Shaken but not stirred

Despite its shaky economy, the US remains the most important reinsurance market in the world thanks to its high natural catastrophe and liability exposures and mature primary insurance market. It accounts for just over half of global reinsurance premiums. But apart from the formidable Berkshire Hathaway, few domestic reinsurance companies remain on US soil, leaving Bermuda, London, Europe and other international markets to fight over the spoils.

This competition has, in recent years, been responsible for continuing downward pressure on rates, causing some players to exit the market. Now, with major international catastrophe losses in the first half of the year, a new catastrophe risk model pushing cedants to purchase more protection, dwindling prior-year reserves and low investment returns, reinsurers are determined to make an underwriting profit.

Whether the 10 to 15 percent rate rises witnessed during the mid-year renewals can be improved upon at year-end is questionable, particularly given new sidecar capacity entering the Bermuda market. Those reinsurers seeking out new opportunities in the saturated market are likely to focus on specialty lines—which continue to offer a better return—as well as continuing to satisfy the insatiable demand for catastrophe cover.

Rate stand-off

When the reinsurance community met in Monte Carlo for the annual Rendez-Vous de Septembre, it was clear a rate stand-off was beginning, with reinsurance companies pushing for price increases, brokers divided as to the direction of the market and cedants hoping for a level-headed response. While everybody accepts that rates must go up for loss-hit accounts, there is a difference of opinion on whether they should increase for other classes and programmes.

The US has seen its fair share of catastrophe losses so far in 2011, but Hurricane Irene was not the monster everyone had feared, and the severe weather losses in the first half of the year were more of an issue for the primary market than the reinsurance market. Tornadoes, floods and storms in April and May cost an estimated $15 billion, according to Aon Benfield, nearly three times the annual average for severe weather losses.

“The late-May stretch was highlighted by an outbreak that spawned a massive EF-5 tornado that destroyed a large section of Joplin, Missouri,” said Steve Jakubowski, president of Impact Forecasting. “The tornado led to 154 fatalities in the city, becoming the deadliest singular tornado event since the National Weather Service officially began keeping records in 1950.

“In addition, it is worth noting that the Tuscaloosa and Joplin events will go down as two of the costliest singular tornadoes ever recorded.”

Few of these high-frequency, low-severity losses went beyond their primary layers of protection, leaving insurers rather than reinsurers shouldering the burden. However, globally, reinsurers have been stung by natural catastrophe (nat cat) events.

In total, nat cat losses in the first half of the year—including the Japan earthquake, Christchurch earthquake in February, floods in Australia and Cyclone Yasi—cost the industry around $70 billion. Losses for the US property/casualty industry in the first half are estimated at $27 billion (up $15 billion on the same period a year ago), according to rating agency A.M. Best, accounting for approximately 12.6 points on the combined ratio.

Insurance loss estimates from Irene, which worked its way up the Eastern Seaboard on August 27 and 28, bringing extensive flooding to northern states including Virginia, New Jersey and New York, are currently between $2 billion and $6 billion. Had Irene not weakened before making its second US landfall in New Jersey, it could have caused a substantial storm surge as it moved up Chesapeake Bay.

“The perfect case for a global increase in rates would have been Katrina as everyone is in the same pool. So [given this theory] they should all have paid more after Katrina, and they didn’t.”

“Irene was not a market-turning event as some people had been anticipating,” says Robert Hartwig, president and chief economist of the Insurance Information Institute. “It simply turned out to be much weaker from an insurer property casualty loss perspective and total losses are likely to be in the $3 to $5 billion range—which would make it only about 10 percent of Hurricane Katrina losses.

“It may be that it’s even less of an event for reinsurers—because the larger the event, the more severe the impact for reinsurers—so more of the loss will be retained by primary insurers.”

While the new model release from RMS—version 11—has been hotly debated, given its increased view of storm risk for areas inland from the coast, there are mixed feelings about its likely influence on pricing. Many cedants using RMS have seen their aggregate exposures increase. They can either hold more capital to write the same amount of business, buy more reinsurance protection, reduce how much business they are writing or opt to use other vendor catastrophe models.

