U.S. Reinsurers Narrow Gap

Reserve strengthening for soft-market years has largely corrected deficiencies

U.S. reinsurers have used the recent hard market to increase reserves for significantly underpriced business written during the soft-market years, adding $14 billion to reserves for non-proportional assumed liability business alone (statutory line "O"). Using the "O" line as a proxy for the U.S. casualty reinsurance industry, we estimate that non-asbestos reserves are still deficient by about $5 billion, or 15 percent of carried reserves analyzed.

While this remains a sizable hole, the current reserve position is a vast improvement over the recent past. Exhibit 1 shows Moody's current estimates for the U.S. casualty reinsurance industry's reserve positions at various points in time. The reserve position appears to have hit bottom at the end of calendar year 2000, with reinsurers steadily filling the hole since then.

Two observations seem to corroborate the improving reserve position of U.S. reinsurers. First, companies strengthened case reserves for the 1997-2001 accident years during 2004, as reflected by the drop in paid-to-reported loss ratios highlighted in Exhibit 2.

Second, in viewing Exhibit 3 from left to right for the 1997-2000 accident years, ceded loss ratios for the entire U.S. property and casualty industry seem to be stabilizing over time–a favorable sign for both domestic and foreign reinsurers. However, the significant increase in ceded loss ratios for accident year 2001 suggests that it is too early for reinsurers to declare victory.

Moody's believes that reinsurers will continue to experience adverse loss reserve development on casualty lines written during the past soft market, particularly for the least seasoned 2000 and 2001 accident years. However, the magnitude of charges for most companies should be lower than it has been during the past few years.

Reserve takedowns on recent accident years may be too optimistic

As concerns over the soft-market years are moderating, concerns over more recent accident years are moving to center stage.

Reinsurers have released some reserves for accident years 2002 and 2003, but their actions may have been premature. With respect to accident year 2002, the industry released $230 million of non-proportional assumed liability reserves during calendar year 2003, only to add back $300 million twelve months later. With respect to accident year 2003, the industry harvested $490 million of reserves during calendar year 2004. Again, this action may have been premature given the long-tail nature of the business.

Moody's expects that the most recent underwriting years will produce very good results given that terms and conditions were tightened throughout the casualty reinsurance market largely starting in underwriting year 2003. This may explain some of the recent reserve releases as well as the increase in paid-to-reported loss ratios shown in Exhibit 2 for accident years 2003 and 2004. However, for companies that have repeatedly strengthened their reserves, there exists heightened risk that business priced during the hard market years may not emerge as profitably as current loss ratios suggest.

Pricing cycle past its peak; holding the line on terms and conditions

Over the past 12 months, the market has experienced a progressive weakening in reinsurance pricing, albeit at a somewhat slower pace than in primary insurance. In several lines of business, such as industrial fire, energy and aviation, rates have reached the technical break-even level. By contrast, natural catastrophe and casualty rates have exhibited greater resilience, which makes sense given the relatively high hurricane losses in the third quarter of 2004 and the continuing reserve strengthening in the casualty business.

Nevertheless, we suspect that the high technical margins of the past two years, fueled in part by substantial profits on property business, are not sustainable.

On the positive side, terms and conditions seem to have held up better than rates. Moreover, terms and conditions usually have a more lasting effect on the underwriting result than rates. So far, it seems that reinsurers remember the painful lessons learned during the previous cyclical downturn and are holding the line on casualty terms and conditions.

(C) 2005 Moody's Investors Service, Inc. All rights reserved.

Kevin Lee is an associate analyst for Moody's Investors Service in New York. James Eck is an assistant vice-president for Moody's Investors Service.

Keep the copyright at the bottom of this article small as we did on July 21, 2003, page 25

Art Caption:

U.S. reinsurers have done a significant amount of work to fill a reserve hole that was as deep as 60 percent of carried reserves at the end of 2000. Now the hole is much smaller at 15 percent of carried reserves, Moody's estimates.

While Moody's believes that most of the pain has been taken, we expect additional reserve charges going forward, further dampening the industry's profitability and capital formation.

For accident year 2002, the industry released $230 million of non-proportional assumed liability reserves during calendar year 2003, only to add back $300 million twelve months later.

Flag: Narrowing The Gap

Head: EXHIBIT 1. MOODY'S ESTIMATES OF U.S. CASUALTY REINSURER RESERVE POSITION

Although U.S. reinsurers have been steadily filling a reserve hole since 2000, Moody's estimates that the non-asbestos reserves for U.S. casualty reinsurance are still deficient by $5 billion, or 15 percent of carried reserves.

Source: Moody's analysis using data from NAIC Annual Statement Database via National Underwriter Insurance Data Services/Highline Data (May 2005). Data use was taken from statutory Schedule P for Reinsurance–Non-proportional Assumed Liability line.

Flag: Strengthening Revealed

Head: EXHIBIT 2. PAID-TO-REPORTED LOSS RATIOS

A drop in paid-to-reported loss ratios for accident years 1997-2001 shown along the highlighted portion of the last diagonal (which shows loss activity during 2004 for accident years 1995-2004) is evidence of significant case reserve strengthening in 2004 related to those five accident years.

Sources: Moody's and NAIC Annual Statement Database via National Underwriter Insurance Data Services/Highline Data (May 2005). Data drawn from statutory Schedule P for Reinsurance–Non-proportional Assumed Liability line. Reported losses are equal to paid losses plus case reserves.

Flag: Concerns Remain

Head: EXHIBIT 3. CEDED LOSS RATIOS

Although stabilizing ceded loss ratios for the U.S. property-casualty insurance industry are a favorable sign for both domestic and foreign reinsurers, Moody's analysis also reveals some troubling trends. Accident year 2001 remains unstable, and reserve releases by U.S. reinsurers for accident years 2002 and 2003 may be premature, the rating firm says.

Sources: Moody's and NAIC Annual Statement Database via National Underwriter Insurance Data Services/Highline Data (June 2005). Data drawn from statutory Schedule P, Part 1 for all lines combined. Data for calendar year 2004 only includes combined group data available as of June 2005. In some instances, 2003 data is substituted for missing 2004 data.