Reinsurance waltz: Hurricane Katrina, skepticism about modeling, and continuing state and federal investigations are giving annual reinsurance negotiations some new turns.

The annual mating dance between ceding insurers and reinsurers has grown more complicated in some ways as the industry faces new questions.

What does it mean that the initial losses from Hurricane Katrina predicted by catastrophe models were off? How will 2005, a year that's churning out the heaviest insured losses in the industry's history, impact reinsurance pricing, terms and conditions? Not to mention the industry, is still coming to terms with a spate of state and investigations into broker commissions, bid rigging and inappropriate finite reinsurance contracts.

"We might possibly have more difficult negotiations," Matthias Weber, a member of Swiss Re's extended management board, said at the Casualty Insurers Association ca's annual conference in "Katrina is definitely an event that created and still creates distortion between demand and supply. By 1] the supply and demand need to be balanced. Right now, no one really knows where the balance point will end up being."

The Ceding Dance

Generally, the ceding dance with the primary insurer's rein committee, typically composed of the head of underwriting, head of claims, chief financial officer and chief executive officer.

"The first question they have to ask is what are the risks that they are underwriting, and based on their capital, surplus, and ratings from A.M. Best or other agencies, what is risk that they can handle," said Vibhu Sharma, chief financial officer of John B. Collins Associates, a reinsurance broker.

Then the company begins a discussion with a reinsurer, sometimes including a broker or consultant.

Reinsurers will respond, saying they'd offer to take up a certain amount of risk for a certain premium under a traditional reinsurance contract.

"Reinsurance companies will price for that based on either exposure or experience," Sharma said. Other types of reinsurance, such as quota share, or excess of loss, require a more complicated process, with the reinsurer often demanding more detailed information.

Who wields more power in the discussion varies from line to line and from pricing cycle to pricing cycle. In times of a soft market, the primary writers often have more pull, while hard markets tend to favor reinsurers, who can push for higher pricing and tougher terms.

"The reinsurance market can change its pricing and terms overnight. The rub is ceding companies' [prices] are regulated, and can only improve incrementally, where reinsurers can double the price if they want to at renewal," said Paul Karon, chief executive officer of broker Benfield's U.S. operations. "It can take some time for that to flow through the system"

Risks are not judged simply on their merits.

For instance, reinsurers might view some risks as attractive because they help diversify the reinsurer's book of business, Weber of Swiss Re said. Other risks might be less attractive, because they correlate with everything else the reinsurer wrote.

"There are risks that are easy to quantify and others where the uncertainty is quite large. Then the reinsurers are a little more cautious," Weber said.

Reinsurance is likely to cost more when there is more uncertainty, for instance in longer tail lines such as workers' compensation and general liability. "In contrast, property has a very short tail and is attractive. But property requires catastrophe capacity, and reinsurers need to get a fair price" Weber said.

Changes in the Wind

This year, many expect to see lines impacted by Katrina harden.

Weber said those lines hit hardest by the hurricanes--property catastrophe, marine, energy and U.S. wind coverage--would face "significant" price increases.

"There is a lot of uncertainty. Katrina is a watershed event," said William E. Donnell, chief marketing officer of GE Insurance Solutions.

On the property reinsurance side, Sharma said he expects reinsurers to change their behavior from insuring large blocks of coverage to covering smaller, regional blocks. "That will help them narrow where the exposure is and improve the rates for it," he said.

Also, he said, reinsurers may not be able to purchase a lot of retrocessional coverage, and so they would offer lower limits. And reinsurers also may limit certain perils, such as wind.

While the winds of Hurricane Katrina have long since stopped blowing, they are still causing change in the way insurers operate. Property catastrophe coverage has historically been very model-driven, and Katrina has shown that the models may not be accurate predictors of exposure and loss, Sharma said.

For instance, Allstate Corp. said it didn't buy reinsurance in Louisiana because models showed a "one-in-500-year" risk of a Katrina striking Louisiana. A one-in-100-year event means there's a 1% annual probability of such a strike; a one-in-500-year event means there's a 0.2% annual chance. Instead, Allstate concentrated its reinsurance program on high-risk areas, such as Florida, where the company could recoup the cost of the reinsurance through premium increases.

"That's one clear thing that has come out. There was too much reliance on models for making business decisions. It's an important factor in your decision making, but it's not the only factor" Sharma said.