While reinsurers argue that the new model release will cause people to look carefully at their retention levels, with a resulting impact on demand and pricing for reinsurance cover in hurricane-prone states, brokers are adamant that they did not see this happen at the mid-year ‘Florida book’ renewals.

“Don’t expect insurance demand to increase significantly in spite of the model changes,” said Bryon Ehrhart, chairman of Aon Benfield Analytics, speaking at the broker’s Monte Carlo press briefing. “At mid-year, it was clear that reinsurers were trying to help Florida rather than hurt Florida. Florida drives the peak reinsurance peril and it depends on that Florida business, so it is not out to damage it with excessive price increases.”

He also doubted whether the $70 billion of catastrophe losses around the world would be enough to turn the market on all lines of business, particularly given the fact these losses have been shared unequally amongst reinsurance players. “The perfect case for a global increase in rates would have been Katrina as everyone is in the same pool. So [given this theory] they should all have paid more after Katrina, and they didn’t.

“Reinsurance has got to be a much better business than it was this time last year,” he added. “Why? Because the prices in Australia, New Zealand and Japan are tremendously better. Capacity is sufficient to supply the anticipated demand of customers.”

Unsurprisingly, Ehrhart’s viewpoint was hotly contested by a number of reinsurers and some of the other reinsurance brokers. At its breakfast briefing in Monte Carlo, Hannover Re CEO Ulrich Wallin argued that there were more dynamics affecting reinsurance pricing than catastrophe losses ahead of the January 1 renewals.

“There have been significant reserve releases in the last year, a heavy tornado season and above-average hurricane activity, and the model change—RMS version 11—brings aggregates significantly higher,” he said. “At the July renewals, we have seen on average increases in prices by 10 to 15 percent and we don’t see any reason why rates shouldn’t increase more at year-end or at least stay that way.”

While retentions remain high in North America, cedants are buying higher limits due to the new RMS model, noted global reinsurance head Andre Arrago. “There will be a need for insurance companies to buy more storm capacity,” he said.

Member of the executive board and specialty lines head Jurgen Graber considered some of the dynamics affecting pricing in specialty lines of the business, which in his view “requires double-digit margins” because of the potential for high losses. This is particularly the case in offshore energy, which was hit by hurricanes in 2004 (Charley, Francis, Ivan and Jeanne) and 2005 (Katrina, Rita and Wilma), Hurricane Ike in 2008 and the Deepwater Horizon disaster in 2010.

In 2011, there has been another large loss, this time in the North Sea where leaks from a Shell oil platform in August caused the largest oil spill in British waters in a decade. The business interruption loss from this event is likely to be around $1 billion, revealed Graber. The losses in offshore energy have “led to rate increases at the April 1 renewals and this has to continue because of the magnitude of the billion dollar losses all over the place”.

Growing casualty retentions

One thing market pundits did agree on was that the size of the US casualty reinsurance market has been decreasing. This is due to a combination of reinsurers’ unwillingness to lower rates further for liability classes, insurers’ decision to retain more of the risk given the mismatch of original and reinsurance pricing, and a relatively benign loss environment since the APH claims of the late 1980s and early 1990s.

Wallin noted that Hannover’s casualty premium had halved over the past seven years, but was optimistic that pricing would have to improve. “We’ve seen a lot of reserve releases and pockets are deeper than many thought, but I feel there is not that much left to be released,” he said. “Accident year combined ratios have crept up to more than 100 percent and that means life is going to be more difficult and there is less room for reductions, so we are cautiously optimistic on the casualty side.”

“There is really no state on the Eastern Seaboard or the Gulf Coast where if the worst-case scenario happened, the state-run insurers would remain solvent.”

Reinsurers need to rethink their approach to casualty business in order to grow the market, argued Aon Benfield. It focused on stagnant growth of the reinsurance market, with an increase in property catastrophe business offset by shrinking demand on the casualty side. Business ceded to reinsurers by US casualty underwriters has fallen by half since 2004— and clients are comfortable with retention of $35 million compared to just $5 million in 2004, pointed out Ehrhart.

