A.M. Best: Reinsurer Financial Strength in Balance.

OLDWICK, N.J. -- A mix of positive and negative forces continues to influence the financial strength of reinsurers, according to A.M. Best Co. in the special report, Global Reinsurance. The net effect continues to be a largely stable financial strength ratings environment. Positive factors include high current accident year profitability, and a clear trend in higher quality underwriting control and analysis. Offsetting factors are concerns about continued adverse development in U.S. casualty lines combined with the challenge of how reinsurers will balance capital adequacy and profitability in a softening market.

Headline accident year profitability has been robust to date, although the ongoing highly active hurricane season will see full-year results worsen from the half-year position for a number of reinsurers. Moreover, for a number of the larger reinsurers, underwriting results remain somewhat disappointing given market conditions, raising doubts about the sustainability of underwriting profitability given any material softening in market conditions.

The ongoing risk from the 1997-2001 U.S. casualty market has again been very clearly demonstrated by the recent reserve actions at Converium. The potential for further recognition of asbestos losses also remains. The uncertainty continues as to whether reinsurers are fully recognising their exposures, especially given the apparent disconnect with the generally higher levels of reserving among U.S. primary companies. With adverse development most commonly recognised into the 3rd and 4th quarters, it would be very optimistic to assume that no further bad news will emerge from the reinsurance market over the coming months.

Risk-adjusted capital strength has recovered somewhat for the traditional players, reflecting both capital raising initiatives and reductions in insurance or asset risk exposures. A particular focus has been the management of reinsurance recoverables, a very important factor given the rise in reinsurance disputes, in addition to the overall reduced creditworthiness of the industry. However, while recoverable leverage is being managed down, there has been a corresponding increase in the use of debt capital, hence increasing the industry's financial leverage.

For the post 9/11 new entrants, market conditions have, of course, been extremely attractive in terms of both pricing and low levels of catastrophe losses. This, in turn, has supported the maintenance of the very high levels of risk-adjusted capital required for a typical start-up to achieve an initial A.M. Best rating of A- (Excellent). These high levels of risk adjusted capital will now be key as catastrophe losses show the inevitable return to trend just as a significant softening in global property pricing has occurred. The capital is also key in supporting the moves made by start-up's into casualty/liability lines where, notwithstanding apparently attractive headline rates, A.M. Best believes there remain material risks from both underpricing and, for new entrants especially, adverse selection.

A fundamental structural challenge for the industry will be its management of capital into a softer market. While recent catastrophe losses may firm up relevant property lines in the short term, an ongoing softening trend overall seems very probable. Casualty/liability lines too have largely peaked after adjusting for loss cost inflation.

Given this pricing environment, reinsurers will need to address how they seek to balance shareholders' expectations for return on capital employed with their ongoing risk-adjusted capital adequacy. Returning capital to shareholders and writing less new business in a soft market makes every sense economically. But, since reserve and asset risk will persist, there is the consequent need to retain capital to support this if a reinsurer's financial strength is to be maintained. If however, in doing so reinsurers feel pressure to then use this capital to write more volume, then the widely claimed commitment to underwriting discipline will prove to be as much of an illusion this time around as in previous cycles. This is a particular risk in casualty, given the potential for new business to seem to be better selected than it subsequently proves.

The cumulative effect of these issues is that, notwithstanding current profitability and partially restored balance sheets, A.M. Best believes reinsurer financial strength will not generally recover to its historic levels, but is more likely to achieve an equilibrium point between the conflicting needs of shareholders and cedants for the use of capital. In particular, A.M. Best expects reinsurers will seek to maintain sufficient through the cycle capital to support financial strength ratings in the A+ to A- range (issuer credit ratings of aa to a-).

For current Best's Ratings, independent data and analysis on more than 470 reinsurance companies, please visit http://www.ambest.com/reinsurance/.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at http://www.ambest.com.