January 5th, 2009

Cats and Credit Push Prices Up

Posted at 1:00 AM ET

Global Reinsurance Review January 2009

Reinsurance rate increases were moderate on average at the January 1, 2009 renewal. The Guy Carpenter World Rate on Line (ROL) Index rose 8 percent, in response to the dual pressures of a financial catastrophe and the second most expensive property catastrophe year on record. The degree to which prices increased was tempered by large capital positions at the beginning of 2008, enabling carriers to absorb the year’s losses, but this is where the generalizations end. Loss history, geography, and line of business led to wide differences in pricing. Expectations of another above-average storm year and the uncertainty surrounding the credit crisis underscore the need for continued capital management discipline in the coming year.

The results in this briefing are based on relatively early reports provided by Guy Carpenter brokers. As the current market environment is highly volatile, the final numbers may indicate a much different profile than that presented here.

Property

The World ROL Index gained 8 percent, after two years of substantial declines. Despite the magnitude of catastrophes and financial losses, the turnaround in pricing was substantially less pronounced than those that followed Hurricane Andrew in 1992, the terror attacks of September 11, 2001, and Hurricanes Katrina, Rita, and Wilma in 2005.

The market-changing events of the past two decades were driven by claims, unlike the factors that led to the most recent renewal. In the past, a market-turning event caused reinsurers to lose capital as a result of claims. Also, it led reinsurers to revise their “pure premiums” upward, arguing that the events led to increases in prospective loss costs (e.g., better modeling and revised views on weather patterns). In regards to the financial catastrophe, the first factor has been an issue, but the second has not. Thus, one would expect rate increases at the recent renewal to be lower than those of prior market turns (such as Hurricanes Katrina, Rita, and Wilma). Further, it implies that an easing of the pressures in financial markets would subsequently tip rates in cedents’ favor.

For the United States, the overall average increase for programs was 11 percent. National program ROLs increased in a range of 8 percent to 12 percent, while those for regional carriers varied widely. Prices increased by 30 percent to 40 percent for loss-suffering programs in the Gulf of Mexico, though some loss-free programs in the Atlantic region registered decreases.

The national and regional averages do not necessarily reflect the underlying realities on a program-by-program basis. Changed loss experiences, limits, retentions, and exposures were reflected in the rates secured by specific cedents. In particular, an increase in limit has the arithmetic effect of lowering average ROLs, as higher layers are priced lower. Current market conditions have rendered this factor even more important, as insurers are being pushed to use more top-limit cover to improve their financial strength.

While the United States was home to the highest catastrophe price increases, Continental Europe was relatively stable, and the UK ranged from decreases to modest increases.

European rates rose 0 percent to 10 percent on a risk-adjusted basis. Though it produced some headlines, Windstorm Emma did not yield substantial insured losses and had only a limited effect on pricing activity. Instead, ROL changes resulted from programs with increased exposure to the Northwest European wind peril and limited capacity in the region. Some programs were completed late and at relatively higher rates. Despite this limited capacity in the marketplace, reinsurers showed little interest in providing new layers, due to capital markets constraints throughout the year. Retentions and structures were relatively static, with some cedents looking to buy additional capacity at reasonable prices. For programs where Northwest European wind was not an issue, renewals were flatter.

In the UK, risk pricing was between -5 percent and flat, driven by experience rather than exposure. Catastrophe pricing ranged from -2.5 percent to 5 percent on a risk-adjusted basis, with rate changes closely linked to exposure. Deductibles were similar to 2008, and catastrophe buying was driven more by capital management considerations with reinsurance being seen as an efficient means of securing contingent capital, especially against the background of the financial crisis. The cost and availability of external capital caused markets to seek higher rates, with Bermuda-based firms among the firmest in this stance. Loss of surplus led carriers to pursue outside financing, and favorable pricing made reinsurance the easiest way for primary insurers to bolster weakened capital positions.

In general, the Asia-Pacific renewal was quite late, as buyers had to contend with reinsurer expectations of price increases. We are witnessing increased reinsurer discipline in the Asian market: loss-impacted treaties are having rates adjusted upward, and we are seeing programs with increased exposures paying more premium. In China, for example, snowstorm and earthquake losses caused reinsurers to press for more stringent pro rata terms and higher excess of loss (XOL) rates. Programs in Australia and New Zealand saw rate changes in the range of -5 percent to 5 percent. Since capacity far exceeds the demand for reinsurance in most Asian territories, however, premium increases often did not match exposure increases, and risk-adjusted reductions occurred in some territories. In Taiwan, which has experienced large rate reductions in prior years, XOL rates were reduced by 5 percent. Japan is the largest buyer of catastrophe reinsurance in the region by a wide margin, but renewals for this market are focused on an April 1 anniversary - after which the picture for the region as a whole will be much clearer.

