2006, both property risk and catastrophe reinsurance will feel the brunt of competition.

As Cam MacDonald, regional vice president for Transatlanic Re, notes this profitability usually attracts competition. “As results improve on both the primary and reinsurance property side, this will obviously put some pressure on rates,” he says. “But I don’t foresee that rates and terms will deteriorate to the point they were a few years ago.”

Property business, especially on the commercial side, has been saved by the relative lack of large claims in recent years. However, the massive Suncor fire loss in early January shows how quickly the market can change. That loss, which occurred in one of the Company’s oil sands upgrader’s in Alberta, will exceed $1 billion. It also prompted the Office of the Superintendent of Financial Institutions (OSFI) to issue a letter in May cautioning: “the Suncor loss is of a magnitude that it may severely stress individual (reinsurance) companies’ capital adequacy positions.”

Suncor hit a specialized sector of the insurance and reinsurance market, but several sources say this kind of claim would pale in comparison to property losses associated with a potential catastrophic event in Canada. Reinsurers express concern that there is not enough premium going into cat covers. In fact, cat rates are slowly falling off.

“I think that worldwide, in general, catastrophe exposures have not been properly recognized either in proportional or non-proportional risk treaties,” Pierre Michel, chief agent for Canada at PartnerRe, says. “We have the illusion we are making profits on cat exposures, but it is indeed an illusion, because you only know if you are making a profit on catastrophes over a period of 50 years.”

Michel adds, “it’s really a matter of whether enough premium has been collected to address the cat exposures that exist in Canada.”

CAT’S NINE LIVES

For the upcoming renewal season in 2006, there are few signs that cat rates will be adjusted upwards to reflect these exposures. “In both the cat and property per risk side of things, I expect it will continue to be competitive, meaning the same rate or 10% off last year,” Fredette says. “I don’t expect any real insanity to happen out there; people are working with (catastrophe) rating models so they don’t deviate from those models.”

Wilmot argues that many of these models may be underestimating the probable maximum loss (PML) of a major earthquake in the Vancouver area. He notes that a review of each primary company’s share of the personal/commercial B.C. market and how much excess cat protection they are buying, indicates what the industry believes the PML is going to be for a significant quake. Wilmot’s own research shows that almost every company was accounting for a loss somewhere between $7.5 billion and $9 billion.

“That is not a coincidence; it is rather what the cat models are consistently guiding them to,” he says. “But if you look at the Northridge earthquake in January 1994, that was a 7.3 quake on the Richter scale with 15 seconds of shaking 20 miles northwest of Los Angeles. That loss was U.S.$15.3 billion. If we take that number in today’s value, it would be U.S. $25 billion or somewhere in the $30 billion range in Canadian dollars. I don’t understand how our industry comes up with the numbers.”

The catastrophe market may be even worse off if reinsurers with “a big lump of cat exposures are not careful, in the form of occurrence limitations, about pro rata property or surplus business, which is very capacity intensive and can amount to a ‘giving away’ of cat protection,” according to Wilmot. He adds that some reinsurers also tend to look at the accumulation of pieces of cat treaties and “take a PML of that, arguing that it might be only 40% of the total exposure.” All these factors make Wilmot less than enthusiastic about cat coverage in Canada.

“I’m not sure if we have the exposures and pricing right,” he says. “We have made some progress, but I am still quite concerned with what I see are inherent problems in the catastrophe business.”

On the casualty side, there are few indications of rate decreases or a loosening of terms in liability. This reflects the fact that the liability market on the primary side, especially long-tail lines and specialized risks, has been tight. Loss ratios for reinsurers in liability business have been relatively poor over the last three years “Individual casualty treaties, particularly on specialty lines, seem to be holding up,” Wilmot says. “They are being priced properly and people generally respect the exposures they represent.”

REVVING UP THE CLAIM ENGINE

In the auto excess of loss business, there are signs of a disconnect between premium and exposure. Several reinsurers’ point to an increase in severe auto claims that are hitting excess layers, sometimes three or four accident years later. At the same time, primary companies are reducing auto premiums, either through legislative requirements or for competitive reasons. Many primary insurers are expecting reinsurance rate decreases as their auto premium base declines.

“This is a real dichotomy,” MacDonald says. “We are being asked to lower rates in step with primary rates going down, but the problem we face is that large losses are actually on the rise. Reinsurers may require an increase on some of the low layers of casualty and that will be a difficult decision for reinsurers in the upcoming renewal season.”

Sources note that most of the provincial auto reforms, whether in Ontario, Alberta or Atlantic Canada, have focused on smaller claims and soft tissue injuries. “The reforms have done a lot to reduce the small stuff below $50,000,” Fredette says. “It is saving a lot of money for the primary companies, because the majority of claims are still small. But where the reinsurers’ interest is, the large catastrophic losses, nothing has really changed.”

“If anything, our exposures in auto are going up due to general and medical inflation,” Wilmot says. “The fact of the matter is that there are fewer markets writing auto excess. They are suddenly waking up to the fact that this is a long tail business that is really dangerous and really hard to get right.”

COPING WITH CAPITAL

With fewer reinsurers willing to participate on certain programs, the inevitable twin questions of capacity and credit quality arise. Reinsurers say the issue with capacity during the most recent hard market was never actually one of capital – it was the cost of that capital.

“I don’t believe at any given point in the insurance cycle, there is an actual shortage of capital,” Michel says. “There is merely an unwillingness of some companies to pay the price for that capital. Primary companies buy reinsurance to protect themselves against the cost of higher claims. They are making the best deal they can. Fair enough, as long as the pay attention to the credit standing of their reinsurance companies.”

Wilmot says he is increasingly seeing “bundles” of reinsurance rates at different price points, indicating a likely flow of fresh capital into the Canadian market. While no one claims there is a surge of new players in the reinsurance market, some new names are popping up.

“I think you will see some programs completed at the lower bundle of pricing and if the primary company is smart, they will go to their reinsurance broker and say, ‘show me my list of reinsurers,'” Wilmot notes. “And they will say, ‘hey why aren’t the big guys there?’ Well, the reason is the price bundle they chose. There is price and there is value.”

For MacDonald, one of the biggest challenges he foresees is “the outside pressure from global markets, namely Bermuda and London, as opposed to the branch operations that are located here in Canada. If you look at it historically, the outside markets have acted as a stimulus to lower rates, certainly lower than we would have wanted to go locally. I hope that doesn’t happen this time around.”

RATING THE RETURN

The projection for this renewal season in treaty business is that the market is now entering a period where more both insurers and reinsurers would be happy to get rate as expiring and are receptive to modest rate decreases for business with a good loss history. The question is how disciplined primary companies will be able sustainable pricing and resisting the pressure to grow too quickly in a mature market.

“Obviously, the situation varies by class of business and regions of the country where a company may want to exploit, but I think there is a real culture of underwriting discipline that has emerged in Canada,” Perry says.

“Ideally we would all like to have a flat renewal or a holding of the line,” Fredette says.

“The reality is that there will be more competition in certain classes of business.”

For the reinsurance treaty market, it’s hard to say if the glimmer of good results should lead to a toast of a glass that’s half full or whether troubling trends in certain classes of business will prompt a resigned acceptance that the cup is only half empty. It all depends on your perspective as reinsurers and insurers begin negotiations for the 2006 renewal season.