Bermuda's Record Results Unlikely To Fuel Deep Jan. 1 Cat Re Price Cuts

"We would have made less profit because we wouldn't have benefited from ceding commissions," he said, declining to reveal commission amounts for an individual reinsurance contract.

Earlier this year, executives were more than willing to turn back time to answer "what-if" questions to demonstrate the potential consequences of their risk management efforts, with many asserting that Katrina-sized losses would have been 40-to-50 percent lower had their newly adjusted portfolios been in place last year.

However, through the first nine months of 2006 their financial strength and risk management capabilities remained untested by land-falling hurricanes and other disasters. The result was Bermuda insurers tracked by National Underwriter posted nine-month earnings totaling more than $7 billion, reversing the $1.9 billion aggregate bottom-line loss total last year–with individual figures setting records for most of the group.

John Charman, CEO of Axis Capital, sized up the situation for analysts covering Bermuda insurers. "I think there are a lot of people in our industry that have been very lucky, and it's very difficult for you guys to work that out. I'm sure that every CEO is spouting this quarter," he said.

With record net income fueling a $9 billion increase in capital for the two oldest classes of Bermuda companies, a key challenge they face in 2007 is finding ways to deploy that capital while maintaining rediscovered risk management discipline.

Although missing from the accompanying financial charts are members of the newest crop of Bermuda firms formed after the 2005 hurricanes–with still more capital and capacity to write business–executives like Mr. Charman optimistically predict hard pricing for Jan. 1 U.S. property-catastrophe reinsurance renewals. While less optimistic about the casualty insurance and reinsurance markets, some even forecast hard-market spillover to international property business, where 2006 renewals were previously viewed as disappointing.

ACE Limited CEO Evan Greenberg is in the latter group. "I believe current market conditions for cat-related risk will continue into 2007, and in fact, I expect international cat-exposed pricing to firm somewhat as well, particularly in peak zones," he said.

"The fundamentals driving the market for cat remain the same and I don't see signs of that changing," he added, listing new versions of vendor catastrophe models released midyear 2006, lack of capacity in peak areas, and rating agency vigilance, among the drivers.

Summing up the earnings picture, he said, "we're frankly experiencing the other side of volatility–the positive side. While it should go without saying, this year's light cat activity…does not change our view of cat risk nor our appetite for this class. In our judgment, that would be foolish."

Still, a reverse question seems natural to ask. Are Bermuda underwriters regretting decisions to cut back on exposures in light of the quiet hurricane season, while mentally tallying missed potential opportunities for even greater 2006 revenue and profit?

"That's a very interesting question. Did people overreact or react too quickly?" said Chris Klein, head of counterparty risk for Benfield Group in London. "We're only asking that now because there haven't been any losses."

"I think it is absolutely fair to say that last year's huge loss demonstrated across the board–even if you were diversified and the effect of the heavy loss was diluted by results in other noncorrelated business–that there was a systemic marketwide failure in catastrophe underwriting," he added.

"It exposed major flaws in the way cat risk was accumulated….So it probably was right" to restrict business going forward, he said. "The snag is that cat is the sector in which prices have responded most sharply. Traditionally, that was part of the game. The following year, underwriters got much higher prices, and that helped them to recover the losses of the previous year."

The Bermuda firm, by NU's count, recovered more than the pre-tax cat loss estimates they posted at this time last year (totaling $8.2 billion in third-quarter 2005, but developing upward for a few companies in later quarters), with a $9.3 billion swing in net income through nine months.

"It will be very interesting to see how they digest this cat season," said Paul Kneuer, senior vice president for Holborn Corp., a New York-based reinsurance brokerage. "Coming off the last two years, it was very easy to believe that 2004 and 2005 were the new norm. People now have to figure out if we were unlucky in '04 and '05, or very lucky in '06."

While experts noted that rating agencies had a hand in forcing Bermuda companies to re-examine aggregations of insured values and limits, Mr. Kneuer stressed that reinsurer managements asked exactly the same questions that rating agencies did after Hurricanes Katrina, Rita and Wilma. "Actually, some managements were tougher than the rating agencies," he said.

Does Mr. Kneuer think managements will have that same kind of discipline going forward? "My crystal ball is getting cloudy. There's always going to be a cycle."

While executives continue to make bullish forecasts about "attractive" property-catastrophe reinsurance pricing next year, some have toned down earlier rhetoric about Jan. 1 prices "catching up" to the record price hikes of midyear 2006–assessments with which Mr. Kneuer and Mr. Klein seemed to agree.

"Cat pricing is pretty responsive to large loss experience," said Mr. Klein. "There's a feeling now that [rates] will increase at 1/1, but in the absence of large losses–particularly outside loss-affected areas–they may not to the same extent as they rose at June and July 1 in the United States."

Chris O'Kane, CEO of Aspen Holdings, gave a dramatic indication of the differential between midyear hikes and Jan. 1, 2006 during a third-quarter conference call. "In January, when the average rate increase was 18 percent, we renewed only 55 percent of expiring premium, but by the third quarter we renewed 149 percent of expiring with average rate increases of 96 percent," he said, highlighting the wisdom of Aspen's decision to hold back capacity early in 2006.

