Hurricanes - financial impact: A storm is coming

stormcoming

After a good year in 2009 for the reinsurance industry, Philip Alexander warns of the perils heralded by the Atlantic forecast for this year, as 2010 looks to be beset by stormy weather.

For the reinsurance industry, 2009 was a good year. It was relatively catastrophe free and this, coupled with a recovery in investment markets, resulted in many companies reporting strong profits and an increase in their available capital resources. Many reinsurers entered 2010 in the best financial shape they had been for years.

Analysts who follow the industry argue there has been a build up of excess capital. For example, Barclays Capital estimated that the total capital positions of property & casualty insurers and reinsurers appeared redundant at the end of 2009 by a median factor of 21% — with approximately $100bn (£65bn) of excess capital available to the US P&C insurance sector alone.

Excess capacity has resulted in rates in reinsurance markets falling. Some companies have sought to address this through the repatriation of funds to shareholders, with $8.8bn or 7.7% of aggregate shareholder funds being repaid in the first half of 2010. However, it seems that this is having little effect, with many commentators arguing that the industry will have to be hit by major catastrophe losses, on the scale of hurricanes Katrina or Ike, before rates start to recover.

Both Guy Carpenter and Aon Benfield reported that, even after a series of losses in the first half of 2010, rates for the 1 June Florida renewal season had fallen by 10% to 15%. These losses included those for the Chilean earthquake and Deepwater Horizon, which are estimated to have cost the industry between $15bn and $20bn. The net result has been rates falling to levels last experienced in 2008 — despite the fact the outlook for the 2010 hurricane season is not benign, with Hurricane Alex, the first major hurricane of the season, already having hit the Gulf of Mexico.

Hyperactive season
The National Oceanic and Atmospheric Administration's 2010 Atlantic hurricane season forecast predicts a very active and possibly hyperactive season. It gives an 85% chance of an above-normal season; a 10% chance of a near-normal season; and just a 5% chance of a below-normal season. The NOAA predicts a 70% chance of there being 14 to 23 named storms, eight to 14 hurricanes, and three to seven major hurricanes.

These forecasts are supported by research undertaken by Dr Bill Gray. He expects "a hell of a year", but does not expect a repeat of the unprecedented violence of the 2005 hurricane season, which saw 28 named storms, 15 hurricanes, and seven intense hurricanes. But he does expect there to be at least four major hurricanes this year — against an average year of just two.

2010 could, therefore, be the year that delivers major hurricane losses. A loss on the scale of Katrina could result in reinsurers having to use their capital to fund losses and, unlike 2005 when economic conditions were more favourable, it is unlikely every reinsurer will be able to top up their depleted reserves by attracting new capital from outside the market. Under this scenario the capacity available within the market will fall causing future rates to rise.

Structural changes
However, there have been structural changes in relation to both pricing and the nature of companies providing cover in the Floridian insurance market since 2005, which have altered reinsurance buying and need to be factored in to any analysis when considering future reinsurance rates.

Since 2005 rates in the primary market have been kept artificially low and set using arguably actuarially unsound rates — through the imposition of limits on increases to protect policyholders from abrupt and massive rate hikes. A number of national companies have pulled out of the Florida market and state-based insurers, including Citizens Property, have stepped in to take up the slack. This has reduced the demand for reinsurance as the Florida Hurricane Catastrophe Fund has provided a basic level of hurricane reinsurance for all admitted insurers writing residential property insurance.

Insurers are finding it tough with some insurance industry executives saying rates are not high enough to build claims-paying reserves. They note that even though Florida has gone four years without a major hurricane, many property insurers lost money in 2009. In the latter part of 2009 and first half of 2010, three property insurers have gone into receivership and Florida's Office of Insurance Regulation notes that many other companies are in financial trouble.

These financial troubles increase the credit risk for reinsurers and decrease the desirability of writing reinsurance for all but the strongest companies. In 2009, concerns over Florida primary insurer credit quality affected reinsurance rates. In instances where there were creditworthiness issues, surcharges were levied to cover the risk of non-payment of premiums. However, rating reductions were offered to the stronger players.

During the 2009 renewal there was a perceived imbalance of excess demand chasing limited capacity and this drove prices higher. As the renewal reached completion, the market saw capacity ultimately exceeding demand by 15% to 20%. For 2010, Guy Carpenter reports that client demand has remained stable, with retentions and limits remaining essentially the same as last year. Reinsurers, with their balance sheets largely improved, have excess capacity available and the rate increases that were pushed through last year have largely been reversed.

Further implications
The impact of the financial crisis and the reduction in property values has further implications as the underlying values of insured property have fallen, reducing the need for primary insurance and for insurers to purchase reinsurance.

An excess of capacity and falling exposures is a potent mix and one that could have disastrous implications for reinsurers. Commentators that argue the market needs a major loss to correct the position may be in luck. The 2010 hurricane season forecast suggests conditions are right for there to be such a loss. But they should be careful what they wish for, particularly with thousands of barrels of crude oil being spilt into the Gulf of Mexico over the past three months.

Philip Alexander is an insurance specialist and partner with accountancy firm Littlejohn

What next for reinsurance rates?
When will prices start rising again?

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