Fighting Fire With Fire

Shake Up Continues In U.S. Reinsurance Market: S&P

Following an array of large underwriting losses in recent years and yet another disappointing year in 2002, the industry has continued to see a number of reinsurance players exit or reduce their participation in the U.S. market.

In just the last 18 months, Gerling Global, AXA Solutions and SCOR-subsidiary Commercial Risk (all on Standard & Poors top 35 list in 2002) were placed into run-off.

This is in addition to the spin-off of Platinum Underwriters from its previous parent, The St. Paul Companies; the recent sale of Hartford Reinsurances renewal rights by its parent, The Hartford, to Bermuda-based Endurance Specialty; and the demise of Trenwicks operations.

These actions have come even as premium rates continue to harden and terms and conditions are the best in more than a decade, underscoring the heavy toll taken by the last soft cycle on market participants.

Unlike their European counterparts, which have been recently hit with significant investment losses from the crumbling values of their large equity portfolios, the major culprit behind U.S. reinsurers significant losses continues to be the need to shore up reserves for the 1997-2000 underwriting years and for asbestos liabilities.

Even after significant reserve strengthening in the fourth quarter of 2001which became known as the kitchen sink quarterreserving actions by U.S. reinsurers in 2002 significantly exceeded the expectations of most industry observers and easily offset the benefits of better premium rates and conditions. This has led the industry to report an unfavorable 122 combined ratio and a dismal 0 percent return on revenue for the year.

Given the magnitude of recent losses, the issue of parental commitment has become crucial in light of the markets structure, in which most U.S. reinsurers are not independently owned, but rather are subsidiaries of larger, often non-U.S.-based reinsurance groups or other conglomerates.

Having entered the U.S. reinsurance market as a means of risk and earnings diversification, many of these parent companies have experienced losses from their U.S. subsidiaries that are much larger than ever contemplated, forcing many to reconsider their commitment to this market.

Although this has resulted in several players exiting the market, such as in the instances mentioned above, a number of parent companies reaffirmed their commitment to their U.S. operations in 2002. Among these are companies such as Munich Reinsurance, which contributed $1.4 billion in capital and strengthened quota share and other reinsurance support arrangements with its U.S. subsidiary, American Re, following a $2 billion reserve strengthening in the second quarter of 2002.

This renewed commitment, however, has often been accompanied by significant changes in management, substantial restructuring and much tightened parental oversight. New management teams put in place in the United States are also under significant pressure to truly turn these units operating performance around, if they are to remain strategically important or core to the parent over the medium and long terms.

Flight-to-quality trends have also continued in the market, as demonstrated by cedents increased concerns about their reinsurance recoverables. The weakened financial position of several reinsurersreflected in the decision by S&P to downgrade several reinsurers significantly in the last two yearshas amplified these concerns.

At one extreme of this spectrum is American International Group, which has recently announced its intention to request its U.S. reinsurers to post collateral for the reinsurance they providea requirement until now reserved for non-U.S.-based reinsurers. Although it is unlikely that this practice will become prevalent in the market, it does illustrate the level of increased concern about the ability of reinsurers to pay their future claims.

U.S. reinsurers are also not yet fully out of the woods with regard to reserving. Given the large numbers of primary insurers posting huge reserve strengthening in the fourth quarter of 2002 and the first quarter of 2003particularly for asbestos liabilitythere is a question as to whether reinsurers fully accounted for these recent losses in their previous reserving actions.

The market also remains exposed to the highly litigious environment in the United States, which continues to produce ever larger and more frequent claims awards. On the asbestos side, although a potential global settlement bill has been introduced in Washington this year, most industry players give it less than a 50/50 chance to pass.

Unless an agreement is reached, insurers and reinsurers will remain exposed to significant uncertainty in this line of business. Given these challenges, it is likely that there will be some further reserve activity by U.S. reinsurers, though not to the same magnitude as what these companies posted over the last two years.

It is worth noting, however, that a closer look at individual performance by market participants suggests that the significant losses incurred by U.S. reinsurers in recent years have not been shared equally among the companies.

The big four direct writers in the marketAmerican Re, General Re, Employers Re and Swiss Rehave recognized a disproportionate amount of the market losses compared with the broker market participants.

There is uncertainty about whether the direct reinsurers wrote less appropriately priced business in the 1997-2001 timeframe or if they have more promptly acknowledged the required need for additional loss reserving. Some believe that the business strategy adopted by the broker reinsurance market allowed reinsurers to avoid the financial distress encountered by their direct brethrens.

Companies that have chosen to take more opportunistic strategies, such as Transatlantic and Everest Re, seem to have managed to avoid the magnitude of losses incurred by others because they chose to cut back premiums and write in less-competitive lines of business during the soft market.

Smaller and more nimble Bermuda writers following similar opportunistic strategies also seem to have been able to perform better. This raises the question of whether more opportunistic players have a better chance to achieve more favorable operating performance over the long term, given their ability to exit or diminish their participation in unfavorable lines of business, while large, market-share-driven companies lack this type of flexibility.

Although operating performance by U.S. reinsurers is expected to improve significantly in 2003 and to remain strong at least through 2005 (barring extraordinary levels of catastrophe losses), the volatility and cyclicality of the U.S. reinsurance business will continue to challenge reinsurers to maintain profitability over the long run.

Looking into 2003 and beyond, it is likely that the face of U.S. reinsurers will continue to change, as global groups continue to reevaluate their strategies and weaker players continue to be weeded out.

Laline Carvalho is a director for Standard & Poors in New York City.

Reproduced from National Underwriter Edition, July 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.