Catastrophe Update

A record-setting Atlantic hurricane season and above-average manmade catastrophe losses put 2008 among the costliest years on record. While the economic downturn dominated the headlines throughout the year, lurking in the shadows was one of the most active hurricane seasons on record. Hurricanes Ike and Gustav, combined with other weather-related events and several large manmade catastrophe losses, triggered insured losses of USD50 billion in 2008, according to Swiss Re.

Although weather-related events remained the largest source of losses (USD43 billion in total), several manmade catastrophic events triggered insured losses of USD7 billion, much higher than the annual average of USD4.8 billion. Insured losses for 2008 are up 79 percent from USD28 billion in 2007, according to estimates from Swiss Re. The insured loss 10-year moving average continued its relentless rising trend in 2008, increasing by 7 percent - from USD35.5 billion to USD38 billion.

Retrocession

The treaty retrocession renewal was late and characterized by reduced capacity and higher prices. Although Hurricane Ike resulted in a partial rather than total losses of limits by reinsurers (as with Hurricane Katrina), the retrocession market was weakened by an inability to replenish balance sheets via sidecar capacity as a result of the financial catastrophe. The situation was exacerbated by the withdrawal of CIG Re and Lehman Re from the retrocession market. Consequently, the upward pricing reaction was more pronounced than in other sectors, and it was particularly difficult to find capacity for losses related to Hurricane Ike.

Product mismatches between the retrocession and primary sectors complicated the renewal further, though this was less severe in the direct and facultative market. Underwriters had already reduced coastal wind exposure following the Atlantic storm season in 2005, and there was a broader panel of reinsurers prepared to write this class of business. The uncertainty of the Florida Hurricane Catastrophe Fund’s (FHCF’s) 2009 bonding - and a continued dearth of new capital - may mean that retrocession capacity will be sold out quickly in the first half of 2009.

Prudent reinsurance buyers focused on securing 2009 protection early, structuring and binding Industry Loss Warranty (ILW) coverage for January 1, 2009, as early as mid-October. They sought well-priced, well-rated capacity. ILW terms stiffened relative to the summer, as a result of the tightening of financial markets and mid-September storm activity. There was no discernible change to the composition of markets offering capacity and the limits set aside for them to deploy, and there were no new entrants.

A few major purchases pushed prices higher, as carriers looked to replace catastrophe bond capacity with ILW cover. The ultimate net loss (UNL) retrocessional market has also been slow to develop, putting additional strain on the ILW market. Increased demand and a lack of additional supply are likely to continue this trend.

Marine, Energy, and Aviation

On average, marine rates rose 10 percent to 15 percent (risk-adjusted). Offshore energy pricing, particularly in the Gulf of Mexico, experienced much higher price hikes. Some energy programs struggled to get placed fully. A number of cedents were prepared to increase deductibles and coinsurance percentages to maintain the same reinsurance dollar spend as last year.

The aviation renewal came without surprises and generally without change. After years of buyers’ market conditions, pricing stabilized, though there was a slight up-tick in the airline business. Terms and conditions showed little (if any) change, and quoting was timely and disciplined.

Despite a slight increase in airline insurance pricing, there recently has been a substantial reduction in the number of airlines and aircraft operated. This shrinking of the underlying exposure is expected to continue in line with worldwide financial catastrophe and consequential recession.

Casualty

Reinsurance pricing grew 5 percent on average, with a salient lack of available capacity. Certain programs could not be placed at any reasonable rate. There was some movement to XOL structures because of decreases in original rates. Unlike the property market, though, casualty reinsurers quoted early and finalized placement in advance of effective dates.

The effects of the financial catastrophe resulted in opportunities for new insurers to enter the market, but reinsurers generally were unwilling to support new capacity in order to keep reinsurance rates from dropping - as they have in the past few years.

Primary insurers in the casualty space have continued to price coverage favorably, despite major changes in the competitive landscape. The number of competitors has dropped, which would normally lead to an increase in primary market rates. Yet, carriers have focused on protecting market share rather than gaining revenue through rate increases. Reinsurers, on the other hand, appear to be focused on profitability instead of top-line or market share growth.

