Reinsurers To Go Back To Basics

The industry will return to basics following a period in which some insurers and reinsurers ventured into new, non-core markets that cost them big time in terms of losses, Mr. Lohmann noted here during a breakfast speech sponsored by PricewaterhouseCoopers at this week's reinsurance Rendez-Vous de Septembre.

During the late 1990s through to 2001, some underwriters became involved in areas such as credit enhancement, collaterized bonds, mortgage and debt obligations, project finance, film financing, and residual value, he said.

"I think some of these new risks that were written in the late 1990s are coming home to roost–the losses are emerging," and no end is in sight, he said. "I think there are a number of things out there simmering below the surface that are going to cause a lot of tears in our business."

Reinsurers entered these new markets because of the lack of profitability in the late 1990s, and stagnating top-line growth in the "mature insurance market we were serving." However, recent corporate governance scandals, such as the Enron debacle, have brought a greater reluctance to entertain such business, he added.

Demands from regulators and rating agencies, as well as new rules on corporate governance are leading to greater disclosure and managerial discipline, he said.

In addition, he said, following last Sept. 11′s terrorist attacks, much of the insurance and reinsurance industry had to go back to the capital markets to recapitalize, he added.

"The capital markets, although they are often considered sophisticated, don't really understand the reinsurance business," he explained. "You want to be understood by your investors." Mr. Lohmann said a lot of insurers and reinsurers have pulled away from these new products because of the "explanation risk" of having to justify involvement in new areas to the investment community if something goes horribly wrong.

There are enough problems in the core reinsurance business without taking on unusual risks, he added.

The post-Enron climate also "has had a dampening effect on the so-called finite reinsurance business," he said. "I think it's still a legitimate tool, but many managements on the insurance company side as buyers are saying, ?I don't want to have to explain this to my board. They won't understand it anyway. My auditors won't sign off on it, and the regulators will probably crucify me.'"

The industry also is contending with the issue of counterparty risk and balance sheet integrity, which are affected by asset risk and reinsurance recoverables, he said. "This is going to be a big focus among investors and the analysts," he predicted.

Mr. Lohmann said the insurance industry is only at the early stage of its recovery because more solvency support will be required due to regulatory requirements and the weakened capital base of the primary insurance industry.

This situation is very pronounced in the European market, where insurers have high exposures to the volatility of equity markets, he said.

He noted that the U.S. industry has a much lower allocation to equities after learning a hard lesson in the 1970s, when its own high exposure to equities at that time pushed some companies to the brink of insolvency.

In Europe, Mr. Lohmann explained, the reliance on equities has led to a massive reduction in solvency capital. As a result, while there is a lot of business available in Europe, "there isn't enough solvency capital to support it," he said, noting that one way to deal with the problem is to buy more reinsurance.

"The losses on the asset side also increased the vulnerability of insurers to adverse underwriting results," which has reduced their risk appetite, he explained. At the same time, it's hard to go out and raise money because capital market support for the industry is limited, he added.

Mr. Lohmann commented that it will be interesting to see the response to Zurich Financial Services' proposed rights issue and how deep the discount will be. Capital markets know there are a number of companies in a similar position "and their share prices reflect it?," he said.

Investors are reluctant to put money into the insurance business until they know that management has "insulated them from further repeats" of what caused the problems in the first place, Mr. Lohmann said. "Managements don't yet have a report card that can say, 'I've taken care of this,'" he added. "The credibility of management in a number of ways is impaired."

Addressing another industry trend, Mr. Lohmann predicted that insurance conglomerates "are likely to dispose, close, or spin-off their non-core reinsurance activities" over the next few years.

In previous years, conventional wisdom held that standalone reinsurers really didn't have a chance, and were best contained within a large conglomerate to balance the volatility of the reinsurance business, he explained.

However, when last Sept. 11 came along, companies with reinsurance subsidiaries looked to get out of the reinsurance business, he noted.