October 27th, 2008

Under Pressure but Standing Strong

Posted at 5:00 PM ET

Andrew Marcell, CEO of Americas

The financial catastrophe that has taken hold of global financial markets has caused much consternation for (re)insurers. Balance sheets have been hit, impairing investment assets and depressing surpluses across the industry. Yet, carriers are faring better than most financial services firms (particularly those in the banking sector), largely because the industry is quite well-capitalized. Even in this capital-constrained economic climate, operating cash flows are strong, and surpluses remain deep.

The devastation of shareholder wealth caused by the ongoing financial catastrophe does have salient implications for the (re)insurance industry. Depressed equity investment values led to an estimated USD19.6 billion in capital losses for insurers for the first half of 2008, with another USD15 billion in unrealized capital losses for the third quarter. The 10 largest reinsurers in the world held USD68.4 billion in equities at the beginning of the year, and by the end, the value had dropped by USD21 billion, assuming that they moved with the markets prevailing 30 percent decline.
Investment performance has also had a noticeable impact on surplus. By the end of the second quarter of 2008, insurers lost an estimated USD12.9 billion and are expected to lose, in aggregate, another USD22.4 billion for the third quarter. The stock market’s 14 percent drop in October may have eradicated another USD19 billion. The situation is much the same for reinsurers. An aggregate surplus of USD94 billion for the industry’s 10 largest likely declined to USD73 billion by the half-year mark, with continued pressure throughout the third quarter and into the fourth.
The precipitous decline in equity markets and ensuing loss of shareholder wealth might lead to regulatory and rating agency responses. Calls for increased capital requirements are quite likely, creating additional demand—beyond that caused by the loss of surplus—pushing the cost of capital higher. The scarcity of credit and the decimation of institutional investor portfolios will also contribute to this dynamic. The upward pressure on risk-transfer pricing will result, but the full effects will take sometime to work their way through pricing system.

Despite the powerful effects of the financial catastrophe, carriers remain well-capitalized. In the primary market, the premium-to-surplus ratio stands at 0.88, well below the traditional 3:1 benchmark. This suggests that capitalization is more than sufficient. Operating cash flow for insurers is off its 2003 peak of USD90 billion but remains substantial at above USD50 billion. The premium-to-surplus ratio for the 10 largest reinsurers is not far above 1:1, indicating that this sector is also not vulnerable to another major decline in equity markets.
Even with these substantial losses, the (re)insurance industry is still quite healthy, with plenty of capital on hand to help it weather the storm. However, a major concern for reinsurers is that their access to additional capital is limited, and a mega-catastrophe could exacerbate the situation. This dynamic will govern reinsurers’ underwriting and pricing discipline in 2009, where demand for capital protection will probably increase as insurers reexamine their risk management strategies to ensure they have enough cover to protect their capital from further erosion.

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