Hurdles ahead - but watch your back too!

Monte Carlo sees the big four ratings agencies pass judgement on the state of the reinsurance industry. Mark Geoghegan highlights the depressingly familiar key themes of their reports

The four main ratings agencies (AM Best, Standard & Poor's, Fitch and Moody's) painted a generally stable picture of the reinsurance sector in 2006 and the coming 12-24 months, but highlighted major challenges ahead as cyclical pressures began to reassert themselves.

Fitch predicts

Fitch was the most predictive of the big four agencies, using its report as an opportunity to reaffirm its strong belief in pricing cycles in the reinsurance market. Under the banner Cycle management - a bumpy ride ahead, the agency said it was generally pleased with the financial health of the sector, which was ironically in better shape than before Hurricane Katrina, Fitch nevertheless cautioned that it saw the greatest challenge facing the industry over the coming 12-24 months as being one of selective underwriting in an increasingly competitive global environment.

According to Fitch, as long as catastrophe experience returns to normal, it expects 2007 to be a year of moderate price reductions overall. But the agency foresees the real crunch in 2008 when, it says, "management strategies will be truly tested".

The agency didn't predict any increase in merger and acquisition activity, but said that if this did materialise, it usually viewed such developments as signs that the sector was having difficulty coming to terms with a competitive environment.

Another significant development noted by Fitch was the strong progress the sector had made toward reserving adequacy after years of adverse development and capital impairment to repair the damage caused in prior soft-market years. Fitch said that most players, buoyed by favourable developments on recent hard-market years, are going to be in a position to report modest reserve redundancies, and that reserve inadequacy is going to be only slight for the industry as a whole.

However, the agency cautioned that adverse developments on 2005 hurricane losses are likely to surface and countermand the favourable trend.

Increased capital requirements for the post-Katrina-Rita-Wilma (KRW) catastrophe worldview were a negative factor, and rising global interest rates were mentioned as a largely neutral factor, but overall, Fitch's message to the market was that the biggest challenge it faces today is to maintain underwriting discipline.

The most prophetic phrase was perhaps: "Management teams strive to avoid knowingly pricing business at a technical loss, except in circumstances when seeking to maintain market share. However, the decision on when to exit or cut back is not clear cut, and many reinsurers have historically either made this decision too late, or not at all." Now there's a challenge.

S&P observation

In contrast to Fitch, Standard and Poor's (S&P) annual report was more muted, but it contained some very interesting observations.

The agency's Global reinsurance highlights looked long and hard at what it said was at the top of the senior management of the sector's agenda today: risk management.

Painting a generally stable outlook for the sector, S&P praised reinsurers for having applied much of what they had learned since Hurricane Andrew in 1993 and coming through the stern test of the 2006 catastrophe losses largely intact. S&P even saw the prominent exits of PXRE and Quanta as a testament to improved risk management, since both had managed to remain solvent.

While referring to the lessons of the past, S&P pointed to the new lessons to be learned from the 2005 catastrophe year. It said the key was a fundamental shift in catastrophe-risk appetite among reinsurers: "Although prior to the experience of Hurricane Katrina, many reinsurers felt comfortable exposing as much as 40-60% of their capital base to a very large catastrophe loss; most management teams now seem to think that 20% or lower is probably more suitable and reduces the potentially life-threatening risk (to the company) of an unsuccessful capital raise following a large event."

According to S&P, this inevitably meant that despite the attractive pricing and terms and conditions currently available in US catastrophe-exposed areas, most reinsurers were maintaining a conservative approach and scaling back their exposures rather than increasing them, which is helping to drive prices higher and keep terms and conditions tighter.

This mismatch had created the opportunity for the class of 2005 to fill - however, despite this market opportunity, S&P said that this class of company formations would find it more difficult to succeed that their class of 2001/02 counterparts: "... with the exception of the substantial demand for reinsurance and retrocessional capacity for US peak catastrophe-zone exposures, there is not nearly as much demand for additional capacity in other lines of business as was the case when the class of 2001/2002 start-ups were formed."

Speaking at S&P's press conference in Monte Carlo, analyst Laline Carvalho added that the calibre of senior management was not as high this time around compared to previous waves of company formation.

