Bermuda Start-Ups Defying The SkepticsFor Now

The groups success may be attributed to good management, structural advantages, good timing or good fortune. Likely, it is some combination of all four.

To date, the start-ups have made few apparent managerial missteps. In particular, our market intelligence generally indicates that these companies have not attracted premium through overly aggressive pricing.

The key structural advantage enjoyed by the start-ups is their lack of legacy issues, such as exposure to latent asbestos liabilities. In 2003, the U.S. insurance industry reported aggregate adverse loss reserve development of $13.9 billion. Conversely, the start-ups reported favorable reserve development and their level of loss reserves relative to capital is currently modest.

The start-ups timing has been outstanding. The group has enjoyed two years of hard pricing across a broad market. Absent major catastrophes, Fitch believes the members of the group have at least another half-year of excellent earnings imbedded in their unearned premium reserves.

Finally, the start-ups have also benefited from extraordinarily good fortune as 2002 and 2003 were quite benign catastrophe years, at least for reinsurers.

The key question, then, is which of these conditions are sustainable?

Certainly, strong management is a sustainable advantage, but has yet to be conclusively demonstrated.

Structural advantages tend to be long-lived. However, with each passing year the start-ups legacies grow, particularly now that many have started writing casualty business.

Likewise, the timing advantage is winding down. Overall pricing is still adequate, but various segments of the market continue to soften and, in some, pricing is already inadequate. Thus, we believe the best part of the cycle has already passed.

Finally, good fortune does not last forever. If it did, there would be no need for insurance! Although catastrophe losses have been modest thus far in 2004, catastrophic events that produce large insured losses are inevitable at some point.

So where, then, do the start-ups stand in regards to the factors Fitch believes are critical to success?

To start, these insurers have accumulated a staggering amount of capital. The size and scope of these companies relative to previous classes of Bermuda start-ups is simply unprecedented. To make the point, AXIS Capital ended 2003 with shareholders equity of $2.8 billion. This exceeds the individual year-end equity of both PartnerRe and Renaissance Retwo members of the Bermuda Class of 1992, each of whom have been in business over 10 years! And AXIS is not uniquethe average equity of the group is $1.75 billion.

Still, these new firms have not fully deployed all of this capital. With a net written premium-to-tangible equity ratio well under one-to-one, the start-ups capital is more than adequate for the business they are writing.

The start-ups ability to maintain underwriting discipline in a soft market also remains uncertain. A large amount of capital and a softening market are a dangerous mix and can result in the transfer of a significant amount of shareholders money to policyholders in the form of underwriting losses.

We have already observed the start-ups beginning to expand into new lines of business (for example, property writers expanding into casualty lines) as the result of declining margins in their original lines of business. This diversification into traditionally more challenging market segments creates some concerns whether required underwriting expertise is in place across all business segments.

There is also an increasing chance that members of the group will use their capital to fund acquisitions, which proved to be a disastrous strategy for many insurers in the late 1990s as acquirers regularly overpaid for transactions that produced reserving surprises and no material synergy benefits.

Rating agencies rarely suggest that companies reduce their capital. From our perspective, it would be just fine if companies held it until it was again needed. However, we recognize that the start-ups are for-profit entities and return on capital is important. Additionally, Fitch believes rational pricing that adequately covers expected loss costs is ultimately a better means to achieve insurer financial strength than inadequate pricing supported by lots of capital.

In the aggregate, then, the group might best be served by a reduction in capital as insurance pricing becomes less attractive. However, we believe a "prisoners dilemma" situation exists whereby the group, as a whole, is best off if capital is reduced when pricing becomes unattractive. The problem is that each individual company is better off if it keeps all of its capital and lets the others reduce theirs.

In such a situation, prices would rise and the company that retained its capital would capture an increased market share of profitable business. To date, we have heard much lip service on the subject of returning capital to shareholders, but seen only a modest amount of capital returned in the form of dividends or share repurchases.

Obviously, brokers and their customers have become comfortable doing business with the start-ups, in spite of their short track record. It would have been hard to write nearly $9 billion in premium otherwise.

Finally, the potential effect on the various companies from a major catastrophe or a series of catastrophes is uncertain. A major event will provide tangible information about the groups aggregate catastrophe management and risk selection skills. The start-ups have discussed their catastrophe risk management strategies and disclosed, to various degrees, the nature of their catastrophe modeling processes and estimates of catastrophe exposure to the investor community.

However, we will not know if the companies have accumulated unexpected catastrophe exposure and to what degree their exposures are correlated until an actual event takes place.

In summary, the Bermuda start-ups have done extraordinarily well. Their timing was excellent and these companies have benefited from the distractions created by legacy issues within more mature competitors. Conversely, they have only experienced the very best of timesthe hard part of the pricing cycle combined with a relatively low catastrophe loss environment. Neither condition lasts forever, and what happens when one or both ends will be telling.

Donald F. Thorpe, CPA, CFA is a senior director for Fitch Ratings in Chicago.

Reproduced from National Underwriter Edition, June 4, 2004. Copyright 2004 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.