January 11th, 2011

2011 Outlook: Potential Catalysts for a Cycle Turn, Part I

Posted at 1:00 AM ET

141x141jan1thumb4Given low valuations, low yields, macroeconomic instability, inflationary pressures and lower pricing, it is not unreasonable to argue that the current operating environment is among the most challenging in living memory. The question most frequently posed in the reinsurance sector currently is: What will it take to turn the market? Below we discuss several potential scenarios that could expedite the turn. However, it is most likely that a combination of events will ultimately create the inflection point from which the sector will again enter a hard market.

Critical-Mass Loss Event

As mentioned, a USD50 billion industry loss event would be enough to stem the decline of property catastrophe reinsurance rates even in the current, capital rich environment while at USD100 billion, Guy Carpenter believes “outlier” reinsurance entity failures could take place. A USD150 billion event would certainly create a sustained and long-term market turn.

Unexpected events could create even more powerful catalysts for a turn. For example, North Atlantic and Gulf of Mexico wind events have been modeled extensively since 2004 when hurricane frequency became a more prominent industry issue. A large hurricane on the southern coast of the US may therefore already be “priced in” to rates on line to some extent. But a large terror event or a nuclear accident may contain an element of”less-known unknowns,” which could constitute a stronger means for a reversal in pricing.

Sustainability of Reserve Releases

Historically, one of the “big cats” has been sector under-reserving, which served as the backdrop for the last hard market. Over the last four years, reserve releases have featured prominently in the reinsurance sector and have continued to do so up until the third quarter of 2010. Figure 12 shows the contribution to reserve releases on the Guy Carpenter Bermuda Reinsurance Composite combined ratios from 2005. It is notable that the benefit from reserve releases has ticked up in the first nine months of 2010 by one full percentage point, to 8.8 points on the loss ratio. This has occurred during a year when many projected reserve releases would diminish.

fig-12

Accident year loss experience is, by contrast, beginning to show signs of lower reserve margins. Figure 13 shows US P&C industry reserve development by accident year since 2000. The reserving cycle is evident in the graph with adverse accident year loss development during the “soft market” years of 2000 and 2001 and favorable
development between 2003 and 2007. The orange line in the graph shows the average initial loss ratio pick. The old reserving adage that “good years get better and bad years get worse” appears to be borne out here.

Although more recent accident years are less mature, it is interesting that the trend of favorable development seems to be diminishing rapidly, with unfavorable development already coming through for accident year 2008 (although this included significant adverse development on mortgage indemnity business). The broader question is,
of course, when does the sum of development turn unfavorable?

fig-13

Another clue which could point to a shift in reserving trends may be evident in US P&C industry percentage of first year incurred but not reported (IBNR) figures, which, all else equal, is a measure of reserving conservatism. Here again, in Figure 14, a trend of potentially diminishing conservatism can be seen. It is significant that the industry is, in aggregate, back to levels of around 30 percent - levels previously seen in the last soft market.

fig-14

Click here to read the Executive Summary of Guy Carpenter’s report: Global Reinsurance Outlook: Points of Inflection; Positioning for Change in a Challenging Market >>

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