Mr. Kneuer agreed that Jan. 1, 2007 prices won't reach midyear 2006 heights. "We put a new contract into the market for a spring effective date, talked to about 70 reinsurers–and it took multiple callbacks and negotiations over weeks and weeks to get done," he said, characterizing the program as "not small, but not Allstate."

The situation started to ease a little by July 1. "That was the new capital and the hedge funds coming in," he explained.

"As we get to 1/1/2007, the start-up companies now have people, procedures and phones–which they didn't exactly have leading up to June and July," he said–admitting to a bit of hyperbole with respect to phones. "They've got their infrastructure in much better order…They're acting like real companies now, not jugglers," he said, explaining that they weren't able to function as effectively back in the spring.

While bigger capital bases for nearly all the Bermudians will also mean more supply, "there's probably some more demand coming on as well," he said, noting that cat model changes did not impact cedents on Jan. 1, 2006. For many national commercial insurers, new versions of cat models released midyear doubled their probable maximum losses, he said.

He added that "the supply-demand imbalance is very much a regional issue," noting that southeast Florida remains tough.

Some of the midyear supply came as reinsurers RenaissanceRe and Harbor Point sponsored sidecars. More recently, Flagstone, Lancashire and Hiscox announced sidecar sponsorships as well–and there are more in the pipeline, according to Mr. Klein.

"The big question for next year is whether that capacity disappears because investors want to bank the profits of a very good year, or will they bank some or none of the profits and leave the capacity in place in the hope of another bumper year," he said.

"And then that ends up–because we've had a very good year [in 2006]–applying further supply-side pressure on the market," he added. "Would it therefore contribute to a softening of the market? The answer is we don't know."

Mr. Klein and Mr. Kneuer both said June and July 1, 2007 market conditions are too far out to predict. "I would guess the average piece of business sold in 2007 would be cheaper than [that] sold in 2006, and assuming average weather, still very profitable," said Mr. Kneuer.

Both also said that if there's no major loss activity, consolidation will occur in Bermuda, with Mr. Klein predicting this within a nine-to-12 month timeframe.

Physically, there are serious challenges to setting up new companies, they agreed.

"They're going to have to fill in the harbor if there are many more," Mr. Kneuer said, dismissing a rumor about full-fledged new start-ups. "We trade with between 25 and 30 [reinsurers] on the island right now [excluding sidecars]. I couldn't see there being 50 cat markets in Bermuda. They're going to run out of [attention] from buyers and brokers," he said, agreeing that the next natural step, instead, is consolidation.

But who will be the targets and who will be the acquirers? The answer is unclear.

"The newest companies, in theory, are supposed to be well diversified," as are the 2001 companies–except for Montpelier, which in its third-quarter statement said it intends to stay focused on property-catastrophe, Mr. Klein reported.

He said the market picture outside the United States is mixed. Based on discussions at reinsurance gatherings in Baden Baden and Monte Carlo, however, he said the overall outlook for the Jan. 1 non-U.S. renewals is generally flat to slightly down in some areas.

Mr. Charman, who went further, saying that international property business is under "severe pricing pressure," offered a reason. "[C]ompetitors have, in my view, wrongly been provided incentives to diversify against U.S. natural perils," he said. Pressed to identify parties providing the incentives, he said that a rating agency is encouraging competitors to diversify into businesses they "don't have experience to be underwriting."

"That will, in certain areas, fuel [short-lived] competition and cost their shareholders a lot of money," he said. "Don't forget, they have to be aided and abetted by the boards and managements of those…businesses," he added.

Mr. Klein said, "The new orthodoxy is diversification–both territorially and by class," noting that A.M. Best, which has issued the most start-up ratings, looks for diversification away from catastrophe risk.

"The concern that established players have" in sectors targeted for diversification purposes "is that this is increased supply. It puts pressure on rates already under pressure from soft original pricing," particularly U.S. casualty and U.K. liability classes.

Mr. Klein said a danger of diversifying to dilute cat risk is that companies get into classes they don't understand and where they don't have an established market presence. "How, then, do you convince people they should buy from you instead of their long-established supplier? The usual way…is by offering a competitive price," he said.

During the Axis conference call, Mr. Charman asserted that his company, now five years old, is "regarded as being part of the incumbent quality reinsurance marketplace," having gained acceptance as a "stable, consistent quoting market."

Mr. Kneuer agreed that there's some distinction among reinsurance buyers between the "class of 2001″ and the "class of 2005."

"I have heard some people say, 'I'm a little less interested in an A-minus start-up when there are some A-rated start-ups just a little bit older,'" he said.

Mr. Klein said brand new companies tend to have A-minus ratings, putting them at the lower end of buyers' ranges of acceptable security. "The question is, are they providing essential capacity that can't be found elsewhere? That will influence buying behavior," he said.

While exactly how much the newest class of Bermuda companies wrote in 2006 is, for the most part, not publicly disclosed, Flagstone Re, in a recently filed initial public offering document, reported gross written premiums of $214 million through six months. Separately, Lancashire also reported half-year financials, including gross written premiums of $316 million.

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