January 8th, 2009

Europe: A Change of Focus

Posted at 1:00 AM ET

David Flandro, Senior Vice President

European reinsurers are focused on two critical issues: residual exposure to risky assets and effective capital deployment. This is a stark change from the past two years, in which the return of capital to shareholders was the dominant priority for many. The excess capital positions of the years following Hurricanes Katrina, Rita, and Wilma have diminished in the face of worldwide market losses, and cedents now have heightened focus on reinsurer counterparty credit risk.

Capital Depletion

Shareholders’ equity for the Guy Carpenter European Composite fell 17 percent to EUR55 billion (USD78 billion) in the first nine months of 2008-after having grown at an above-average rate in each of the prior two years. Net income was positive for most groups, but the resulting addition to shareholders’ funds was offset by share repurchases and dividends of EUR5.6 billion (USD8.5 billion) and unrealized losses of EUR7.9 billion (USD12.0 billion). Munich Re and Swiss Re were most active in share repurchases, with EUR1.4 billion (USD2.1 billion) and CHF1.9 billion (USD1.8 billion), representing 5 percent and 6 percent of capital, respectively, at the beginning of the year.

Losses from declining capital markets caused significant capital destruction in the first nine months of 2008, though exposure varied by group. Companies with significant exposure to mortgage-backed securities-not to mention broader equity and credit markets-experienced higher losses.

Swiss Re’s investment losses (realized and unrealized) were the largest of the European Composite during the first nine months of 2008. The market value of the group’s residential mortgage-backed securities (RMBS) and other structured products portfolio totaled CHF39.9 billion (USD36.4 billion)-about 1.6 times September 30, 2008 shareholders’ funds. Swiss Re has hedged its structured product, corporate bond, and equity portfolios following a CHF5.2 billion (USD4.9 billion) unrealized loss for the nine month and year-to-date realized losses (including unit-linked and with profit business) of CHF6.1 billion (USD5.8 billion).

The next most heavily exposed company was ACE, which experienced USD2.7 billion in asset-side losses-approximately 16 percent of its opening capital. Flagstone’s losses of USD163 million were more modest by comparison but nearly as significant as a percentage of shareholders’ funds. The majority of Hannover Re’s losses were driven by exposure to equities. To remedy this situation, the firm sold a significant portion of its equity holdings. The asset loss exposures of Munich Re, SCOR, and Paris Re were all below 5 percent of opening shareholders’ funds.

The degree of asset-side losses in the first nine months of the year broadly reflected companies’ exposures to RMBS, equities, and “other” investments. Swiss Re, ACE, and Flagstone had relatively high exposures to these asset classes.

Note: The majority of Munich Re’s corporate bond portfolio is comprised of covered bonds or Pfandbriefe. Funds-withheld assets are broken out separately for all but Paris Re, the sole member of the composite that discloses the investment breakdown of this asset class.

Smaller (But Still Positive) Underwriting Margins

Underwriting results were less positive in 2008 than in 2007, with earnings mitigated by hurricane losses. Still, most groups had combined ratios of below 100 percent, with only two companies reporting technical losses in the first nine months. The simple average of Europeans’ nine month combined ratios was 98.8 percent. For comparison, in the first nine months of 2007, only Hannover Re reported a combined ratio above 100, and the simple average of combined ratios was 92.3 percent.

Losses from Hurricanes Gustav and Ike contributed substantially to technical profit declines. Hurricane losses were more significant as a percentage of capital for smaller European companies than for larger ones. Relative loss of capital appears to have been broadly, although not exactly, correlated to size. Hannover Re and Flagstone were hit hardest, with each losing 9 percent of its capital.

Also, a significant driver of lower underwriting margins (though to not to the extent of Hurricanes Gustav and Ike) was less favorable reserves development than in the first nine months of 2007. For example, positive reserves development reported by Swiss Re in the first half of the year was offset in the third quarter by adverse development in Workers’ Compensation and Credit & Surety lines, which meant reserve releases had little effect on Swiss Re’s nine-month results. Elsewhere, releases in Aviation lines at SCOR contributed to a 0.4 percentage point decrease to the nine-month combined ratio. Nevertheless, both of these cases represented less significant developments than in the same period of 2007.

Hurricane vs. Investment Losses

The effects of natural catastrophes and asset-side losses differed significantly by company. While the two major hurricanes had a relatively minor effect on Swiss Re, third quarter asset losses impaired capital severely. The opposite was true for Paris Re, which saw larger hurricane losses than asset losses in the quarter. Hannover Re and Flagstone experienced significant asset-side impairments and storm-related underwriting losses, while Munich Re and SCOR had relatively low losses from both events in the third quarter.

Change of Domicile

A number of Bermudian reinsurers have set up operations in Switzerland in 2008. Consequently, the country has continued to flourish as a reinsurance hub, due to its favorable tax environment and access to European business. Its long-standing tax treaty with the United States adds to the benefits of domiciling in Switzerland, as it exempts Swiss-based companies reinsuring U.S. risks from paying a federal excise tax on premiums. In July, ACE completed the re-domestication of its holding company from the Cayman Islands to Zurich. ACE was followed by Flagstone Reinsurance Holdings Ltd, which centralized its operating platform in Switzerland. Unlike ACE, however, Flagstone has kept its holding company in Bermuda.

In September, Allied World Assurance Company Holdings Ltd created a branch in Zug, Switzerland. Over the past few years, other Bermuda-based companies - including Endurance, Montpelier Re, Aspen Re and Arch Reinsurance Ltd - have either launched subsidiaries or opened offices in Switzerland. In April 2008, Paris Re transferred and merged its Bermuda-based operational entity into its Swiss operational entity.

Depending on legislative developments in the United States, migration from Bermuda to Switzerland could continue.

Well-Positioned for 2009

Insured losses and asset-side impairments have eroded carriers’ capital positions year-over-year. In 2007, European reinsurers were focused on managing capital in a competitive marketplace driven by the needs of demanding shareholders. This year, capital adequacy and the optimal use of capital are at the top of the agenda.

Although several members of the European Composite have suffered what would normally be considered exceptional write-downs, these have occurred relative to industry-wide capital depletion of 15 percent. In this environment, underwriting discipline and generally (though not profoundly) higher rates would seem the logical outcome. Indeed, from late in the third quarter through the end of 2008, most European players asserted vocally that broad and significant rate increases were in order, but these have not materialized to the extent advocated by many.

The implication is that rates and capital are adequate. Losses on both sides of the balance sheet have been uncomfortable, but carriers entered 2008 well-equipped to handle both capital market shocks and above average hurricane losses. Reinsurance rates did not spike at the January 1, 2009 renewal as they did after the 2005 storm season and the terror attacks of September 11, 2001. The members of the European Composite persevered in 2008 and are well-positioned for 2009.

Additional Contributor:

  • Marie-Emilie Teissier
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