U.S. Reinsurance: Not All Plain Sailing

Recent news by Munich Reinsurance Co. that it is currently undergoing an in-depth reserve review of its U.S. subsidiary American Re-Insurance Co.'s loss reserves indicates that more loss reserve strengthening is likely to be seen by this sector in 2005, bringing into question when U.S. reinsurers will be able to achieve underwriting profitability, and if they do, whether it will be sustainable. (Editor's Note: This article was written before XL Capital announced that it would take a $183 million reserve charge in the second quarter.)

While there are signs that pricing has declined and to a lesser degree the market has witnessed some softening in terms and conditions, the evidence is that the majority of reinsurance contracts are still being priced at economical terms. The January 1, 2006 renewal season will therefore be key in determining the degree to which reinsurers worldwide are committed to maintaining underwriting discipline.

In recent weeks management teams at many global reinsurers have echoed a more optimistic tone, noting that some of the recent premium rate declines have begun to slow down. Particularly for U.S. reinsurers, which suffered the biggest losses in recent years and were also the first ones to experience pressure on premium rates and terms and conditions over the past 18 months, the maintenance of discipline remains crucial in helping to recover some of their losses and shore up their financial positions.

Additionally, although very strong parental support toward U.S. reinsurers continued to be seen in 2004 and underpins Standard & Poor's ratings on these companies, the continuation of this support is expected to be partially contingent upon U.S. subsidiaries being able to maintain minimum levels of profitability in coming years.

The 2004 results for U.S. reinsurers show a combined ratio of 111 and return on revenue of 2 percent, excluding the results of National Indemnity, which substantially distort industry figures. However the price increases over the past four years should have meant that results for 2004 would be very good. Instead, they have been dragged down by continued reserve strengthening of slightly over $4 billion reported by U.S. players, which contributed to an estimated 16 points in the 2004 combined ratio.

These results come at the heels of equally unimpressive operating performance in 2003 and 2002, with the U.S. reinsurance industry reporting a combined ratio of 106 and return on revenue of 6 percent in 2003, and 127 and negative 7 percent in 2002, respectively.

Reserving–the nightmare continues

The reserving issue reached a dramatic conclusion for Converium AG, which was forced to make a degree of reserve strengthening that surprised everyone—altogether $578 million (based on generally accepted accounting principles), most of which related to its North American operations. Finally, a previously supportive parent company found the losses too great to bear and walked away from its U.S. subsidiaries–a move that still failed to halt a major downgrade for the group (pushing Converium AG to "triple-B-plus).

Other companies with substantially adverse results in 2004 due to reserve strengthening included large reinsurers such as GE Insurance Solutions Corp., which reported the largest reserve strengthening in the market of $1.2 billion (GAAP), as well as American Reinsurance Corp., Swiss Re America Corp., and General Re Corp. However these companies continued to receive substantial parental support via continued capital contributions, quota-share stop loss arrangements and capital maintenance arrangements provided by their parents.

The reserving should finally be coming to a point where it is less of a drag on the balance sheet with the peak of reserve strengthening actions for the 1997-2001 years in sight. However there continues to be a gap between the timing of the reporting of primary companies' reserve deficiencies and when these deficiencies are recognized by reinsurers.

While the magnitude of reserve additions reported by reinsurers over the last three years suggests that they are addressing this gap, in reality both sides probably have to acknowledge a higher degree of loss. Primary companies need to recognize that they are not going to recover everything they say they will, and reinsurers will have to take some higher losses than the ones they have on their balance sheets.

Pricing resolve to be tested

Reinsurers have held the line on pricing and terms and conditions relative to the primary markets over the past six-to-12 months. But the larger challenge will come at the January 1, 2006 renewals, when there is expected to be further pressure on pricing and terms and conditions.

It should be noted that the magnitude of price reductions seen in the reinsurance market have been larger in the United States, with price declines in this region ahead of what has been seen at other regions of the world. This will further place pressure on U.S. reinsurers to post strong profits in coming years.

Following a trend of anemic premium growth rates in 2002 and 2003, U.S. reinsurers reporting to the Reinsurance Association of America actually reported an aggregate decline in gross premium writings of about 3 percent to $43 billion in 2004. This decline in gross writings is partially indicative of high single-digit/low double-digit premium rate declines observed in the U.S. reinsurance market in 2004. It also reflects the continued shrinking of the market, with a growing number of players exiting the market. A substantial amount of business has also been increasingly taken up by Bermuda, which continues to be a world apart from the U.S. reinsurance experience with another year of strong growth in the low double-digits in 2004.

Parental support crucial; challenges remain

The continued support received by U.S. companies from their stronger parents, most of which are based in Bermuda and in Europe, is a crucial factor for the market. Not only would many U.S. reinsurers not be able to achieve their current rating without the parental input they enjoy, but in fact, without the support of their stronger parents, a much larger number of U.S. reinsurers would have gone into run-off or insolvency over the last four years.

It looks like the premium rates and terms and conditions of business written over the past 12 months will enable most U.S. players to report 2005 accident year combined ratios in the mid-90s. However the challenges remain significant, with reinsurers expected to post further reserve additions into 2005 and 2006, although smaller relative to prior years. Thus, it is unlikely that the market will achieve an underwriting profit in 2005.

As of March 31, 2005, the market turned an unimpressive 99 combined ratio for the first quarter, and this did not include the substantial reserve additions that are typically seen in the third and fourth quarters of the year. Declining premium rates and pressure on terms and conditions in the U.S. reinsurance market will place further pressure on this market to post adequate rates of return over the medium term.

The weak prospects of profitability in the U.S. market will continue to pose a challenge both for the U.S. companies and for the global groups and other parent companies that are supporting them.

Laline Carvalho is a director for Standard & Poor's in New York where she specializes in analyzing the reinsurance sector.

Chart Info:

Flag: Disappointing Year

Head: Top 10 U.S. Reinsurers Ranked by Gross Premiums Written

Reinsurers that report statistics to the Reinsurance Association of America reported dismal results in 2004. According to Standard & Poor's, excluding distorting figures for National Indemnity, the 20 remaining reinsurers had an overall return on revenue of only 2 percent last year. Results for the 10 largest reinsurers (based on gross premiums) are shown here.

Source: Standard & Poor's based on data provided by the Reinsurance Association of America

"Without the support of their stronger parents, a much larger number of U.S. reinsurers would have gone into run-off or insolvency over the last four years."

Laline Carvalho, Director, S&P

Worth Noting!

While U.S. reinsurers reported an aggregate decline in gross premiums in 2004, a substantial amount of business has been taken up by Bermuda, which continues to be a world apart from the U.S. reinsurance experience with another year of strong growth in the low double-digits in 2004.

Art caption–if we use art

U.S. reinsurers continued to underperform in 2004 and prospects for an underwriting profit in 2005 are weak, as reserving issues continue to drag down performance. Investigations into finite products have also emerged as a new challenge.