September 6th, 2008

Under Pressure: Rate Drops Slowed by Asset Squeeze

Posted at 5:56 PM ET

Christopher Klein, Global Head of Business Intelligence

The next renewal period may be four months away, but it is uppermost in everyone’s mind across the (re)insurance industry. Without a crystal ball, it is impossible to predict the market’s exact trajectory, but several trends have become evident in 2008. Absent a mega-catastrophe, rates likely will continue to trend downward but will be tempered by pressure on investment gains arising from the ongoing effects of the global credit crunch and reinsurers’ fears of an imminent market-changing disaster.

Without doubt, prices are falling. There has not been an industry-rattling mega-catastrophe since Hurricanes Katrina, Rita, and Wilma devastated New Orleans in 2005. As a result, cedents have benefited from lower rates. Through each major renewal period this year—January 1, April 1, June 1 (Florida), and July 1—the Guy Carpenter World Rate on Line (ROL) index showed a double-digit decline year-over-year.

At this time last year, we looked back on several “near misses.” Summer floods in the UK, earthquakes in Japan, wildfires in California, and other events had the potential to cause substantial losses, but they did not materialize. The atmosphere of heightened risk continued into 2008, even gaining momentum. This year, in fact, several disasters actually have occurred. Floods soaked the midwestern United States, and severe winter storms froze China’s infrastructure. Earthquakes struck California and China’s Sichuan province. There have been plenty of insured losses, but the industry has had ample capital to absorb them.

So, how long can this last?

In theory, of course, technical pricing can edge ever closer to zero. The reality, though, is more complex. While rate reductions are likely to continue into the new year, the pace probably will slow. Despite several consecutive years of relatively low insured losses, other pressures are beginning to mount on reinsurers.

So far, catastrophe losses for 2008 are estimated to be above USD8 billion. Even though the industry has been able to handle the losses without disruption, they have already exceeded those for the same period in 2007. Further, they feel the chances of a major catastrophe event have taken an unfavourable turn.

Fears of a market-changing catastrophe and a higher rate of insured losses this year account for only part of the anticipated slowing of ROL declines. Capital markets activity is hitting the asset side of reinsurer balance sheets and further threatening carrier earnings.

Lower equity values—a direct result of the subprime mortgage market’s collapse—have made investment gains a less reliable source of earnings. In a study of several large carriers, we found that realized investment returns fell from an aggregate USD98 million gain for the first half of 2007 to a combined loss of USD566.2 million for the first half of 2008. Next year, underwriting profits will be more important than ever, and reinsurers will be less likely to write business that falls below acceptable return levels.

Post-catastrophe liquidity, also a result of precarious financial market conditions, may pose a problem. Though we have enjoyed relatively easy access to capital since the market stabilised following the 2005 storms, depressed equity values and constraints on alternative capital sources (such as hedge funds and private equity funds) may make it difficult to replenish post-loss balance sheets. 

Of course, some of these pressures are based on potential events.  We have not yet suffered a mega-catastrophe. Post-loss liquidity problems have not arisen. The drag on investment gains likely will slow the current pricing trend as we head into the next renewal season, but it will not be enough to turn the market. For now, it seems as though hypothetical post-catastrophe loss scenarios are enough to keep the pricing trend from gaining steam.

As we wait for the next substantial event, steps can be taken to protect balance sheets by planning ahead.  The focus will be to take advantage of favourable pricing in the near term and develop a long-term risk management strategy that accounts for worst-case scenarios.

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