Restoration Operation.

Special report: Global reinsurers look to restore profitability through disciplined underwriting, prudent capital allocation and improved operating efficiency.

Market forces--globalization, deregulation, and technology--continue to transform the competitive landscape of the financial-services industry. The ability to innovate, execute and control are critical success factors in this dynamic environment. A.M. Best Co. believes that reinsurance industry leaders are competitively well positioned to capitalize on these changes while those that lack the financial fortitude and operational agility will continue to fall prey to consolidation.

The financial strength of the global reinsurance industry remains strong, despite prolonged competitive market conditions, which have affected recent years' earnings and resulted in lower reserve margins. Consolidation has had a strong role in weeding out the weaker market participants in this segment. As a result, there has been a significant contraction of market share, with the top four reinsurers commanding roughly one-third of the global reinsurance market. Given their dominant position in the world markets, unquestioned financial strength and generally strong performance, these largest organizations command A.M. Best's highest ratings.

The following discussion largely focuses on the financial condition of the U.S. reinsurance industry. However, the significance of this market makes it highly representative of conditions affecting the global reinsurance industry.

A Market Compromised

While recent years' results reflect the deterioration in general market conditions, historically, reinsurers have produced above-average results as compared with the total industry. On average, U.S. reinsurers outperformed the total property/casualty industry by nearly 10 points, based on after-tax net income as a percentage of net premiums earned, for the five-year period ending Dec. 31, 1999. But given the sector's excess capitalization--a factor that continues to fuel competition--returns on equity have been less favorable, marginally underperforming the total industry.

The leading global reinsurers have benefited from risk diversity in both business class and geographical territory. Stable profitability from life reinsurance operations and significant investment earnings bolstered by increased realized capital gains generated from their sizable investment portfolios have helped mitigate the recently weak and, at times, volatile performance of their nonlife risk portfolio.

Despite the fundamental strength of the reinsurance industry, the erosion of underlying earning trends in recent years and uncertainty about the future's challenges and prospects have caused concern among industry observers. When A.M. Best examines the prevailing market conditions, however, the sector's recent earnings performance is not unexpected. The underlying trends reveal clearly what has happened and provide an indication of what can be expected over the near term.

The excess capitalization in both the primary and reinsurance sectors has been augmented since 1997 by significant increases in realized capital gains. This has fostered severe competition, manifested in declining product demand from primary companies and increased use of alternative risk-transfer methods. As a result, net premium growth has been relatively flat over the five-year period, with a compounded annual growth rate of only 3.7%. Reinsurers have maintained this modest top-line revenue growth--forsaking near-term underwriting profitability--by lowering rates, relaxing terms and conditions, developing new and innovative risk-management strategies and expanding into global reinsurance markets through acquisition.

Compromises in underwriting discipline have resulted in a deterioration of accident-year loss and combined ratios, beginning with unfavorable loss emergence in 1996. The effects of weaker pricing have been compounded by an increase in the frequency and severity of catastrophe losses that occurred around the globe in 1998 and 1999. Gross catastrophe losses totaled $14 billion in 1998 and $24.4 billion in 1999. Reinsurers took their share of these losses, which weighed heavily on their bottom lines.

Until 1999, the reinsurance sector's deteriorating accident-year underwriting performance had been masked by the release of prior-year loss-reserve redundancies. In 1997 and 1998, reported loss ratios for the reinsurance industry had benefited from harvested reserve redundancies, providing roughly a three-point and 10-point benefit, respectively, each year. Weakening underwriting results also have been mitigated by realized capital gains, perpetuating the competitive pricing cycle.

By year-end 1999, after two consecutive years of increased catastrophe losses and depleted reserve redundancies, many reinsurers retrenched and refocused their operating strategies to restore underwriting discipline and return to more prudent reserving practices. In Europe and other parts of the world, many of the same market characteristics are evident, further hampering the profitability of the global reinsurance leaders. But some organizations have benefited from stable performance in their life reinsurance segments and favorable regulatory practices within their domiciles, which have allowed them build up equalization reserves to offset severe losses and smooth reported underwriting results.