Lines of business directly impacted by the credit crisis - such as errors and omissions (E&O) and directors and officers (D&O) insurance - experienced some difficulties at renewal. Demand for D&O protection has increased because of the financial catastrophe, as declines in stock prices have triggered shareholder class action lawsuits. While insurers have experienced an increased need for reinsurance protection, the reinsurance market has not added capacity, due to pressures on their capital from the collapse of global financial markets. And, the situation is worsening. As a result of the alleged impropriety of Bernard Madoff, for example, E&O reinsurers are experiencing considerable anxiety, and aftershocks will likely follow in 2009.

Professional Liabilty and the Financial Catastrophe

D&O pricing was expected to push higher through 2008, because of the collapse of the subprime mortgage market. Of course, the contagion spread rapidly, ultimately affecting the entire insurance industry. Given these developments, D&O and E&O insured losses from the original subprime mortgage market collapse are expected to reach USD8 billion, though this could be a relatively small portion of total professional liability exposure.

At the beginning of the crisis, exposure was thought to be limited to Financial Institution carriers. As the crisis has deepened and broadened, however, a wider range of companies has become exposed to the risk of shareholder class action litigation, with disappointed investors using legal means to try to recoup losses. Filings are already at their highest level in six years.

As casualty carriers remedy their financial conditions, both from investment asset impairment and insured losses, the memory of the financial catastrophe will be kept alive through an increased focus on market security. Termination clauses are being scrutinized, and cedents have sought to introduce other measures such as letter of credit provisions and loss deposit requirements. Reinsurers generally have resisted such enhancements, but if the economic situation continues to worsen, they will remain a topic of intense debate throughout 2009.

Workers Compensation

Workers compensation catastrophe pricing ranged from -10 percent to no change. Rates for working layers spanned -5 percent to 5 percent, mostly based on cedent experience. Terms and conditions tended to be stable, though some insurers with California exposures purchased increased limits.

Umbrella and Excess

The primary market for large account umbrella and Bermuda excess liability is undergoing change, as original customers are limiting aggregate credit risk to any one insurer and seeking greater diversification on syndicated placements. While these conditions have resulted in start-up activity, primary rates have softened slightly in the lead market and remain flat in the excess market. Reinsurance capacity for umbrella and excess is largely quota share and remains stable. National account and Bermuda excess market segments are experiencing increased pressure on ceding commissions, whereas the regional account market remains flat.

Life, Accident, and Health

Rates dropped for many life, accident, and health cedents. For life/personal accident (PA) catastrophe placements, rates were generally down 5 percent to 10 percent, as reinsurance market capacity increased. In cases where private placement strategies were employed, savings in excess of 10 percent were observed. Lloyd’s remains the most favorable market for pricing and capacity. Per person capacity remained stable for life, accident, and medical markets, with rate increases commensurate with increased exposure. Quota share capacity remained stable, as well.

While prices continued to favor cedents, reinsurers pushed back on rating downgrade clauses, with recapture terms being subject to mutual agreement at the time the provision is triggered. Otherwise, terms and conditions are largely unchanged.

International Casualty

Casualty treaty reinsurance outside the United States was unchanged in most areas, though there were pockets where prices rose - despite the shrinking of many cedents’ premium incomes. Programs in specific classes (such as Financial Institution) or with deteriorating reinsurance results sustained the highest price hikes. Cedents did have access to an increasingly diversified group of reinsurance markets, putting pressure on established traditional reinsurers. Many are beginning to turn over their reinsurance panels, and the London and European branches of Bermudian reinsurers are the primary beneficiaries - at the expense of traditional European reinsurers.

A Financial Catastrophe Unfolds

The ongoing financial catastrophe has affected pricing, though not to the extent that some expected. This event, which has caused far more economic damage than the most severe property catastrophes, was muted by strong carrier capital positions at the beginning of 2008, conservative investment practices, and careful capital management. According to the Guy Carpenter Global Composite, consisting of 141 publicly traded carriers from around the world, carriers lost 15 percent of their implied aggregate book value (based on Bloomberg consensus estimates), compared to 32 percent for the S&P Banks Index.

The Guy Carpenter Reinsurance Composite, consisting of 16 firms, lost aggregate shareholders’ equity of USD17 billion (16 percent) by the end of the third quarter of 2008, and the continued slide is expected to be confirmed when full-year results are announced. Unrealized investment losses were the primary culprit, responsible for 65 percent of the capital contraction. Net income for the first nine months of 2008 was down 73.2 percent year-over year - at USD3.8 billion. Despite these severe losses, the Reinsurance Composite’s capital position is still above that of year-end 2005.

