February 3rd, 2009

A Tight Retro Market at 1/1

Posted at 1:00 AM ET

Christopher Klein, Managing Director
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A late treaty retrocession renewal was characterized by reduced capacity and higher prices. Buyers grappled with uncertainty concerning their risk mitigation requirements, based on inward writings and an extremely limited market - especially for standard Ultimate Net Loss (UNL) retrocession protection. Although Hurricane Ike resulted in only a partial loss of limits by reinsurers (as with Hurricane Katrina), the retrocession market was unable to replenish balance sheets via sidecar capacity - as a result of the financial catastrophe. 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.

Capacity

There were no new entrants to which buyers could turn at January 1, 2009, unlike in previous sellers’ markets. The withdrawal of capital from hedge funds (via redemptions) and increased pricing in the direct catastrophe excess of loss (XOL) market put pressure on capacity. The situation was exacerbated by the withdrawal of CIG Re and Lehman Re from the retrocession market.

The retrocession market sources a significant amount of capacity from collateralized reinsurers, and capacity declined in this due to the locking-up of collateral supporting the 2008 year. This occurred on loss-free layers for which Hurricane Ike losses were in excess of a certain percentage of the deductible. The lack of any new capacity entering the market magnified the problems carriers experienced in trying to replace lost existing capacity.

Catastrophe Treaty UNL Retrocession

Pricing was up by 20 percent on average for catastrophe treaty UNL retrocession. Increases were dependent on loss experience in 2008, with programs suffering large Hurricane Ike losses attracting the biggest price hikes. However, most programs were not hit by the storm, so the effects tended to be limited to the U.S. regional specialists. Overall in the United States, price increases ranged from 15 percent to 40 percent, and retentions for the United States grew, as the market found it difficult to attract capacity at an attachment point less than a buyer’s Hurricane Ike loss.

At the placement stage, buyers that kept their expiring panels intact generally secured their renewals. However, any lost capacity, regardless of the underlying reason, was very difficult to replace.

For programs outside the United States, the renewal process was also slow and capacity short. Buyers that approached the market early were able to secure capacity, but as the season progressed, the market slowed and capacity ran short. Price increases ranged from 10 percent to 15 percent.

Catastrophe Direct & Facultative

The catastrophe direct and facultative (D&F) renewal was more orderly than that in the treaty market. The market was protected from a large Hurricane Ike-related loss as a result of the significant re-underwriting that followed Hurricanes Katrina, Rita, and Wilma. Capacity in this market is tight, but it attracts a wider panel of supporters than treaty retrocession, and these supporters have generally been loyal to their clients. Nevertheless, prices were up by an average of 15 percent, and capacity was restricted.

Industry Loss Warranty

The Industry Loss Warranty (ILW) market started its 2009 season promptly, with buyers approaching the market as early as October 2008 to secure capacity. Large amounts were purchased in the three months leading up to January 1, 2009. The global financial crisis prompted this move, causing buyers to fear that the catastrophe bond market would dry up and that standard UNL retro market would become tight because no new capital was entering the market. Overall volumes for the ILW market were similar in 2008 to those in 2007.

There were several new buyers, and some risk-bearers sought large amounts of capacity for 2009. Yet, sellers’ capacity did not grow at a sufficient rate to meet all the demand. The ILW market draws much of its supply from collateralized markets, up to 40 percent, according to some estimates. Across all sectors of supply, there were few exits from the ILW market. With global capital at a premium since the middle of 2008, there were no new entrants to a market that would welcome them.

Record demand for 2009 ILW capacity pushed prices significantly higher. U.S. windstorm and U.S. earthquake saw rates that were 20 percent to 30 percent higher year- over-year and up 15 percent relative to June 1, 2008. For ex-U.S. covers, pricing also increased by approximately 10 percent.

An ILW is a form of alternative risk transfer designed to protect (re)insurers from significant defined events, typically natural disasters. Payouts under these index based instruments are triggered when the level of industry- wide insured losses for a particular event exceeds some pre-defined threshold. The trigger is usually on a binary basis (i.e. once the threshold is exceeded, the full limit of the ILW is available for payment). Furthermore, because the ILW contract is a reinsurance contract the buyer must bear a retention and can only recover the ILW limit to the extent of its own losses from the trigger event. However, the retention is normally small and thus there is little risk of non- collection in the event of a trigger event occurring.

Outlook for 2009

The substantial increases in Hurricane Ike loss estimates (50 percent to 180 percent of original loss picks) announced by a handful of reinsurers in early January 2009 could exert additional upward pressure on pricing. Meanwhile, 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.

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