Regarding the recent phenomenon of sidecar formation, S&P described the vehicles as "probably a good idea", but tempered the comment with the observation that some of the hedge-fund capital entering the market in 2005 was "naive".

Looking to the overall state of the pricing cycle, S&P said that it saw flatter cycles in the future, but described the 2007/08 period as the "key moment of truth".

AM Best angst

Released a few weeks ahead of its rivals, AM Best's report was entitled: Reinsurers humbled but most not broken by hurricane losses. It was the only agency to hold out an overall negative outlook for the sector, pointing to the "tenuous" underlying stability of the market, due to the ease of entry for new capital and the high level of current investor expectations.

As the only rating agency that rates start-up companies, AM Best's report devoted a section to the class of 2005, saying that a key consideration in rating start-ups was the quality of management. The agency said that each new venture attaining it's A- rating "demonstrated varying, yet reasonable degrees of proficiency".

However, AM Best described the key difference between the class of 2005 and the class of 2001/02 as being the new group's principle short-tail focus, and hence its comparative lack of diversification compared to previous start-up classes.

AM Best also highlighted the companies' "lack of unique franchise in an increasingly competitive catastrophe market" and expressed doubts about the stability of their capital bases, given the nimble-footed reputation of their largely hedge-fund backers.

Moody's in moderate mode

Finally, Moody's went for a stable outlook, describing the industry's "generally sound balance sheets and good earnings momentum".

Like the other agencies, among other pressing market issues, Moody's looked at the trends toward improved risk management, the changes in modelling techniques after the 2005 catastrophes and the increased trend towards securitisation, but the firm did go into considerable detail on the vexed subject of US reserve adequacy in casualty lines.

Moody's produced detailed figures showing a continued overall improvement in the industry position, with continued reductions in overall reserve deficiencies in this difficult class. At the end of 2005, the agency estimated an overall deficit of just $1bn, or 2.8% of casualty reserves, down from over 60% back in the nadir of the last soft market in 2000.

However, according to Moody's, the US casualty sector is not out of the woods yet - it still sees asbestos claims as a probable future drag on earnings, and highlighted Workers' Compensation and directors' and officers' liability as two other classes that still had potential to produce unwelcome negative developments.

TABLE 1: AT A GLANCE- HOW THE BIG FOUR RATINGS AGENCIES SEE THE INDUSTRY TODAYRATING AGENCY/Reinsurance outlook Key Themes View of sidecars?AM BEST/NEGATIVE Catastrophe peril"The likelihood for "AM Best considers "The benefit of the trans-assignment of ratings catastrophic loss, action to the cedingof positive outlooks both natural and company will be given aor upgrades over the man-made, to be the haircut depending on themid-term appears greatest threat to operational and tail riskremote." the financial to the ceding company, strength of property should the sidecar not be and casualty (P&C) sufficiently capitalised." insurers."STANDARD & POOR'S(S&P)/STABLE Risk management"Standard & Poor's "In recent years, "Although many investorsdoes not expect a the industry has are well versed on thelarge number of suffered from its risks of reinsurance, amongrating changes during fair share of shocks those enthusiasticallythis period ... Behind as a consequence of backing the reinsurancethis veil of stability, poor management of sector in recent yearshowever, lies a very pricing, accumu- (including the recent wavedynamic sector." lations, reserving of sidecars) are some new and asset-liability investors who might or matching." might not be prepared for the potential volatility inherent in the sector."FITCH/STABLE Cycle management"Over the next 12-24 "Cycle management is Fitch views sidecars as anmonths, underwriting, probably the biggest alternative source ofoperating & capital challenge facing the capital for the reinsurancetrends will generally reinsurance sector sector, albeit a temporarysupport reinsurers' today." and opportunistic one, andcurrent ratings." thus generally considers the emergence of sidecars as a positive for the sector.MOODY'S/STABLE Catastrophe and ERM"Our outlook reflects Industry focus on Moody's notes that while athe generally sound catastrophe and sidecar is designed tobalance sheets and good Enterprise Risk achieve legal separationearnings momentum Management (ERM) from its sponsor, the two(absent catastrophes) might still be linked infor most reinsurers, practice.tempered by the in-herent volatility ofcatastrophe-relatedbusiness, the currentpricing pressure oncasualty lines ofbusiness and the easewith which capitalenters the market"
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