Reinsurance Demand, Prices On The Rise

Reinsurers are entering a hardening market, leaders in the sector predicted here, with one admonishing industry peers to seize the opportunity to rethink standard operating procedures to sustain whatever level of profits comes as a result of the shift.

“We talk about the soft market as if someone came in and put it there. But the fact of the matter is, the markets are us,” said Anthony Kuczinski, chief executive officer of Munich Reinsurance America, based in Princeton, N.J.

“Markets get soft because of our actions, and they get hard because of our actions,” he said after presenting historical data demonstrating that catastrophic events don’t drive cycles.

Mr. Kuczinski delivered his take on the market here during the 20th Annual Executive Conference for the Property-Casualty Industry, presented by The National Underwriter Company, and sponsored by Ernst & Young and Dewey & LeBoeuf.

During a session entitled, “The Reinsurance Sector: Achieving Profitability,” he noted that in 2006, the reinsurance industry made its first underwriting profit in over 25 years—posting a combined ratio less than 100, then achieved an underwriting profit again the following year.

“We should be looking at ways to continue that process, and absent the events of 2008, I’m not convinced we would have gone there,” he said.

As a result of the financial crisis and catastrophe losses that will exceed $35 billion for the year, “we believe there’s a market turn [coming],” he said. “Why don’t we use the market turn as a way of changing how this business gets done going forward.”

Mr. Kuczinski said that at this point reinsurers have enough information in their extensive data bases to price business at technically-correct levels.

“Sometimes the technical gets persuaded by the emotional. We have to figure out a way of saying, no, the technical really does drive the outcome,” he advised.

“At the end of the day, we are in a cyclical business, but we determine the market,” said Mr. Kuczinski.

During the first half of his talk, Mr. Kuczinski presented slide after slide of historical data setting the stage for his call for reinsurers to stop a history of unprofitable results from being repeated.

Referring to the two isolated years of profit—2006 and 2007—he said, “the only reason we had those results, or at least the primary reason, was because of Mother Nature,” referring to the lack of catastrophe losses in those years.

At one point, he displayed a graph of dollars of underwriting profit and loss from 1991-to-2007 for the U.S. reinsurance industry. Profits of $1.3 billion in 2006 and $1.7 billion in 2007—only $3 billion together—were not even enough to cover the underwriting losses in the earliest years on the graph, 1991 and 1992, he noted, referring to numbers that ranged from an $800 million loss in 1991 to a $3.6 billion loss in 2000.

Despite the fact that Munich Re and other reinsurers have been trying to maintain discipline, downward pricing trends for the past three years have moved the industry overall “dangerously close” to inadequate pricing, he said.

Illustrating the industry’s failure to get pricing right during another part of his presentation, Mr. Kuczinski displayed a history of accident-year loss ratios (including loss adjustment expenses) evaluated at the end of each accident year, assuming that these loss ratio picks serve as a basis for pricing.

He then superimposed revised loss ratios for each accident-year evaluated 24 months later and 36 months later on the same graph, revealing that in each subsequent evaluation—12, 24 and 36 months after the start of each accident-year—the ratios remained strikingly similar.

“Three years after we made our decision on what the pricing was, there’s not much change” in the loss ratios, he said.

But ultimately—beyond 36 months—the ratios moved very far off the initial estimates, he showed. “In hard markets and soft markets, there is a big dispersion between the ultimate loss ratios and the original loss ratios,” and periods of underestimation far outweigh the overestimated periods, according to Mr. Kuczinski.

In an attempt to put to rest the idea that the discrepancy is driven by catastrophic events, he noted that for accident-year 2001, which encompasses losses from the 9/11 terrorist attacks, the gap between the original loss ratio and ultimate loss ratio is about the same as it was for corresponding gaps for several accident years preceding 9/11. “It’s not because of the event that we were that far apart. It’s because we got it wrong to begin with,” he said.

“Cycles are not impacted by the catastrophes. They may be an impetus for changing conditions, but they are not what get us there in the first place. What gets us there in the first place is getting the loss ratios wrong to begin with,” he said, adding that reinsurers don’t find out the magnitude of their errors until many years after they make their initial estimates.

