Christopher Klein, Global Head of Business Intelligence
The ongoing financial catastrophe is already shaping the market’s perception of the next reinsurance renewal. A unique confluence of factors has complicated the annual ritual of anticipating the direction of reinsurance rates. Though a number of factors have coalesced to prevent the continued rapid decline in risk-transfer pricing that characterized 2008, pricing on average at January 1, 2009 renewals is likely to remain within a narrow range of expiring rates. Nonetheless, the global credit crisis is far from over. Conditions are changing daily. New financial developments—or a mega-catastrophe—could change market conditions substantially and with little lead time.
The market is experiencing a fundamental tension of factors right now. On the reinsurance market side, an increase in the cost of capital and higher catastrophe losses are applying considerable pressure to increase prices. In some cases, markets are reporting price increases for certain classes of business.
Many cedents, on the other hand, have absorbed most of the year’s catastrophe losses, as for many insurers, losses are estimated to be below attachment points, thus sparing reinsurer balance sheets. Also, reinsurers seem to have enough capital on hand. They have not had to acquire much on the open market—meaning that a higher cost of capital has not had a major impact on actual operations. Further, some reinsurers have actively returned capital, indicating that a higher cost of capital is unlikely to have a market effect in the near future.
While both insurers’ and reinsurers’ capital may appear to be adequate by many measures, both allocate more capital for certain risk products and geographies. This fact, coupled with reduced investment income, suggests that reduced allocations will be the leading indicators of any change.
Financial Catastrophes, a New Type of Risk
The reinsurance market has become entangled in a global financial catastrophe, which began with exposure to subprime mortgages in the U.S. market. This new type of disaster event has the power to affect both sides of the balance sheet—damaging carrier investment assets and possibly leading to professional liability claims. A financial catastrophe can cause far more economic damage than the greatest of property mega-catastrophes.
Financial catastrophes destroy wealth, as evidenced by the turmoil in both credit and equity markets, but this is not the full extent of their destructive power. A self-reinforcing downward spiral in asset value will bring waves of write-downs that trigger further cuts to asset values across the broad financial landscape. However, insurers and reinsurers are conservative investors, and have, in general, escaped the worst effects of the global credit crisis.
Primary Market Implications
Several primary market conditions have helped keep rates tipped in cedents’ favor. Catastrophe losses have been above average this year, but we have had no market changing events on the order of Hurricane Katrina or the Northridge earthquake. The losses instigated by the natural catastrophes have been chastening rather than punishing—reinforcing the potential for catastrophe losses without necessarily inflicting them.
Complicating the matter is the fact that the industry has yet to see firm numbers on the implications of Hurricane Ike. Immediately post-event the loss estimates were lower than expected. Over the past several weeks, however, they have been rising. It seems as though the insured losses caused by this storm could be twice as high as the early post-loss estimates. Most of the losses have been absorbed by the primary market, though, as a result of higher retentions.
The decline in the stock market throughout 2008 has had a negative impact on insurers’ capital. Total realized and unrealized losses reached USD19.6 billion for the first half of 2008, with an additional USD15 billion estimated for the third quarter. Surplus declined by an estimated USD12.9 billion for the first half of the year, with another USD22.4 billion expected in the third quarter. By October 14, 2008, the stock market had dropped by 14 percent relative to the end of September, implying a further fall in surplus of USD19 billion. This has had a noticeable impact on carrier surplus, and the trend is likely to continue.
While surplus has been hit, some perspective is necessary. The losses have occurred within the context of a well-capitalized industry. Insurers have had sufficient capital on hand to weather the storm. For example, primary carriers’ premium-to-surplus ratio stands at 0.88:1. This is far below the traditional industry benchmark of 3:1. Further, losses resulting in a decline in equity values tend to be perceived as temporary. Once stability is restored, equity values can be expected to rise.
An analysis of primary insurer cash flow indicates that primary insurers are well-prepared to withstand the effects of the global financial catastrophe. For primary insurers, cash peaked at USD90 billion in 2004, and can be expected to exceed USD50 billion in 2008. A lack of cash, it seems, will not be a problem in the near future.
The Reinsurance Market
Many of the financial pressures felt by primary carriers have affected reinsurers as well. After a few years of strong profitability (following Hurricanes Katrina, Rita, and Wilma), the industry faces a higher profitability hurdle, along with increased competition and slipping prices. These factors, along with a general increase in the cost of capital, have created a challenging business environment for reinsurers.
The world’s 10 largest reinsurers have been hit hard by the financial catastrophe. At the beginning of 2008, they held a combined USD68.4 billion in equities. If the value of these assets fell by 30 percent—the rate at which the broader equity market declined—their holdings would lose USD21 billion in value. This translates to an aggregate surplus of USD73 billion (from USD94 billion at the beginning of the year). Yet, the premium-to-surplus ratio is slightly above 1:1, indicating that the industry’s stability is not in jeopardy.
The ambiguity in the market makes forecasting risk-transfer pricing at the next renewal difficult, and pricing could change during the run-up to January 1, 2009. As 2009 continues—particularly through the June 1, 2009 renewal for the Florida market—increases become more likely. In an environment where new developments occur daily, the potential for market-changing news is quite high. In general, though, Guy Carpenter does not believe there is a fundamental need to increase reinsurance prices, and we will work with cedents to develop strategies to minimize upward pressure on prices.
For the near term, cedents could benefit from the early acquisition of cover, particularly if prices increase through the first half of 2009. Thinking further ahead, though, now is the time to investigate of worst-case scenarios … to imagine the unmanageable and develop realistic plans to cope with such disasters. Carriers need to modify how they interact with (and depend on) on credit markets, including the use of letters of credit. Increased pressure on capital will come from regulators and rating agencies. In some instances, risk-transfer solutions can ease the pressures arising from these sources, but a broader strategy for capital management will distinguish the survivors from the market leaders.
- Sean Mooney, Chief Economist
- David Flandro, Senior Vice President