Impact on Reinsurance Market
So what does all this mean for the reinsurance market and pricing? On the back of the heavy losses in the first half of 2010, reinsurers were hoping to see an end to the soft market and for prices to rise. However, Guy Carpenter data shows the high payouts have generally been insufficient to turn prices. According to the Guy Carpenter World ROL Index, global catastrophe reinsurance rates fell by 6 percent on average through the 2010 renewal season (see Figure 2) as surplus capital and capacity drove down prices. This rate decline followed an increase of 8 percent in 2009 and a fall of 10 percent in 2008.
Rates in the United States fell during the January, April, June and July renewals. The decline in prices varied by region, exposures and loss history but generally moved in a channel of down 6 percent to down 15 percent. Risk-adjusted catastrophe prices in the United States fell by an average of 8 percent through 2010, though the picture was somewhat complicated by adjustments to catastrophe models that decreased predicted losses for earthquake and wind perils. Factoring in modeling adjustments, rates declined by 12 percent on average. Rates in the United States have fallen back to levels last seen in 2008 as improved investment returns and low catastrophe losses in 2009 bolstered(re)insurers’ balance sheets and exerted gradual downward pressure on prices.
Heavy losses sustained so far in 2010 have therefore done little to stem the softening trend in the United States. Apart from a few local exceptions, this is also true on a global level. Although markets that suffered catastrophe losses in early 2010, such as Chile, saw prices increase, the underlying trend elsewhere was for rate reductions. Guy Carpenter data shows Asia and Europe also saw prices fall (see Figure 3). Although the downward trend was less marked in Asia and Europe (down 5 percent and down 2.5 percent, respectively), the decline generally saw rates fall back towards 2008 levels in both regions.
July 2010 Reinsurance Renewal
Data collected by Guy Carpenter at the July 1 renewal indicated that global property rates were down by as much as 15 percent. Predictions of an active hurricane season only had a slight impact on pricing, and U.S. property rates decreased by 10 percent to 15 percent.
However, the Chilean marketplace did experience significant hardening following the earthquake in February. Treaty excess of loss (XOL) and facultative risks saw rates increase in the range of 50 percent to 70 percent in Chile. Excluding Chile, terms and conditions in the property XOL and prorata lines in the wider Latin America and Caribbean region generally were unchanged, as readily available capacity and new entrants into the marketplace continued to put downward pressure on rates. The Chilean earthquake losses, however, had somewhat of a mitigating effect on the pressures on rates.
The Deepwater Horizon loss had a limited impact on reinsurance rates for marine business at the July renewal. The disaster did not affect reinsurers’ quotes on international placements, as accounts were underwritten separately based on specific account losses and exposure. However, the impact of the loss was felt by carriers with energy exposures, as price increases of more than 10 percent were seen for deepwater drilling risks similar to those of the Deepwater Horizon. As indicated, prices for such risks are expected to continue to rise in 2011.
One of the main reasons for the general decline in global rates is excess capital in the reinsurance market. The amount of capital in the market soared after investors bankrolled the sector to exploit the significant rise in rates following the destructive hurricane season of 2005. Although the financial crisis and Hurricane Ike’s landfall in Texas combined to deplete the amount of capital in 2008 and early 2009, reinsurers’ balance sheets have since recovered (see Figure 4). Part of this excess capital has been used to absorb the losses so far in 2010 and stifle any upward pressure on rates.
Guy Carpenter estimated that the sector was overcapitalized by more than USD20 billion, or 12 percent, at the beginning of 2010. The abundance of capital in the reinsurance market was demonstrated by the volume of share buybacks initiated earlier this year. During the first five months of 2010, 21 companies that underwrite reinsurance returned capital totaling USD8.8 billion to shareholders, compared with USD1.8 billion in all of 2009.
The share buybacks, combined with hefty losses in the first half of the year, general risk aversion stemming from the ongoing debt crisis and pressure on asset values, meant the overcapitalization fell to about USD13 billion (or 8 percent) by the end of June, according to Guy Carpenter figures. This overcapitalization remained the driving factor at the 2010 renewals, and all indications suggest the marketplace will experience further rate softening if no market-changing catastrophe occurs in the second half of 2010.
Surplus capital also has led to elevated levels of reinsurance capacity. The hefty losses of 2010 have done little to reverse the trend, as supply continues to exceed insurers’ demand. If the situation persists, some reinsurers could be in a position of having to decide whether to write new business at an underwriting loss to defend their market share, underlining the difficult situation facing the industry as it begins to focus on the January 1, 2011 renewal.
As always, the market’s direction is difficult to predict. Indeed, much can change between now and the beginning of 2011. Market conditions at the January 1, 2011 renewal will be influenced by the extent to which reinsurer capital is eroded by loss activity through the rest of the year. Although no market-changing event had occurred at the time of writing, this could change as the 2010 hurricane season is forecast to be active. Any other large unforeseen catastrophe, whether it be natural, man-made or financial, also could change the market in an instant.
In the absence of such an event, excess supply is likely to continue to depress pricing for the remainder of the year. That said, several reinsurers’ catastrophe budgets have been depleted or even exhausted following the expensive first half of 2010, and any further payouts could help stabilize the market.