COUNTERPOINT

Meanwhile, reinsurance market optimists may need to pen up their bullish forecasts for premium growth a little longer, suggested one global reinsurance brokerage leader speaking at the NUCO conference.

Bryon Ehrhart, president and chief executive officer of Aon Re Global Services in Chicago, offered a cautious outlook even as he agreed with some of the factors that reinsurance company executives have mentioned in third quarter earnings reports as pointing to increased demand for reinsurance in 2009.

Unlike more positive forecasters however, Mr. Ehrhart, looked at one key factor—the disappearance of insurer cushions of capital—and a very long list of additional demand drivers, and weighed them against a shorter, but formidable list of impediments. This led him to conclude that insurers may continue to increase their retentions going forward.

Referring to the optimistic commentary from reinsurers, he said “there has been speculation that there will be a bull reinsurance market,” which caused reinsurance company stocks to react favorably recently. This “premature rally,” however, has already “come in some,” he noted—attributing the short life of the rally to the realization of “a disconnect” between buyers and sellers.

Going on to describe what he meant by the term “disconnect,” Mr. Ehrhart said reinsurers are also suffering reasonably significant capital declines. “If you buy more reinsurance, who are you going to buy it from?” he asked.

“Intuitively, the right risk management move when capital is down from the supplier of risk-taking capacity is that you buy less … from them. That’s general fundamentals,” he said.

Earlier in his presentation, Mr. Ehrhart displayed numbers showing that insurer capital declines have been steeper than reinsurer declines.

Overall, a group of insurers he tracked, which had $366 billion at the end of fourth-quarter 2007, lost 19.4 percent of their capital by the end of third-quarter 2008.

On the reinsurance side, capital fell only 8.2 percent in the same period for a group of reinsurers that had $360 billion in capital as of fourth-quarter 2007. But while some large companies, like Berkshire-Hathaway, had no capital change, others have suffered “reasonable declines” that will get the attention of ceding companies, he noted.

Three of the larger reinsurers have capital drops ranging between 15- and 20 percent through the third quarter, he said—without identifying them. “While that’s better than we’re going to see for a lot of insurers, it is material enough that it’s not going to go unnoticed,” he added.

There are significant reinsurers that “are possibly even facing control changes or other uncertainties,” he said.

In addition, reinsurers that “qualified on the margin last year” for the reinsurance programs—in other words, who just hit cedents’ credit quality thresholds with ratings of “A-minus” from A.M. Best and “BBB-something” from Standard & Poor’s—now have lower capital cushions than they had last year. That means “clients are going to be more cautious about buying from people with those ratings,” he said.

“And then there’s the price,” he continued, noting that while there’s been a lot of talk about insurance prices stabilizing, there hasn’t necessarily been any indication that “new money is flowing in the door” from insurance rate hikes.

Speaking from the perspective of an insurer, he asked: “How am I going to spend more going out the door” to buy the higher levels of reinsurance protection, “without more coming in the door?”

That will cause insurers to wait—“if they’re going to buy more, to do it after they see the money flowing in.”

In efforts to increase the inflow of dollars, insurers may try to grow their business in 2009, but “there’s real growth risk when there is real competition on the street for business,” Mr. Ehrhart noted.

“While there is some $30-to-$40 billion worth of premiums in companies that have difficult economic circumstances in their own books, there’s still competition for moving that business,” he said.

On the reinsurance side, after two years of reinsurance price declines, insurers know that the cost of reinsurance is going up. Therefore, he concluded, “you are going to see [cedents] defeating some of that price increase with raised retentions.”

This is counterintuitive, since lower insurer capital levels should coincide with lower risk tolerance, he conceded. “I think it’s probably something that will occur even though it feels unnatural,” he said.

On the demand side, in addition to the disappearance of insurer cushions of capital, Mr. Ehrhart said a greater respect for model uncertainty, and a $12.0-to-14.5 billion shortfall in the Florida Hurricane Catastrophe Fund are factors working in the opposite direction—potentially fueling more reinsurance demand in line with more bullish predictions.