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Reinsurance weather report

The good, the bad and the ugly

By Phil Zinkewicz

Primary insurance carriers recently have begun to express considerable concern about the state of the global reinsurance market. After having been stung in the last two years by hurricane losses of significant magnitude—last year’s Katrina being the hurricane of hurricanes—primary insurers worry that the world’s reinsurers are in precarious financial condition. The industry has already seen at least two reinsurers fall by the wayside, and insurers are hard put to find A rated reinsurers with whom to place their business.

Well, for those who are biting their fingernails, there may be a glimmer of hope—but only a glimmer. The fact is, recent reports on the reinsurance industry and projected weather conditions, when taken together, might be characterized in motion picture terms as “The Good, The Bad and The Ugly.”

On the “good” side, consider a recent report by Standard & Poor’s Rating Services which says that the reinsurance industry has been upgraded by S&P to stable from negative. S&P said the upgrade is due to the “strong fundamentals of the industry and resolution of some of the short-term uncertainties created by the unprecedented scale of the losses arising from the 2005 North American hurricane season. “However, the industry is benefiting from the emergence of profits from the hard market, strong pricing and reduced cyclicality, the report says.

Specifically, S&P says that diversified reinsurers have fared better in the aftermath of the hurricanes. “The year 2005 will be remembered for Hurricanes Katrina, Rita and Wilma, which were responsible for an estimated, unprecedented $80 billion of insured losses, a significant proportion of which fell on the reinsurance industry,” says the report. “Standard and Poor’s estimates an industry combined ratio for 2005 of approximately 114%, including 23 percentage points relating to catastrophe losses. Since we last looked at the impact of these losses on the industry, they have taken their toll on the financial strength of PXRE. In addition, both Munich Re and Everest Re have needed to increase loss reserves for the hurricanes by material amounts.”

Continues the report: “We have commented in the past on the diverging fortunes of reinsurers in Europe, Bermuda and the U.S. The year 2005 saw something of a reversal of fortunes in that the largest European reinsurers performed better than many of the Bermudians, as the benefits of a global, diversified portfolio were made plain in a year of unprecedented catastrophe activity. Within the Bermudian population of companies, the more diversified players fared much better than those with a narrow property catastrophe focus such as PXRE, ICPRe and Montpelier Re. Investor and cedant sentiment also seems to have swung in favor of the diversified groups.”

S&P also says that the hard market helped the reinsurance industry weather the storm losses. “Premium adequacy is strong. Since 2001, the reinsurance industry has benefited from prices and terms and conditions that represent a significant improvement on those that were experienced previously. This represents five renewal seasons in which the fundaments of the industry have been strong.”

The S&P report also says that one emerging trend that has become more transparent is that of highly rated reinsurers beginning to be compensated for their superior financial strength. “Swiss Re highlighted this development publicly for the first time in its presentation on the January renewals, but we believe that the benefits are not unique to this group,” says the report.

S&P says that its stable outlook for the global reinsurance industry is reinforced by the view that the chronic cyclicality that has “blighted the industry” in the past will be reduced in the future. Says the report: “The environment in which reinsurers operate has changed for the better. There have been positive trends in the regulation of reinsurers in Europe; risk management has improved; and reinsurers are more transparent in the way they do business and in their disclosure of financial information.”

Now comes the “bad.” Andrew Barile, an insurance and reinsurance industry consultant based in California, allows that reinsurers have managed the hurricane season and recognizes that as a positive thing. However, he says that the reinsurance industry still faces major challenges. “First, there is the issue of retrocession capacity. There just isn’t a lot of that out there for the reinsurance industry to take advantage of. Second, the reinsurance industry still doesn’t have a handle on how to underwrite catastrophe risks,” he says.

The S&P report recognizes these negatives, plus a couple of others. Says the report: “Retrocession capacity is being squeezed and this could, in turn, restrict the underwriting capacity of some reinsurers at the same time that demand is increasing. The retrocession market consists of a handful of reinsurers that write meaningful amounts of cover, and a larger number of reinsurers that write retrocession business on a highly selective basis. Two of the former look set to leave the market: GE Insurance Solutions will not continue to write retrocession business if and when the group becomes part of Swiss Re. Nevertheless, offsetting concerns in this area is the availability of alternatives to traditional retrocession and capital, much in evidence after the 2005 North American hurricane season.”

The S&P report names these alter-natives as sidecars, catastrophe bonds and other forms of securitization.

Another “negative,” according to S&P, is the start-up operations, which may dampen the hard market. “The addition of $7.4 billion of new capital in late 2005 through start-ups is on a par with the $8.6 billion raised in late 2001 and is likely to act as a dampener on the hard market. Although the participation of these companies in the January 2006 renewals was constrained by their formation late in 2005, we expect them to write brokered short-tail business in meaningful volumes in 2006 and beyond.”

Regarding the need for proper underwriting, the S&P report says: “Although we believe that the outlook for the financial strength of the global reinsurance industry is stable, we nevertheless recognize that the industry is in a dynamic state and the reverberations of the events of 2005 will continue to pose many challenges. If we look at the impact of September 11, 2001, and the 2005 North American hurricane season, we can see that, in two years of the past five, the industry has been shaken by unprecedented losses. Investors and policyholders alike must question the volatility of the industry’s earnings and its ability to get sufficient payback. Improvements in modeling and in underwriting and pricing will surely follow in the wake of the catastrophes in 2005, but will these be sufficient to drive down the volatility?”

But Barile brings up another subject, which could represent the “ugly” element of the global reinsurance scenario. “We are now at the beginning of another hurricane season. What will happen to the reinsurance industry if there is a season like the last, or worse, similar catastrophes in other parts of the world?”

His point is well taken. Recently, Tropical Storm Risk (TSR), a forecasting consortium led by the University of London’s Benfield Hazard Research Centre, issued its forecasts for Atlantic hurricane activity in 2006, and for Northwest Pacific typhoon activity for 2006. TSR predicts another active Atlantic hurricane season in 2006. Based on current and projected climate signals, Atlantic basin and U.S. landfalling tropical cyclone activity are forecast to be about 50% above the 1950-2005 norm in 2006. There remains a high (83%) probability that U.S. landfalling hurricane activity will be in the above average tercile. The chance of a near average season is 16%, and the probability of a below normal season is just 1%. The forecast spans the period from June 1 to November 30, 2006, and employs data through to the end of April 2006.

TSR predicts a slightly above-average 2006 Northwest Pacific typhoon season overall, with 27 tropical storms, 17 of those being typhoons and 8 of the latter being intense typhoons. The typhoon season lasts from January 1 to December 31, with 95% of typhoons historically after May.

So, there you have it—the good, the bad and the ugly. According to S&P, the global reinsurance industry has managed the 2005 hurricane season fairly well, but there are still challenges to be met. The question is: Can the industry meet those challenges when impending disasters become a reality? *

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