In view of these developments, only the unknown seems certain and the questions all remain: How much further will the last three accident years develop, and can the reinsurance sector's current reserve picture be a meaningful indication of what is to come? Have the various underwriting actions taken by reinsurers been enough to improve the trend in future accident-year performance? Can sophisticated capital models help reinsurers to better allocate their capital resources to profitable business segments and help to improve overall profitability? And, should underwriting performance fail to rebound to favorable levels, will investment earnings be sufficient to fill the gap?

Maintaining Safety Margins

As loss reserves represent only an estimate of the ultimate liability for unpaid claims, reasonable fluctuations for each accident year are generally anticipated, especially as an accident year matures and more variables about specific cases, risk parameters and inflation become known. Reinsurers also must contend with added delays in reporting, due to the time required for a primary company to determine a reinsurer's participation and provide the first notice of loss. Nonetheless, it is the materiality of these fluctuations and historical reserve-development patterns over an extended period of time that generally provide confidence as to the reasonableness of a reinsurer's current reserve position and credence to a company's reserving philosophy.

Reserve trends for the U.S. reinsurance sector indicate that calendar-year loss ratios from 1990 to 1994 were negatively affected by reserve strengthening relating to the pre-1985 accident years, largely asbestos and environmental cases. During the early 1990s, primary insurers and reinsurers both increased their carried reserves relating to these long-tail latent liabilities to the detriment of calendar-year underwriting profitability. But beginning in 1995, overall reserving patterns started changing as reinsurers began to harvest available reserve redundancies from prior accident years and reduce funding of the old latent liabilities. These changes helped cushion the effect of emerging deterioration in current accident years brought on by inadequate pricing, relaxed underwriting criteria and increased catastrophe losses.

This more recent reserving trend is evident in a review of accident year reserve development over the same 10-year period. From 1990 to 1995, all accident years--with the exception of 1992, the year of Hurricane Andrew-developed favorably, indicating that reinsurers were generally conservative with accident-year loss picks creating reserve redundancies. In 1996, however, accident-year development began to trend unfavorably, indicating that reinsurers had generally been less conservative in establishing original loss estimates for the latter accident years.

While reinsurers were able to cushion this emerging adverse development in the more recent accident years with available prior-year redundancies, most companies in 1999 elected to refrain from further harvesting of these available reserves and instead returned to more prudent practices. As a result, the 1999 calendar-year loss ratio was 82.2, its highest since 1992.

Underlying development trends are changing due to changes that have occurred in coverage parameters, reinsurance terms and conditions, as well as concessions in pricing over the past several years. While actuaries attempt to set reserves using hindsight provided by analysis of historical data, they also must rely on their knowledge of the current business environment to select reserve estimates. Given the degree of change that has occurred in the reinsurance sector over the last several years, it is likely that actuaries have encountered exceptional difficulty in selecting accident-year loss picks. As recent accident years mature, original underlying reserving assumptions may prove incomplete.

The ultimate question remains: Are the current levels of carried reserves enough to reasonably provide for claim obligations, given the trends of the last decade? For an answer, one can look to measures, such as reserves to earned premium, which at year-end 1999 were at the lowest level in three years. Considering the erosion in pricing over the last severa1 years, this trend could be viewed as even more disconcerting.

Accident-year loss ratio trends also can be considered a reasonable indication of the conservative position in the reserve estimates. The obvious uptick in 1998 and 1999 indicates that reinsurers have taken a more conservative position for these accident years. This current position is no doubt the ramification of the negative accident-year trends developing for primary companies in workers' compensation, auto and other liability classes of business. But it is much too early to conclude on their ultimate outcome, given the relative immaturity of these reserves and the impact of catastrophes in these years.

