David Edwards, Managing Director
Guy Carpenter & Company, LLC (Guy Carpenter) has released its fourth annual market update from its London-based Credit, Bond and Political Risk Team.
The January 1, 2009 reinsurance renewal season saw significant changes over the preceding years. With apparent continued uncertainty in the economy and the (re)insurance environment, the seeds were well sown for a year of exciting predictions from industry observers. The January 2010 renewal season was far more interesting than that of January 2009. The market continues to change in ways that some participants did not expect. The next major set of renewals will stretch the market even further.
The Global Reinsurance Environment
The global reinsurance sector is still highly important to the behavior of the credit, bond and political risk sector. Almost all of the reinsurers in the sector are multi-line. Cedents are accessing a pot of capital that is not simply exposed to an increase in commercial default rates.
2010 has been a difficult year for the reinsurance industry after it suffered one of the most costly first halves on record. Spiraling costs from disasters such as the Chilean earthquake and the Deepwater Horizon explosion in the Gulf of Mexico meant (re)insurers’ catastrophe budgets took a severe hit even before the hurricane season had begun. Although insured losses reached USD23 billion in the first six months and an active hurricane season is forecast by many commentators, reinsurance rates generally declined through the 2010 renewals as excess levels of capital drove prices downwards.
According to the Guy Carpenter World Rate on Line (ROL) Index, global catastrophe reinsurance rates fell by 6 percent on average through the 2010 renewal season. Although markets that suffered catastrophe losses in early 2010, such as Chile, saw prices increase, the underlying trend elsewhere was one of rate reductions. Guy Carpenter estimates that the sector was overcapitalized by as much as USD20 billion, or 12 percent at the beginning of 2010. Although the overcapitalization fell back to around 8 percent by the end of the second quarter, surplus capital among reinsurers remained the driving factor at the 2010 renewals.
As ever, it only takes one market-changing event to precipitate a turn in the market. The marketplace will look very different at next year’s January 1 renewal if a big loss were to occur in 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. Of course, such a loss does not simply remove the excess capital, which occurred previously. A significant proportion will regenerate itself. Both existing and new reinsurers will seek to reap the rewards of an expected hard market that may not materialize or may already have softened before the new capital is in place. However, if no market-changing event occurs, excess capital is likely to continue to depress pricing.
The abundance of capital in the industry was demonstrated by the volume of share buybacks initiated. Between January and May of 2010 21 companies active in the reinsurance market returned capital totaling USD8.8 billion. This compares against USD1.8 billion for 2009 in its entirety. This activity, combined with losses and other financial factors, reduced overcapitalization to around USD13 billion by the end of the second quarter.
An obvious problem with excess capital is its remuneration at levels that the core of the business struggles to deliver when pricing is depressed. In a typical reinsurance cycle some potential shortfall from current underwriting activity is usually bridged by reserve releases. As typical combined ratios for reinsurers increase from the low to mid 90 percent range in 2009 to the 100 percent to 105 percent range for the 2010 half year other sources of net income need to be generated – and any reserve surpluses are an easy target. This reserve pot is not unlimited, and with the 2008 year showing modest adverse development during 2009 the trend may continue through 2010. Will this be enough to stem the underlying pricing trend? The answer is probably not in isolation, but would be an important additional factor if other circumstances conspire to deliver upward pressure.
Market Overview – Credit
Mid-year 2010 results for the leading credit insurers show strong improvements. All key insurers in the class have enacted core underwriting plans to turn around prior results. The general success in avoiding severity losses has made apparent the primary challenge in a downturn: Reducing and avoiding attritional losses. A concern remains that subsequent easing of underwriting parameters could continue without adequate regard for the prevailing downside risk. In recent quarters insolvencies have remained high and significant uncertainty in the economic environment remains. Positive results and growth potential are seductive forces, especially at a time when reinsurance commissions can be lower than gross expense levels. Furthermore, there is concern that the results of the insurers are too good and turning too quickly. Annual results of the key mono-line credit insurers are public and while profit fell during the peak of the downturn, it cannot be said that bottom line results were catastrophic. The observation of this by sophisticated clients and brokers is expected to create some pressure on the original product. It is anticipated that trends into 2011 will improve. .
Market Overview – Surety
The surety sector continues to show significant growth potential, though reinsurers are concerned that the market has yet to experience the true extent of losses that will come out of the economic downturn.
There are specific areas where growth potential exists. Infrastructure projects remain necessary in many countries, power facilities continue to be a major source of activity, and mining projects are slowly returning to market as commodity price growth returns. Governments may provide further short-term, limited invigoration by delivering work to the private sector. Banks also continue to seek ways to transfer business to the insurance sector. Risk awareness continues to grow among employers and more guarantees are being sought.
However, the growth potential in the sector is balanced by challenges that exist in non-construction bonds. The travel industry is experiencing difficult times. Customs and other legal bonds face continuing threats of reduced trade activity, potentially harming the financial status of importers and logistics companies. Changes in bonding requirements across the world are also generally not positive as a shift to risk based assessment deteriorates average risk quality of an insurer’s portfolio. Problems persist in the surety class, and the reinsurance community is concerned that bond insurers have not yet seen their downturn due to the longer tenors of the underlying exposures. If reinsurers are correct, meaningful losses will continue in the sector, with pricing/structures likely to reflect this into 2011.
2011 and beyond:
The reinsurance market will likely continue to soften further, though the softening will be mitigated by reinsurer caution over potential catastrophe scenarios, further economic downturn and perceived “lag” on surety portfolios. While the possibility of double-dip recession and an increase in claims is possible, our expectations are based on further improvement in original results across all sub-classes. Guy Carpenter believes that the improvement will dominate reinsurance market conditions positively. There may be localized deterioration, but the broader market will continue to perform well because of the remedial steps taken during the period of poor economic performance. We believe we are at the mid point of a typical cycle and are entering a profitable period.
The prospects for 2011 through 2013 remain highly attractive for reinsurers because of indications seen in the better than anticipated 2009 and 2010 results. We expect to see competition increase further where results are strong. More reinsurers will be keen to quote programs as they seek to expand their portfolios. New reinsurers and those with above average growth aspirations will deliver value for under pressure risks. The outlook remains quietly optimistic, with anticipation about the future.
Guy Carpenter clients have access to the full report “2010 Market Update: Insight from Guy Carpenter’s Credit, Bond and Political Risk Team.” Others may request access.
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David Edwards, Managing Director