October 27th, 2008

Manage Against the Changing Nature of Risk

Posted at 12:01 PM ET

Nick Frankland, CEO of European Operations

The (re)insurance market is fraught with uncertainty. As the next renewal looms large, buyers and sellers are attempting to find common ground for risk-transfer pricing, particularly in the wake of a high-frequency hurricane season and a severe financial catastrophe with implications for both sides of carrier balance sheets. While it is too early to tell if reinsurance rates are turning, it is clear that continued substantial declines are unlikely.

The ongoing financial catastrophe is now the most potent force in the (re)insurance market, having led to earnings reductions, particularly from the asset side of the balance sheet. With credit markets in disarray, growth efforts must be financed from retained earnings—or costly equity capital. Consequently, carriers have lost some capital flexibility, and investment hurdle rates will creep higher.

Financial market turmoil and rising capital costs have spurred a preference for cash and cash-equivalent investments for security and the ability to pay claims. The net effect is an extra squeeze on investment returns as yields are traded for safety. This will exert increased pressure on underwriters to remain disciplined. After all, they are losing the investment gain subsidy, so returns on underwriting capital must exceed their costs. The need to cope with a higher hurdle arises again.

Mounting catastrophe losses are exacerbating the financial situation. While there has not been a market-changing mega-catastrophe, frequency has increased, and catastrophe losses are estimated by some to have exceeded USD40 billion for the first three quarters of 2008. Higher retentions and a lack of attachment to reinsurance have forced cedants to bear most of the losses themselves. Meanwhile, reinsurers continue to fear another mega-catastrophe, which could further constrain access to fresh capital post-loss.

In light of tightening financial markets on the supply of capital, (re)insurers will have to take a closer look at the continuity, availability, and concentration of cover in an uncertain marketplace. Further, a regulatory response to the financial catastrophe’s effects on the banking sector seems likely, and any measures enacted (particularly involving increased capital requirements) could seep into the (re)insurance industry.

A higher frequency of property catastrophes and a severe financial catastrophe are poised to push the cost of capital higher … and with it, the overall cost of doing business. Factors that could cause reinsurance pricing to turn are accumulating, though it is still too early to project. The near-term agenda should be to address the erosion of capital from smaller but more frequent catastrophe losses and to assess the implications of asset-side impairment. But, buying down retentions and adjusting investment strategies should be the first step in a larger risk and capital management strategy. The nature of risk is changing, and carriers must adjust their planning to account for the changes.

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