Relationship Business

Katrina may be the single largest loss the industry has ever faced, but it shouldn't result in hardening across all lines and in all markets. While some January renewals will be delayed, some that weren't impacted by Katrina could be resolved sooner rather than later, Weber said.

Sharma said while property catastrophe reinsurance rates are likely to harden significantly, he didn't expect other property/casualty lines to see significant increases or decreases. "We're not expecting to see medical malpractice reinsurance rate increases because of Katrina," he said.

Benfield's Karon said reinsurers try to operate as a relationship business.

"Companies that are successful with their reinsurers have trusting relationships built over time, and prices are fair and based on exposure, not on how much either the reinsurer can take or the client can extract. It goes both ways. The idea is the treaty relationship should be treated as a partnership," Karon said.

That's coming into play now, GE Insurance Solutions' Donnell said. So while much of the market still faces much uncertainty dealing from the fallout of Katrina, companies that weren't directly impacted by the storm shouldn't have to face higher prices and tougher terms, he said.

Smaller, middle-market companies have been concerned and have asked Donnell how Katrina would impact their rates. "Despite all the chaos in the industry, we're expecting a smooth renewal season for our middle-market accounts," Donnell said. "Clients that have a good handle on exposures, have transparent data and want to build relationships with their reinsurers will find a smooth process."

If reinsurers gain an edge in negotiations post-Katrina, it will likely be a short-lived advantage, Sharma of Collins said. Companies were able to quickly raise capital--more than $5 billion--plus more hedge funds are entering the market every day.

"We have hedge funds lining up around the block right now, and they want to enter the reinsurance assumed game," Karon said. "The best thing about hedge funds is they have dampened the price shock that we would have had if they hadn't been there. They were a big part of the reloading of Bermuda. The fact that the capital is out there ready to come in keeps the rates from doing Andrew-type things."

Property catastrophe is a perfect line for hedge funds to enter, Sharma said. "All other lines are too long-tailed. Like the Powerball jackpot, either you won or you didn't win, but you know at the end of the year. It's not something that has to be played out three years down the road."

Moving Forward

Despite pressing uncertainties, including state and federal investigations into insurers' bid rigging, broker compensation and finite reinsurance, companies are moving forward with renewals.

"Everyone is talking to more reinsurers" said James Whitelaw, marketing leader, North America & Asia P&C Reinsurance, GE Insurance Solutions. "What we see is a lot more activity in the renewal system."

Karon noted that the additional pressure rating agencies, including A.M. Best Co., are putting on insurers and reinsurers to manage their risk and capital could ultimately lead to a more efficient market.

"Where the business is going now is toward what I call front-door solutions. We are using technology to help carriers pick the right policies in the first place, and the right distribution of policies. So instead of just aggregating a bunch of risk and saying 'Oh my, look at all this risk I have!' and laying off some of it by purchasing reinsurance, the solution needs to harness the technology that exists and look at a company's books," Karon said.

For instance, perhaps by eliminating 1% of a primary insurance company's book of business, the company could lower its probable maximum loss by 20% to 30%.

"We're helping insurance companies pick the right insurance policies, instead of just buying reinsurance," Karon said.

Also, while the market faces unanswered questions, it has not reached the same level of turmoil that followed other major catastrophic events. Unlike after the terrorist attacks of Sept. 11, 2001, and Hurricane Andrew in 1992, the market is running fairly smoothly in response to a major event, Karon said. "After 9/11 and Andrew, the market really seized up. No one knew what to do. Now insurers are raising capital. The day after Katrina hit, [reinsurers] had a banner sales day," Karon said.

"Is reinsurance going to cost more? Yes. But after 9/11 and Andrew, coverage couldn't be placed at any price. That's not happening now," Karon said.

Key Points

* Those looking to buy reinsurance for property catastrophe risks are likely to find higher prices and tighter terms and conditions.

* Lines and companies that did not experience losses directly related to Hurricane Katrina shouldn't see wholesale increases and tighter terms for reinsurance.

* The market is still functioning well, and unlike the aftermath of other major catastrophes, capacity is still available.

Learn More

GE Insurance Solutions Group A.M. Best Company # 00347 (Employers Reinsurance Corp.)

Swiss Re Group A.M. Best Company # 85010 Distribution: Reinsurance brokers

Allstate Insurance Group A.M. Best Company # 00008 Distribution: Exclusive agencies

For ratings and other financial strength information about these companies, visit www.ambest.com.