Bermuda Faces Embarrassment Of Riches As Record Earnings Generate More Capital

With a second straight year of benign loss activity contributing to a second year of record earnings, Bermuda insurers and reinsurers ranging from established old-timers to relative toddlers face an enviable problem--an embarrassment of riches.

Alan Murray, senior credit officer of Moody's Investors Service in New York, described the situation that way as he highlighted "robust balance sheets and strong operating profits" among factors leading the rating agency to put a stable outlook on the Bermuda insurance market.

"These companies have better capitalization than they've ever had, and their profitability is fantastic with no [major] catastrophes this year," he said. "With the stars seemingly all aligned, one might very reasonably ask: 'Doesn't this translate to good news for the industry?'"

"The answer is absolutely yes," he said, explaining the outlook, which reflects the view that the number of rating actions will be moderate over the next 12-to-18 months.

The embarrassment of riches, he noted, accumulated in the wake of huge catastrophe losses for 2005 and 2004, as companies recapitalized, prices hardened dramatically in catastrophe-exposed business lines, and Bermuda market participants tightened their risk management practices.

"It's a happy conundrum to have--to be very profitable, well-capitalized and heading into a downcycle where you're probably, in general, starting to pare back your writings," Mr. Murray said.

Moody's published its report on the Bermuda market outlook back in September, and since then, most publicly traded Bermuda insurers have reported third-quarter financial results with record returns on equity, solid underwriting results and even stronger capital positions.

In total, 17 companies tracked by National Underwriter reported overall net income jumps of nearly 6 percent in third-quarter 2007, and 21 percent for the first nine months, while total shareholders equity for the group rose more than 14 percent over the level reported at year-end 2006.

Only four of the 17 companies reported third-quarter income declines, with the biggest drops--for XL Capital and RenaissanceRe--coming from investment losses and markdowns attributed to turmoil in the credit markets.

On the underwriting side, with favorable loss developments benefiting results for many of the selected companies, the average combined ratio for the group was near 82 for the quarter and the nine-month period--roughly unchanged from the comparable 2006 periods.

The Bermuda firms now face the challenges of a softening market, and executives who say they'll reject underpriced business have already started reporting shrinking top lines.

While overall gross premiums fell only 1 percent in the quarter, reports of declines in their reinsurance books of 20 percent or more were not uncommon, and neither were discussions of a variety of challenging primary insurance markets.

With more capital than they can use in the businesses they're already engaged in, insurers and reinsurers said they stepped up efforts to expand into new lines and geographies during the quarter, and talked about plans to give back capital they can't deploy to their shareholders.

"Any companies at this point in the cycle [that] are not showing...discipline, are not frankly admitting that rates are declining rapidly--and perhaps more rapidly than hoped--and are not taking capital management steps, should have to explain why they're not," said Richard Brindle, chief executive officer of Lancashire, during a third-quarter earnings conference call.

Lancashire, one of the youngest companies and the one with the biggest jumps in income among the 17 companies reviewed--100 percent for the third quarter and 200 percent for the year so far--plans to give the majority of 2007 profits back to shareholders through the combination of share buybacks and a "strategic dividend."

"We're matching the capital to the underwriting opportunities," said Chief Financial Officer Neil McConachie.

Speaking for one of the oldest Bermuda companies, PartnerRe CFO Albert Benchimol also said his firm is giving back capital. Reporting year-to-date share buybacks totaling $152 million, he noted that from its inception, the reinsurer has now returned $1.6 billion through dividends and share repurchases to common shareholders. "This exceeds all common equity ever raised by this company," he said, describing the company milestone during a conference call.

Articulating the second strategy at Montpelier Re, which had been among the least diversified members of the class of 2001 with a property-cat reinsurance focus, CEO Anthony Taylor described a trio of diversification actions--in London, the United States and Switzerland.

During Montpelier's third-quarter conference call, Mr. Taylor said that "we are first reacting to the change in the environment" after 2004 and 2005, in which "capital required to support given peak-zone exposures more than doubled. This encouraged diversification...geographically and by class."