Since 1990, the reinsurance sector's unfavorable reserve development has not been material, both in terms of percentage of surplus and to original reserve estimate. These measures indicate that reinsurers have been prudent in estimating loss reserves. Reinsurers' reserve funding for latent liabilities, such as asbestos and environmental, also appears to be conservative, supporting a 1999 survival ratio of 13.2 years, compared with an industry ratio of 6.6 years. Further, given the lengthy tail associated with liability business--currently representing more than 80% of total carried reserves for the U.S. reinsurance sector--and the reinsurance market's robust capitalization, A.M. Best believes a sufficient cushion exists to absorb a potential shortfall, unlike the early 1980s.

The Restoration Phase

Most global reinsurers are now seeking to restore historical profitability through business strategies that evoke more disciplined underwriting, prudent capital allocation and improved operating efficiency. While some are reporting early success, it has not yet manifested itself in improved performance.

The reported price firming may not be enough, considering the prolonged period and extent of prior rate decreases. As well, the long earnings tail associated with most reinsurance transactions will mean a delay in measurable bottom-line results. There is also always the possibility of a single catastrophe or series of events to impede the recovery process.

There is no doubt that underwriting discipline is key to restoring operating returns to appropriate historical levels. In addition, a new business model is emerging from some of the largest companies. This model employs multiple distribution networks, global reach into less mature markets, life and nonlife business platforms, nontraditional products and services and tax advantage strategies. These far-reaching changes can be directly linked to the pressure to not only maintain market share but improve and stabilize operating returns.

While greater earnings diversification has achieved greater earnings stability for some broadly diversified insurance organizations, it also presents significant challenges in performance management and measurement. Discrete business units may complement one another, but they must be able to stand on their own for the organization to benefit. The essence of reinsurance is the management of risk, and companies are continually developing new and improved tools to help manage risk while providing optimal returns.

Optimizing Strategy

The dramatic changes in the reinsurance sector have resulted in increased risk diversity on the balance sheet, necessitating better use of capital models as a tool for efficient deployment of capital to specific business segments. The increasing complexity of a reinsurance organization and the risks underwritten is causing management to struggle for an effective method to allocate capital while accurately measuring each business segment's profitability.

The current generation of capital models calculates risk-adjusted returns on capital. The basis for many of these models is the identification, categorization and summarization of risk, based on individual characteristics. Various methods and resources are employed to complete this difficult task, but once risk parameters are identified, the required level of capital to safely support a specific risk can be determined. These tools enable the effective evaluation of the profitability of a specific account, product line, business unit or territory; they also enable the total insurance organization to more efficiently identify current capital requirements and provide a reasonable basis for deploying capital to profitable businesses.

The U.S. reinsurance sector's returns on equity have averaged just under 15% since 1995, but in recent years have deteriorated materially due to weak underwriting performance. The relative strength of this historical return measure has prevailed, despite the perceived level of excess capital available in the reinsurance sector. Conceivably, capital models should enable reinsurers to price risks prudently in their efforts to rejuvenate underwriting profitability and avoid risks that do not provide an acceptable level of return on capital.

These models also should support corporate management strategies that seek to more effectively deploy excess capital to new business ventures that provide greater return opportunities than achieved through investment activities. Thus measures of profitability should improve as excess capital is deployed to the most profitable business segments.

While capital models and dynamic financial-analysis models have been used by U.S.-based reinsurance organizations for some time now, they are increasingly being utilized by global non-U.S. based reinsurance organizations. Globalization efforts and entry into the U.S. reinsurance market have fostered a need for improved financial transparency and a consistent method by which to evaluate the financial stability of an organization. For generations, these non-U.S. reinsurance organizations had little concern about impressing unaffiliated investors with robust return measures, due to the extent of cross holdings in other sovereign corporations and regulatory protections which muted return measures.

With all the changes occurring across Europe--the formation of the European Union, adoption of International Accounting Requirements and changes in local tax and insurance regulatory codes--multinational organizations are now seeking methods by which to optimally manage and deploy capital. The increased sophistication of these models and technology advances have rendered them as a reliable resource for the prudent allocation of capital throughout a complex organization and management of risk-adjusted returns on capital for the total organization as well as for specific business segments.

