April 16th, 2009

Bermuda Capital Constrained but Sufficient

Posted at 1:00 AM ET

Market Information Department

Like the rest of the world, the Guy Carpenter Bermuda Composite has suffered a drastic financial change from the share buybacks and dividend payments that were common a year ago. Excess capital has become merely sufficient, and the goal of a 15 percent return on equity (ROE) seems ever more distant, as the five-year rolling average for the composite fell to 8.7 percent. Nonetheless, disciplined risk management cannot be ignored, and a strong underwriting performance has created a platform for future profitability.

Having weathered the second costliest catastrophe year since at least 1970 and a global financial catastrophe not seen in decades, the Bermuda (re)insurance companies remain financially strong — with “only” a 16 percent decline in capital — especially when compared to their banking counterparts.

Beneath the surface, however, the dual catastrophes of 2008 have left their mark. While the Bermuda Composite groups recorded an underwriting profit for the year, investment losses resulted in an aggregate net loss, and the depletion of capital comes at a time when capital is hard to replace.


Gross and net written premiums fell a mere 1 percent from 2007 to 2008. With a five-year compound annual growth rate (CAGR) of 2.6 percent for gross written premium (GWP) and 2.2 percent for net written premium (NWP), last year provided only a slight deviation from the norm. Overall, GWP fell to USD41.1 billion.


Most GWP growth occurred in the primary insurance sector of the Bermuda Composite, as it did in 2007, with GPW up 8.8 percent from 2007 to 2008. Reinsurance GWP, on the other hand, declined by 6.7 percent year-over-year.


The Bermuda Composite posted an aggregate comprehensive net loss of USD7.8 billion for 2008. The decline was driven largely by realized and unrealized investment losses of USD10 billion. Yet, diligent risk management practices still led 15 of the 19 companies in the Bermuda Composite to underwriting profits.

The Bermuda Composite’s combined ratio increased 9 points to 94.6 percent, staying below 100 percent in 2008 only because of the release of prior year loss reserves. This does reflect deterioration from 2006 and 2007 levels — 84 percent and 85 percent, respectively — but is still a strong performance given industry insured losses and general financial market conditions. The first half of 2008 was particularly active for individual risk losses, such as a large sugar refinery loss in Georgia. The second half, of course, involved Hurricanes Gustav and Ike, the latter alone causing insured losses of USD11.5 billion and registering as the third largest Hurricane in history.


The Bermuda companies continue to release reserves from prior years. The releases were greater for the “Class of 2001″ companies, whose loss experience is now maturing to a point where they can start to rely on their own loss trends rather than those for the broader industry.


The Bermuda Composite’s asset allocation did not change substantially from 2007 to 2008. An already conservative investment strategy left little room for more caution. Fixed income securities stayed at 75 percent from 2007 to 2008. Equity allocations were halved year-over-year, dropping from 4 percent of the aggregate portfolio in 2007 to 2 percent last year. Allocations to cash and short-term investments increased from 14 percent to 17 percent. While a “flight to quality” was not possible, a movement in that direction was discernable.

Overall, asset allocations barely moved in 2008. Fixed income was and remains the predominant asset class for Bermuda Composite portfolios. The increase in cash and short-term investments came at the expense of equities and “other investments” — such as alternative portfolios — last year. However, this was a deliberate shift, as companies decided to keep more cash on hand given the volatility in financial markets and a lack of attractive investment returns. Equity allocations fell from 4 percent to 2 percent, and other investments accounted for only 6 percent of the Bermuda Composite’s aggregate portfolio last year, down from 7 percent in 2007.


While the changes to asset classes other than fixed income were drastic, they were small in the context of the USD141 billion in total investment assets held. The conservative investment strategy prevailing before the financial catastrophe of 2008 insulated the Bermuda Composite from the worst the market had to offer and consequently required little reason for drastic reallocations.

In the past, Bermuda-based carriers were able to anticipate a certain amount of insurance gains when setting return on equity (ROE) targets. These expectations will have to change this year - and for the foreseeable future. Underwriting will have to drive the growth strategy, as continued financial market volatility will frustrate efforts to supplement earnings with outsized investment returns.

Capital and Leverage

The realized and unrealized losses included in net income and other comprehensive income were 13 times greater than the combined realized and unrealized gains reported in the preceding four years. Even under these conditions, the Bermuda-based carriers have shown continued strength over the past five years. The companies in the Bermuda Composite grew capital and surplus by approximately USD17.4 billion since 2004, with much of it coming from retained earnings. High returns in the low cat years 2006 and 2007 made the use of retained earnings to increase capital levels possible.


Capital levels declined for the first time in half a decade for the Bermuda Composite last year. In the past, carriers would have compensated for lost capital by raising more, but fallout from the worldwide financial catastrophe made this nearly impossible in 2008. Yet, the Bermuda Composite companies entered 2009 sufficiently capitalized, largely because they had had such robust balance sheets 12 months earlier. A steeper decline was obviated by this group’s cautious — though selectively optimistic — stance on current underwriting opportunities.

The amount of debt carried by the companies in the Bermuda Composite did not change materially in 2008. Equity capital, on the other hand, fell 16 percent year-over-year. Consequently, the average debt-to-capital ratio grew to 17.6 percent — from 15.6 percent in 2007. The 2008 level is nonetheless fairly conservative.

The adequacy of loss and loss adjustment expense reserves — overwhelmingly the largest component of net technical reserves — has been of particular concern in this capital-constrained environment. Though lower in dollar amount than in past years, some believe that any redundancies have been wrung out of these reserves in recent years. The largest redundancy reported in the last five years was USD3 billion, recognized in 2008 for the 2007 year-end loss and loss adjustment expense reserves. This far exceeds the USD2.1 billion for 2006 and USD728 billion for 2005. Overly optimistic estimates of loss reserves may mute future profitability.

Next week, look for deeper examinations of each of the topics above. To have these updates delivered directly to your inbox, register for e-mail updates from GC Capital Ideas.

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