In addition, he said, "the London market has rebuilt itself post 9/11...Business today, particularly in the large commercial and specialty arenas, is no longer automatically flowing to Bermuda as it did in 2002-2005 but instead is being retained and written in the London market."

"We felt we needed to get closer to our clients and the sources of access to their business," he said, explaining that to do this, Montpelier first set up a Lloyd's syndicate to locally access London market business, and next opened a marketing office in Zug, Switzerland, to access regional European business.

Finally, through a newly formed U.S. managing general agency, Montpelier seeks to access U.S. business with limited peak-zone exposure via binding authorities to the Lloyd's syndicate.

"This is an important change of tactics for Montpelier and sets the company on a broader path for the future," Mr. Taylor said in a statement. "We have concluded that now is the appropriate time to expand our platform beyond the shores of Bermuda," he noted, adding that the syndicate would write a small amount of specialty casualty business in addition to nonmarine property and engineering.

Back in the summer, Montpelier said the MGA would acquire some property reinsurance business for the syndicate. More recently, in November, Montpelier announced it would buy a U.S. excess and surplus lines company from GAINSCO to develop its U.S platform further.

STRATEGIES SCRUTINIZED

Strategic shifts in business mix and announcements of offices being positioned outside Bermuda--in places like Dubai and Latin America--were a common theme of announcements during the quarter. (See related story, page 19.)

At Moody's, Mr. Murray told NU that as the market softens, attempts to break away from narrowly defined business strategies "are worthy of monitoring."

Mr. Murray said he's particularly watchful of companies pursuing the U.S. E&S market. "Those of us that watched the evolution of the market in the late 1990s remember how the E&S market became a target growth business for companies heading into that downcycle. A number of those either are no longer in the market or they found that it was a slippery slope," he said.

"A common denominator to look out for is companies that haven't been in the E&S market that choose the onset of a downcycle as their opportunity to enter for the first time," he added.

While Mr. Murray said he hasn't seen anything terribly concerning about the forays of Bermudians into the E&S market this time around, the next two or three years will be telling. "After all, these companies may be big in Bermuda, but the E&S marketplace here is established and there are other big names that have their own strategies," he said.

"What happens in a market downcycle isn't entirely determined by what's in a particular company's control. There are a lot of forces at work--and a lot of that may have to do with the fact that standard market companies are looking to defend their share of business in the marketplace," prompting them to also shift their activity to E&S.

Marty Becker, CEO of Max Capital--the first Bermuda insurer to enter the U.S. E&S market in 2007--said his company's E&S subsidiary, Max Specialty, has already seen market competition heat up on all sides.

"These aren't unusual facts," Mr. Becker told NU. "This seems to happen every cycle. The standard lines companies become more aggressive in what they're willing to write in their search for premiums. So they will write some risks that traditionally have been in the E&S market. And likewise, existing E&S players will take a greater share of accounts. In the hard market they might have written a $25 million line; in this market they might write $75 million," he said.

For Max's age as an organization, "we actually probably were one of the last ones" in Bermuda to enter the U.S. E&S market, he said, noting that Max has tended not to go into any segment where it didn't have someone with a proven track record and a following.

Although industry veteran John Vaccaro is now leading the effort, timing has been an issue for Max Specialty this year, Mr. Becker disclosed during Max Capital's third-quarter earnings conference.

"Year-to-date [E&S] gross written premiums will be less than originally projected," he said, noting that Max Specialty, which is operational in 46 states, is not up and running in the largest state for E&S business--California--where a regulatory seasoning requirement will delay startup until second-quarter 2008.

In addition, he said electronic interfaces for real-time quality control of 43 MGAs are only two-thirds complete.

Despite these issues, "we would still likely have less premium than initially forecast," he said, noting that softer pricing and increased appetites of some larger E&S players have made Max Specialty cautious about growing its E&S platform too quickly.