With the US accounting for a massive 70 percent of worldwide casualty reinsurance premium, reinsurers need to undergo a fundamental rethink on how they add value to the class. They should differentiate their product, help clients innovate new casualty products, and “follow the fortunes” of the primary market. If that fails to happen, “you will continue to see a decline in purchases”, he warned.

State-backed reinsurance

While there has been less talk this year about state-subsidised catastrophe insurance and reinsurance, the residual remain a big issue in the US market. There are more than 30 fair access to insurance requirements (FAIR) plans in the US, several beach and windstorm plans (such as the Texas Windstorm Insurance Association), two state-run insurance companies (Florida and Louisiana Citizens) and one state-run reinsurer (the Florida Hurricane Catastrophe Fund, FHCF).

Had Irene been a more intense hurricane when it made landfall, the weaknesses in the plans would have been exposed, suggested Hartwig. “There is really no state on the Eastern Seaboard or the Gulf Coast where if the worst-case scenario happened, the state-run insurers would remain solvent.”

In Florida in particular, where politics and insurance have always been an uneasy mix, the ability of the state-backed insurer Citizens and the FHCF to absorb large storm losses has been questioned in recent years, with Berkshire Hathaway stepping in at the height of the financial crisis with a guarantee to buy bonds.

The decision to increase the fund’s capacity four years ago caused a great deal of controversy. Not only was this seen as unwelcome competition with private reinsurers, the fund’s ability to raise postevent capital led many to question whether the cover being offered to insurers was robust. Rating agency Demotech has encouraged insurers to purchase more cover from the private market in order to maintain their financial strength ratings.

It is hoped that the gradual reduction in the FHCF’s Temporary Increase in Coverage Limits (TICL) will boost demand from the private market. From $8 billion a year ago (down from $12 billion in 2008 and $10 billion in 2009), the TICL has been reduced by a further $2 billion in 2011. With the price differential between the TICL and the private market shrinking, cedants are expected to buy more of their reinsurance protection from private sources.

“The reduction in subsidised FHCF cover would certainly increase demand in the private market (and there are already signs that this is happening with companies buying open-market TICL alternatives),” said Simon Clutterbuck, a director at broker BMS. “But at the same time, there would need to be a further increase in primary rates to offset the additional private reinsurance spend, as without this, policies will find their way back into Citizens, therefore putting pressure back on to the state.”

He does not think the state’s involvement in catastrophe re/insurance is sustainable. “First, Citizens, the state-funded ‘insurer of last resort’, became the ‘insurer of first resort’ for distressed properties or those on the coast, and the policy count ballooned to more than one million. Thus the state provided a direct subsidy to the Florida homeowner by selling cover for well under market rates and gambling on the outcome.”

“Second, the state doesn’t currently have the ability to fund all obligations associated with the FHCF in the case of a severe hurricane, which is why there is new draft legislation out last month from the FHCF that would incrementally decrease the mandatory layer from $17 billion to $12 billion by 2015, as well as reducing the maximum available coverage from 90 percent of the mandatory layer in 2012 by 5 percent per annum to a maximum of 75 percent in 2015, as well as increasing the industry retention above which the cat fund sits.”

While Irene was not a big enough storm to test the residual market, it has highlighted the lack of flood insurance in the northeastern US. Most of the damage from the storm was caused by extensive flooding, which is largely uninsured, according to cat modelling agency Eqecat.

Should the National Flood Insurance Program (NFIP) be reformed—as has been recommended under Bill HR 1309—it could provide an opportunity for the private reinsurance market to step in and provide cover, particularly in such underinsured loss-hit areas.

Another cat pool that could see reform or even non-renewal is the country’s terrorism backstop, which became all-important following the events of September 11, 2001, when conventional terrorism reinsurance was largely unavailable. Today, the Terrorism Risk Insurance Program Reauthorisation Act (TRIPRA) covers acts of foreign and domestic terror but does not cover nuclear, biological, chemical and radiological (NCBR) attacks.

Other legislative changes could also encourage more participation in the US market from international reinsurers. The Non-admitted and Reinsurance Reform Act 2010 (NRRA) opens the door for reform of the 100 percent collateral requirements for foreign reinsurers in many states. So far, Florida, Indiana, New Jersey and New York have relaxed their rules for reinsurance collateral and others are expected to follow suit.