The recently enacted changes in German tax law, which are to take effect in 2002, promise to free up significant capital resources for some of the larger multi-national giants, as they unload these cross-holdings without the burden of capital gains taxes. A.M. Best believes this new liquidity will result in further consolidation of the industry as excess capital used to facilitate expansion into new markets through acquisition. Continued globalization is also likely to result in many of these European giants seeking listings on the U.S. security exchanges, once their methods of financial reporting conform to Securities and Exchange Commission requirements and can be readily compared with competitors.

Managing Returns

Since 1996, realized capital gains have played a material role in the net income performance of the U.S. reinsurance sector, bolstering returns as investment yields have declined over this period. In fact, without the benefit of realized capital gains in 1999, the year's net income would have been considerably lower than reported.

With pretax operating returns measuring less than 1%, based on both revenue and equity, the availability of capital gains from equity investments was key in mitigating the year's significant underwriting losses. This clearly illustrates the importance of a strong investment-management strategy and the need for an appropriate balance of risk, particularly given the recently challenging underwriting environment and lower interest rates that have prevailed over the last several years.

This sector has generally maintained a higher percentage of invested assets in equity holdings as compared to the total property/casualty industry. At year-end 1999, U.S. reinsurers had 27% of their invested assets in equities, compared to 20% for the total U.S. industry. This seems to parallel the total return approach long taken by European reinsurers that has now transcended the global reinsurance sector. The excess capital built up by many reinsurers has afforded them greater financial flexibility and the ability to take higher investment risks than primary insurers.

While high-quality fixed-income securities are still viewed as a more dependable driver of investment earnings stability, the increase in interest rates in 1999 caused significant unrealized losses on these holdings. This added to the year's poor underwriting performance and, despite the realized capital gains from equities, reduced the reinsurance industry's total return measures to almost zero.

While most reinsurers were able to realize some capital gains to preserve overall profitability, unrealized losses stemming from fixed-income portfolios contributed to the industry's first loss of capital in recent history. Global reinsurers domiciled outside the United States, but with significant investment holdings in U.S. currency, were somewhat cushioned from the rising U.S. interest rates on fixed-income investments. The decline in the euro against the U.S. dollar partly negated the losses from the decline in market values of bond holdings.

Tax management is also playing a larger role in reinsurers' investment and operating strategies, evidenced by the number of redomestications to Bermuda. Domiciling a parent or affiliate in a tax-advantaged country allows a company to take advantage of the favorable tax treatment on investment earnings. More companies are seeking to enhance overall earnings through a managed tax strategy.

Market Outlook

Despite the more conservative operating stance adopted by many of the global leaders, A.M. Best believes it will take at least one year to achieve the anticipated turn around in underwriting performance, assuming a normal level of catastrophe losses. Therefore, 2000 is expected to be a year of transition for the global reinsurance sector, with improved profitability--more consistent with historical trends--not fully emerging until 2001.

The prolonged recovery reflects the fact that meaningful rate increases did not take effect until after the January 2000 renewal season was completed. As well, a number of three-year contracts remain in force with year-end 2001 expirations, which also will impede recovery.

While underwriting performance will take time to improve, the leading global reinsurers remain well-capitalized and are well-positioned to withstand the lingering negative market forces. In addition to restoring underwriting discipline, most global reinsurers have implemented multifaceted business strategies to optimize capital, improve earnings diversity and gain operating efficiencies. The culmination of these actions should enable this industry segment to restore future earnings to historical levels.

The gap between the top-tier global reinsurers and the smaller market players continues to widen, as the significant capacity of these industry leaders enables them to seize new business opportunities. Reflective of their dominant position in a consolidating marketplace and superior level of financial strength, which enables them to effectively withstand a downturn in the market, these companies continue to command A.M. Best's highest ratings. While we believe regulatory and competitive forces will challenge these organizations, it is anticipated that they will have a hand in reshaping and redefining the future of the reinsurance industry.