Investment losses have arisen from a multitude of sources. Write-downs included high-profile exposures to debt and equity from Lehman Brothers, Freddie Mac and Fannie Mae, and the effects of the widening spreads on fixed-interest securities. A small number of reinsurers also sustained heavy losses from investment activity associated with mortgage-backed securities (MBS) and over-the-counter credit default swap (CDS) trading. The general drop in stock market prices also had an effect, particularly on European companies that historically have had higher equity allocations.

Equity markets fell 25 percent from the beginning of October. On occasion, double-digit fluctuations occurred in a single day, causing companies with higher exposures to equity markets to reduce their holdings. While this has crystallized losses, reinsurers have been able to reduce latent volatility and risk-based capital costs by switching capital to more stable investments and cash.

Damage to reinsurer capital was swift and potent … but far from crippling. The broader financial services industry rushed to merge and hunted for survival strategies, though reinsurers had to cope only with discomfort - not discord. Most carriers avoided direct hits, but the secondary effects will be felt well into 2009. External capital is likely to remain difficult and costly to acquire, and constraints on capital markets will force the industry to reconsider how it transfers risk.

The Capital Markets Waiting Game

A strong start to the 2008 catastrophe bond market ended abruptly in mid-July, with a USD320 million issuance. No activity occurred for the balance of the third quarter, and the fourth quarter was completely silent, as the financial market events of September 2008 caused carriers to defer planned catastrophe bond issuances to the beginning of 2009. New principal of USD2.7 billion came to market from 13 bonds. While those already issued largely withstood the twin pressures of property and financial catastrophes, reinsurers decided to gauge the direction of traditional reinsurance pricing at January 1, 2009, before pursuing capital from alternative sources.

In addition to the catastrophe bond issuance standstill, reinsurers were forced to reconsider their strategies for relying on capital from alternative investment sources. Catastrophe funds remain a viable source of alternative investment capital, but multi-strategy hedge funds are beginning to withdraw from the market for securitized insurance risk in the hopes of securing greater returns (e.g., in distressed debt). The alternative investment community does not seem to expect 2009 to resemble the market following Hurricanes Katrina, Rita, and Wilma. The tide has not turned decisively toward suppliers of capital.

Outlook for 2009

On a single weekend, the reinsurance market changed. Hurricane Ike wreaked havoc on Galveston, TX, and several major financial institutions disappeared. A worldwide recession was triggered, as already tenuous financial market conditions deteriorated rapidly. Nonetheless, effective risk and capital management practices enabled the industry to absorb the shocks of 2008 - which, after all, is what reinsurers endeavor to accomplish.

Climatologists predict that 2009 will be an above-average catastrophe year, which could apply pressure on rates. And, another surprise related to the financial catastrophe - such as the insolvency of a major carrier - could derail the market and lead to a greater insistence on counterparty security. With full-year results reported through February and into March, unexpected developments could affect the year’s major renewals. On the other hand, an early resolution of the credit crisis could restore the market values of many assets and improve the reported financial conditions of many reinsurers. This would also alleviate the squeeze on financial markets, making external capital more accessible and counteracting any upward rate tendency.

The next major renewal - April 1, 2009 - will likely be influenced heavily by the full-year financial reports that immediately precede it, and then all eyes will be on Florida at the beginning of June. The industry’s chief concern at present is the FHCF’s ability to raise funds through bond issuances. If, as many believe, the fund has limited financing capacity, there will be a gaping hole in many cedents’ Florida programs. Given the capacity pressures on the market evident at the most recent renewal, this issue will need to be addressed ahead of the FHCF’s June renewal.

So, the first half of 2009 will involve a waiting game, as cedents and markets examine major financial developments both inside and outside the industry. Dramatic events are possible - from either a financial recovery or revelations of further impairment. If catastrophe forecasts are met or exceeded, insured losses will mount. Another September surprise could have devastating repercussions, but signs of an economic recovery and a mild catastrophe year could have the opposite effect. For risk managers, therefore, there is only one alternative. Manage to the extremes … and heed the lessons of 2008.

Contact Information

This briefing was prepared by Guy Carpenter’s Business Intelligence Unit. Please contact one of the following team members if you have a question or require additional information.

Christopher Klein, Managing Director, Head of Business Intelligence
London     +44 (20) 7357 2514

Sean Mooney, Chief Economist
New York  +1 917 937 3189

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