Down, but not out: brokers say property reinsurance pricing continues to soften.

Key Points

* Reinsurers are seeing a shift in focus in property coverage from pricing to negotiations over terms and conditions.

* U.S. market competition will continue to feed primary insurers' demands for security guarantees from reinsurers.

* Pricing pressure and improved technical techniques for measuring risk are encouraging securitization as an alternative to reinsuring risk.

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As results emerged from the Jan. 1, 2005, reinsurance renewal season, brokers working in the market noted trends that appear almost counterintuitive.

Despite a record year in 2004 for property catastrophe losses, pricing continued to soften, with the sole exception the property treaties in regions directly hit by hurricanes and typhoons. In other lines of business, such as directors and officers coverage and other professional liability and U.S. casualty lines, underwriting discipline appears to be softening more quickly among primary insurers than among reinsurers, a trend brokers say is the reverse of the usual in a softening market. (See "The Bloom Fades" on page 68.)

A record four hurricanes in Florida in the third quarter, in addition to a record 10 typhoons hitting Japan, helped slow- a softening trend in property and catastrophe coverages, but their effect was surprisingly limited in the market overall, said Scan Mooney, chief economist for reinsurance intermediary Guy Carpenter & Co. "Our expectations back in August and early fall certainly changed, because of the Florida hurricanes and typhoons in Japan," he said. "That changed the general tenor of the market, so it was not as soft as what we have seen earlier in the year."

The consensus among reinsurance brokers is that the Dec. 26 earthquake and tsunami that devastated coastal areas around the Indian Ocean occurred too late in the year to affect January renewals. While that disaster was unprecedented in its sheer scope--at least 200,000 people dead--the insurance implications are relatively small, since most of the destruction was uninsured.

Hurricane Effect

Julianne Jessup, head of research for reinsurance intermediary Benfield Group plc, said the single biggest surprise coming out of January renewals is the limited effect of 2004's catastrophes on pricing. "If you had said to anyone in the market on Jan. 1 last year that we would have $40 billion in catastrophe losses, and the market would still be softening, nobody would believe that," she said.

"The reason for that is that the hurricane losses in the United States didn't hurt the reinsurers that much," said Jessup. "Because there were tour losses, a lot more of the claims were retained in the primary market, as opposed to what would happen if we had another Hurricane Andrew."

Jessup also cited a "feel-good" factor in the reinsurance market, fed by several years of good returns and balance-sheet strengthening among reinsurers. "That factor leads underwriters to believe that they have scope for cutting rates," she said.

The low impact of 2004's substantial catastrophe losses is even more startling when the previous year is taken into account. Insured losses from catastrophes in 2003 totaled $18.5 billion. In the United States, 2003 catastrophes cost insurers $8.6 billion, an aggregate from a series of disasters that individually weren't particularly large.

Jessup pointed to "an ample amount of capacity" as the reason none of these losses had a strong impact on pricing. "After 9/11, there was a lot of new capacity coming into the market, mainly in Bermuda but in Lloyd's as well," she said. Despite pressure from investors and rating agencies to clamp down on underwriting, abundant capacity combined with the feel-good factors led reinsurers to believe they have to compete for market share, she said.

Catastrophe modeling techniques got a closer look from underwriters after the unprecedented frequency of storms in 2004, said Mooney. "I wouldn't say it has caused rethinking about modeling, but it's caused people to look at the recalibration of the models," he said. "Given that the models show how much an insurer can expect in losses given a storm of a certain intensity, actual losses from these events showed some discrepancy."

Existing models do point the way toward further refinement of modeling techniques, he said.

Recent catastrophes notwithstanding, reinsurers are seeing a shift in focus in property coverage from pricing to negotiations over terms and conditions, said Mooney. "We are not seeing that shift in emphasis so much in casualty lines, except possibly workers' compensation, which is getting a lot more technical," he said.

One other issue on the minds of reinsurers this year is the Terrorism Risk Insurance Act, which the U.S. Congress hasn't yet decided to extend beyond the end of this year. Mooney said the fate of TRIA hasn't played a big role in January renewals, since those contracts will expire on the same day as TRIA, if the latter isn't renewed. He predicted more concern about TRIA as more renewals come up during the year.

Financial Security

U.S. market competition will continue to feed primary insurers' demands for security guarantees from reinsurers. According to Jessup, Benfield polled its brokers and found that terms and conditions rank high in clients' minds, but slightly lower than cost or pricing, and roughly on a par with the financial security of the reinsurer. "They want to know that the reinsurer is secure and is going to be around in five or 10 years," she said.

Counterparty credit-risk analysis, which Benfield provides to its clients, is in growing demand, said Jessup.

Pricing pressure and improved technical techniques for measuring risk are encouraging securitization as an alternative to reinsuring risk. Catastrophe bonds are a growing, though still small, form of securitization, and they have had a boost from 2004's storm experience. Another interesting trend is the growing presence of hedge funds in the reinsurance market, said Mooney.

"A significant move we've seen is hedge funds coming into the business as a source of capital," he said. Hedge funds often do business in U.S. reinsurance markets on a fronting basis, sometimes on a direct basis, usually through an international market such as Bermuda, said Mooney.

"It's been a trend through the 1990s, and even more so in the 21st century, that there's a growing community of investors that are knowledgeable about insurance market transactions," Mooney said. "The source of capital for reinsurance is larger and more diversified than in the past."

Securitization techniques have "exploded" the notion that there is a fixed, limited amount of capital available for any particular type of risk, a trend begun with the creation of the California Earthquake Authority in 1996, funded partly with investors' participation, said Mooney. "Increasingly, when someone asks how much capital is available to cover a certain type of risk, the response is, 'At what price?'," he said.

"Some hedge funds have quite an appetite for writing property catastrophe business," but the amount of capacity provided by hedge funds in 2004 was still small, said Jessup. "There's quite a lot of potential out there for capacity via hedge funds. At the moment, they're not major players in the reinsurance market."

Reinsurance transactions involving hedge funds are fully collateralized, mitigating any perceived credit risks related to them, said Jessup. Hedge funds "are not directly involved in the underwriting, strictly speaking," she said. The reinsurance expertise comes from brokers and other sources brought in to support the transaction.

The verdict on the January renewal season this year is that reinsurance markets are down, but not out. Benfield's Jessup said competition and weaker pricing have been fed in part by very robust performances in the past two years.

"We're not predicting a headlong rush into the kind of soft market we had in the 1990s," she said. "We still feel the market's quite finely balanced." The big difference, she said, is that the bull market for stocks in the 1990s is no longer there, denying reinsurers the cover strong investment returns provided for weak underwriting results.