The reinsurance sector is at a crossroads. On one hand, reinsurers could see capital tighten if the hurricane season produces a large loss. However, should they suffer no significant hit for the remainder of the year, capital could remain plentiful with buyers continuing to call for price cuts.
So what will it take to turn the market? Given the elevated levels of capital and capacity, the industry would have to see a big loss that shakes the confidence of capital investors for rates to increase. New capacity continues to enter the market, and such appetite for (re)insurance investment must dampen if the market is to harden.
It only takes one market-changing event to precipitate market hardening. The marketplace will look very different at the January 1, 2011 renewal if a big catastrophic loss were to occur in the second half of 2010. A loss in the region of USD20 billion to USD30 billion, while not likely to lead to significant rate hardening, would decrease capacity and stabilize the market. A loss exceeding USD50 billion, however, could lead to an immediate correction in pricing. Such a loss potentially could deplete underwriting profit from 2009 and readdress the recent supply/demand imbalance. Multiple losses in the USD20 billion to USD30 billion range also could bring significant change to the market since retention levels would be hit.
Catastrophe Bond Update
A market that has experienced a resurgence is the catastrophe bond market. Eight catastrophe bond transactions were completed in the second quarter of 2010, with USD2.05 billion in risk capital coming into the market - making it the second-most active second quarter on record (see Figure 5). Of this total, USD1.7 billion (and all but one transaction) included exposure to US wind, as sponsors and investors focused on this peril.
Activity was significantly up compared to the same period in 2009. The number of bonds issued increased 33 percent year-on-year (up from six bonds in the second quarter of 2009), and risk capital issued jumped by 154 percent from the USD808 million issued during the second quarter of 2009.
For the first half of 2010, a total of 10 catastrophe bonds were issued, generating risk capital of USD2.35 billion. This compared favorably with the first half of 2009, when nine transactions were completed, resulting in USD1.38 billion issued. From the first half of 2009 to the first six months of 2010, risk capital issued rose by 70 percent.
Catastrophe Bond Arrangers
Throughout the first half of 2010, there has been a shift in the percentage of risk capital that has been placed by broker-dealer affiliates of reinsurance brokers (see Figure 6). Prior to 2007, investment banks largely dominated cat bond issuance, with broker-dealer affiliates of reinsurance brokers placing no more than 30 percent of cat bonds (in terms of risk capital) in any single year. Since 2007, sponsors of cat bonds have increasingly recognized the value brought by broker-dealer affiliates of reinsurance brokers. In the first half of 2010, the percentage of risk capital issued arranged by broker-dealer affiliates of reinsurance brokers as deal managers was more than 90 percent. (Only one deal did not have a broker-dealer affiliate of a reinsurance broker in the dealer group.)
Risk Capital Outstanding
Despite the strong recovery in cat bond activity during the second quarter of 2010, total risk capital outstanding declined USD105 million to USD11.82 billion as the USD2.05 billion of new issuance was outstripped by USD 2.16 billion of maturities (see Figure 7). This is the second consecutive quarter of declining risk capital outstanding. An additional USD1.92 billion of risk capital is scheduled to mature before the end of 2010. Yet, although not all of this maturing risk capital has flowed back into the hands of active catastrophe bond investors, demand for new issuance remains robust.
Industry Loss Warranties
Compared to the first quarter of 2010, industry loss warranty (ILW) negotiations and trading picked up significantly in the second quarter. Reinsurers, reluctant to retain additional potential losses after the disasters in Chile, Australia and offshore energy books, began looking for ways to enhance and supplement existing reinsurance protections. Initially, this prompted a sharp increase in traded volumes in late April
and May and a rate hardening of 10 percent after a sustained period of softening since early 2009.
Protection buyers generally were able to find protection sellers at these increased rates. However, sustained demand from protection buyers by mid-June began to outstrip available supply from protection sellers. This prompted a frenetic two-week period during which it became increasingly difficult to find carriers to support even small limits at ever-rising pricing - in many cases 15 percent or more over the initial 10 percent increase. Based on general market trends, it appears that this spike was more of a temporary dislocation rather than a sustained widening since final “pre-season” deals recently have been bound successfully.
Outlook for Reminder of 2010
The catastrophe bond market outlook for the (typically quiet) third quarter and fourth quarter of 2010 is entirely subject to catastrophe activity - in particular, the number and severity of landfalling hurricanes in the United States. However, assuming no market-moving events occur, and based on the existing pipeline and onsideration of scheduled maturities, a total year issuance in 2010 of USD4 billion to USD6 billion
(implying additional issuance in the second half of 2010 of USD1.7 billion to USD3.7 billion) is a reasonable estimate.
Securities or investments, as applicable, are offered in the United States through GC Securities, a division of MMC Securities Corp., a US registered broker-dealer and member FINRA/SIPC. Main Office: 1166 Avenue of the Americas,New York, NY 10036. Phone: (212) 345-5000. Securities or investments, as applicable, are offered in the European Union by GC Securities, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., MMC Securities (Europe) Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance, or insurance product.