Class Of '05 Startups May Not Get An 'A'

While Fitch said its rating methodology does not impose a ceiling on startup reinsurer ratings, the agency said a few factors would make it difficult for the majority of the Class of 2005 to achieve insurer financial strength ratings as high as the "A" range, but would not preclude "secure" ratings in the "Triple-B" range.

Mark Rouck, senior insurance analyst with Fitch in Chicago, told National Underwriter his agency doesn't believe premium hikes spurred by hurricane losses are going to be "very broad-based."

"We think there will be a comparatively narrow focus on catastrophe-exposed business lines, and we think the investor base that has put a lot of money into these companies in some instances is likely going to have a shorter-term horizon than other insurers might have," he added.

He said that "management talent" for some of these quickly formed carriers might be questionable. Historically, in three-to-five years, he added, "a lot of these companies may be writing different business lines, or they may have sold a piece of their business, or been acquired by a different company–it's almost like [keeping it going] involves a different skill set."

At Fitch, noted Mr. Rouck, "we think this raises the risk somewhat–that the companies tend to evolve, and three-to-five years out they can look a lot different than they do today."

While the agency said it expected significant rate increases on property exposures in hurricane-prone areas, premium rates on business outside of these geographic areas, and prices for casualty-related business, are unlikely to increase materially in response to 2005′s hurricanes. Further, Fitch said significant uncertainties exist as to how long any hard market shift might last.

This contrasts with market conditions that existed following 9/11, when rates increased significantly across a broad spectrum of lines, Fitch said. This resulted from a convergence of several factors, including years of inadequate pricing and subsequent adverse reserve development, equity market declines, and 9/11 losses.

These factors, Fitch said, eroded the reinsurance sector's capital base and essentially imposed underwriting discipline on the reinsurance market, which became evident in the form of rate increases.

In contrast, the global reinsurance sector's 2005 hurricane-related losses, while staggering, followed two years of very strong earnings and capital formation. Fitch noted that the aggregate equity of some 30 global reinsurers it tracks on an ongoing basis increased to $261 billion at year-end 2004 from $173 billion at year-end 2002.

To the extent the market opportunity leading to the formation of the Class of 2005 is narrow, and ultimately proves to be short-lived, this adds greatly to the uncertainty reinsurers face in successfully executing their business plans, according to Fitch.

Fitch also warned that the Class of 2005 is likely to be narrowly-focused on property-catastrophe related business lines–a natural situation given the events that have lead to the class's formation (very large property-catastrophe losses) and corresponding lack of broad-based rate increases across other business lines.

However, Fitch said, this is a risk concentration with negative implications from a rating perspective.

Additionally, Fitch noted, these concentrations are arising during a period in which its capital requirements for reinsurers with exposure to extreme events have increased. As discussed in its Nov. 9 special report, "New Thinking on Catastrophic Risk and Capital Requirements," Fitch is adopting a tail-value-at-risk (T-VaR) approach to measure capital levels required to support catastrophe exposures at different rating levels.

Another concern cited by Fitch is that the proportionately large amount of capital contributed by hedge funds and private equity investors to the Class of 2005 has negative rating implications. Fitch views hedge funds and private equity firms as opportunistic, shorter-term investors.

Thus, Fitch said, long-term ownership remains a significant uncertainty with respect to the Class of 2005, as does the risk the companies will be managed with a short-to-medium-term business focus, mainly to support an IPO or other exit strategy.

Fitch also noted that with few exceptions, one of the Class of 2005′s greatest challenges is obtaining management talent, especially in light of the comparatively large number of companies being formed in such a short period of time.

The rating agency's primary concern here is whether top managers have the depth of experience required to adapt to changing market conditions or to reposition the company, since history suggests that relatively few startups exist in their original form three-to-five years after incorporation.

Fitch's concerns also include management's operational capabilities, since startup reinsurers are often dominated by entrepreneurial underwriters who sometimes lack a strong operational focus. Such risks become especially pronounced when market conditions inevitably start to soften.

Favorably, Fitch said underwriting talent is generally present among these reinsurers, at least in limited scope, and that without a proven level of underwriting expertise, the reinsurers would not have been able to raise their substantial amounts of capital.

Flag: Class Picture

Head: Newbies Face Big Hurdles

Given the role startup reinsurers in the "Class of 2005″ are likely to play in this January's renewal season, Fitch Ratings noted several factors affecting the quality of the reinsurers' credit:

o Premium increases are not expected to be broad-based and may be short-lived.

o The new carriers feature a narrow focus on volatile business lines.

o Backing the startups are a prevalence of short-term, high-risk and high-reward capital providers.

o Management talent might be too thin to support so many startups at once.