July 22nd, 2009

Mixed Bag

Posted at 1:01 AM ET

David Rains, FSA, MAAA, Managing Director and Head of the Life, Accident and Health Specialty Practice and Dean Kidd, Managing Director

There’s no single answer to the question of capital availability in the global life, accident, and health (LA&H) market. Reinsurers are responding to the returns possible for specific risks, which is driving their capital allocation decisions. Meanwhile, cedents are uniformly focused on managing the cost to transfer risk. As these factors converge on reinsurance rates — along with concerns about investment asset performance, geography, and the underwriting profitability of other lines of business — the result is a price stalemate caused by competing pressures of comparable strength. Without an unexpected market development, the norm is likely to persist.

The availability of capacity and cost of reinsurance heading into the July 1, 2009 renewal may be varied by line of business in the LA&H sector, but the underlying conditions are remarkably similar. Reinsurers are eager to compensate for 2008 investment losses and underwriting profit declines by pursuing higher-gain opportunities this year, leading some to consider allocating more capital to property and casualty (P&C) lines of business. Meanwhile, LA&H cedents are steadfast in their almost collective refusal to accept substantial price increases, and they generally have been successful.

More than other sectors, traditional life reinsurance markets are reflections of the total industry — including their clients. (Re)insurers’ expectations for underwriting results are stable, and they have sufficient capital to write pure protection business. However, for popular term and universal life products, the capital needed to support redundant but required reserves is scarce. Growth in these products in recent years has been financed with inexpensive collateral provided by commercial banks and capital markets. Those sources of “other peoples’ money” have dried up, forcing the effective costs of holding reserves up.

Meanwhile, market prices for these products have moved very little, creating a “pressure cooker” situation. High costs for reserves (or reserve credit) coupled with decreased investment returns — with no relief through higher retail rates — are compressing margins to well below targets. Re(insurers) are likely pricing with future assumptions for these costs that include reversion to the mean, which can ease some pressure.

Of course, the historically tight spreads that characterized the heyday of insurance securitization are just as unusual as the wide spreads sparked by the financial crisis. No one knows how long reversion to the mean will take or what the mean should really be expected to be. This is a critical assumption for life insurers, as retail and reinsurance premium are typically guaranteed for decades, offering no opportunity for correction if events unfold unfavorably.

As insurers deal with these issues, they are turning back to reinsurers for coinsurance to help manage reserves. Reinsurers with capacity for this business find themselves in a unique situation — it is a seller’s market for coinsurance, but the retail prices limit the amount that can be charged. Reinsurers are responding by seeking the most profitable opportunities to deploy their limited capacity, but that varies according to each reinsurer. Some are trying to maximize lifetime customer value by reserving capacity for long term partners while others are hunting for the best near-term returns.

This environment has also resulted in market opportunities for new entrants. P&C reinsurers with strong balance sheets are considering expanding into the life sector in the coming six to 12 months, which is likely to impact the dynamics of the market.

The collision of increasing capital costs and competitive pricing is also at play in the personal accident (PA) sector. Higher returns for some P&C lines has threatened to draw capacity from PA, as reinsurers seek higher underwriting profits after a tough 2008. For some P&C catastrophe zones, pricing increased 15 percent to 25 percent at the April 1, 2009 renewal, giving reinsurers plenty of incentive to reallocate — a trend that could lead to attempted PA price increases this year. And, the impact of diminished investment returns can’t be ignored. Even with plenty of capacity available, reinsurers will have to rely on underwriting profits to compensate for realized and unrealized investment losses.

Renewal activity so far this year suggests that reinsurers will have a difficult time securing higher rates. An average rate on line (ROL) decrease of 3.8 percent for April 1, 2009 renewals confirmed a decline of 1.5 percent at January 1, 2009, showing salient resistance to higher prices. Competing pressures, so far, have failed to accumulate to the point where the market favors sellers.

As with the life market, though, it all comes back to the availability of capacity. Cedents are able to push back on rate increases for this reason, and for several years, they have been successful. Financial market developments - such as increases in the cost of capital and investment performance - could catch up with the PA reinsurance market this year … but this is a possibility that’s been discussed for more than a year already with little realized impact.

For Bermuda reinsurers, there are further signs that sufficient pressure may have mounted. Fifteen of the 19 companies in the Guy Carpenter Bermuda Reinsurance Composite were able to secure underwriting profits last year, though they dropped precipitously from 2007. Further, investment income fell to 16 percent of net premium earned (NPE) — from 20 percent of NPE in 2007, and the group’s five-year average combined return on equity (ROE) fell to 8.7 percent, well below the perennial target of 15 percent and the previous five-year average of 14.5 percent (2003 to 2007). Of course, property-catastrophe results are included, and this sector will likely attract increased attention this year, as carriers hunt for the risks with the greatest potential for restoring ROE to previous levels.

The essential tension of the LA&H reinsurance market — and the lofty goals of Bermuda carriers - is likely to remain, absent an outside stimulus that reshapes the business. The LA&H sector has performed quite well, particularly for Bermuda reinsurers, muting threats of capacity withdrawal. Busy catastrophe years have been short on mortality for the past decade, sparing reinsurer balance sheets and fueling consistent underwriting gains … even if they are tightening a bit. So, look for more of the same, this summer. LA&H margins may be slimming, but the sector has served its writers well and reinsurers may need to be willing to reflect that positive experience to gain market share.

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