REINSURANCE DOWN

While executives say specialty insurance price competition is worrisome, reinsurance businesses had the most pronounced third-quarter gross premium declines for the 17 Bermuda companies reviewed by NU.

"Insurance and reinsurance both are having price declines, but what you also see on the reinsurance side is the insurance companies--your customers--buying less [reinsurance] because they, too, are having difficulty growing," Mr. Becker said. "If they buy less reinsurance, it helps them show more net premiums."

"This is classic cycle behavior," said Mr. Murray at Moody's. "Especially after a relatively benign and very profitable two years, there may be a sense that there's less risk out there. And because of shareholder expectations, managements do want to protect top lines. The absolutely easiest way to do that is to change attachment points of reinsurance programs."

At PartnerRe, CEO Patrick Thiele said that for the past two successive Jan. 1 renewal periods, his company "started out 10 percent in the hole" because clients had raised attachment points on their reinsurance contracts. During an earnings conference call, he said these clients, with improved financial positions, sought to keep more business rather than pay high reinsurance costs.

Looking ahead to Jan. 1, he said that actual proposed programs Partner has seen so far suggest this trend is abating, basing his assessment on early discussions that recently took place at a conference in Baden Baden. Ceding company attachment points are now at levels where any increases in loss frequency or severity hit them first instead of getting into reinsurance programs, he said, referring in particular to the impact of second-quarter and third-quarter U.S. storms that didn't impact reinsurers.

"That, combined with the idea that there is some moderation--slow and gradual as it may be [in reinsurance pricing]--should lead to a slowing in the increase of attachment points" in the United States and Europe, he predicted.

Mr. Thiele and others also reported "some beginnings of attempts to have differential pricing" and terms for each reinsurer on a single reinsurance program. "It's probably a little bit more advanced in Europe than in the United States," where a broker market predominates and brokers shy away from the administrative complexity that differential treatment introduces.

"The impact on the industry, I think, would generally be a beneficial, because at the moment...the lowest-rated reinsurer can help set the price--usually downward," Mr. Thiele said. "If a system allowed high-quality reinsurers to charge a fair price for increased assurance that would meet their financial obligations, I think that would actually be a good thing," he added, noting that established companies would benefit.

MOST STRESSED CLASS?

However, even a CEO for one of the newest Bermuda companies--Edward Noonan of Validus Re--said his company had been the recipient of differential pricing and preferential signings, attributing the favored treatment to the value clients put in the reinsurer's use of proprietary risk analytics.

While rating agencies such as Moody's and S&P both identify the initially narrowly focused "Class of 2005"--on short-tailed business lines--as the most stressed class of Bermuda companies, executives at Validus said the company is fully utilizing its capital.

Asked if Validus will repurchase stock or pay a dividend this year, Mr. Noonan said, "we're not there today," during a third-quarter conference call. "We're not going to reach and try to find a way to deploy [or] hold onto capital we don't need," he said, adding, however, that capital returns aren't likely until next late year.

At Lancashire--where Mr. Brindle said his company's good results are "a vindication of [a] centralized underwriting structure" that has executives "convene daily" to review every risk put on the books--Mr. McConachie described a continuous process of capital management.

Noting that a $100 million share repurchase scheme has been put in place this year, the CFO also said that if results play out as expected this year, Lancashire will pay out at least half of 2007 profits in "a strategic dividend."

"We chose the phrase 'strategic dividend' because we felt [the more commonly used term] 'special dividend' implies a one-off event--and I think that large dividends are something we will use relatively often through cycles in years to come," he said. "They could become a recurring part of capital management that you see happening every year to match the capital to underwriting opportunities."

Mr. Murray said Moody's looks more favorably on share repurchases than dividends, because the latter tend to create shareholder expectations of capital returns, while buybacks are something companies can do more opportunistically.

"The bottom line is now companies are headed into the down market in both property and casualty lines, and they're looking to balance their growth trajectories with their capital needs, consistent with their risk management guidelines. It's a balancing act," Mr. Murray said.