The bloom fades: new capacity is putting pressure on the primary U.S. casualty market, and reinsurers are shying away from some lines they think might be underpriced.

Key Points

* The primary casualty market is apparently softening more than the reinsurance market.

* Primary directors and officers premium rates fell 10% in 2004 in spite of increasing severity and claims costs.

* Security class action filings increased 17% from 2003, and approached the highs seen in 2000 and 2002.

* Higher levels of workers' compensation reinsurance are very competitive.

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While the property reinsurance market is a lush field for primary writers and their brokers, who easily find more than enough capacity to fill their baskets, some of the blooms have faded for the U.S. casualty reinsurance market, leaving primary writers to carry more of the risk themselves in some cases.

Reinsurers simply aren't as hungry to fill demand for some casualty lines, experts said.

"In the property market, if you hit the proper price, you'll find an abundance of capital. Well-priced programs are materially oversubscribed," said Linda Johnson, executive vice president of casualty reinsurance for Benfield Group plc. "The casualty reinsurance market had signs of softening on Jan. 1, 2005, but the renewal process was orderly and reinsurers were not succumbing to inadequate pricing."

In some fines, such as medical malpractice, the underlying primary writers sought increases of 5%, to 20% in some difficult states. Reinsurers, who generally receive a percentage of the primary writers' premiums, received the same rate increases without raising their rates directly, Johnson said.

In other lines of casualty business, such as directors and officers and employment practices liability, underwriting discipline appears to be softening more quickly among primary insurers than reinsurers, a trend brokers say is the reverse of the usual in a softening market.

"Reinsurers have been consistent with an attitude that you would see with a hard market, whereas on the primary side it has been quite soft," said Sean Mooney, chief economist for Guy Carpenter & Co.

"The fact that the primary market is apparently softening more than the reinsurance market is the opposite of what you would normally see, because the conventional wisdom is that the reinsurance market will lead the market down," said Julianne Jessup, head of research for Benfield Group. It's an interesting scenario, since primary insurers' margins will be squeezed if they lower their pricing more rapidly than their reinsurers do, she said.

Casualty Lines Soften

Casualty lines, particularly in the U.S. market, softened rapidly in early January on the primary side, a disturbing development for reinsurers that had been enthusiastic about the market over the past two years, said Mooney. "That's a scenario that's scary to the reinsurers, particularly when they're basing their pricing on the premium volume," he said.

Ironically, many players may have been drawn to the U.S. casualty market because of softening in the property market. According to a Willis Re report, "there's some evidence that predominately property-oriented reinsurers are starting to show greater interest in casualty lines because the softening in the property market is perceived to be more pronounced than the casualty lines."

More players in the market often means more pressure on pricing. While many reinsurers' enthusiasm for U.S. casualty lines over the past two years has led to competitive pricing, casualty rates still haven't deteriorated to the same extent as property rates, Jessup said. Competition in U.S. casualty lines is risky business, she said, as that is where many reinsurers struggling with reserving issues from prior-year business have been hurt.

"I don't know of any other market where you have the issues of punitive damages and jury awards for liability, as in the U.S. market," said Jessup. "There are increasing liability risks in other markets, but nowhere near the extent as in the United States."

Corner Office Cornered

Directors and officers premium rates fell 10% in 2004 in spite of increasing severity and claims costs. Not since Sept. 11, the collapse of Enron and the Y2K scare have insurance buyers seen such a decline in D&O prices, according to a study by the Tillinghast business of Towers Perrin.

"It's a very tough line," Johnson said. "The question is what is the proper pricing? What will the ultimate losses be? No one anticipated the losses of 1999 and 2000."

Reinsurers have taken steps to limit their losses by asking for loss ratio caps, or additional exclusions. "They are looking at accumulation," Johnson said. "They're not supporting as many programs as they have historically."

Mark Lescault, head of divisional underwriting at Swiss Re Group's Americas division, said there seems to be new primary D&O capacity entering the market, and the new players haven't had the past exposure. According to the Tillinghast survey, much of the current softening in the D&O market can be attributed to the new capacity now available in the market. Capacity hasn't returned to the level it was in 2000, when it peaked at $1.58 billion, but it's returned to 2002 levels at $1.5 billion.

"Reinsurance has a lot of concerns that the price increases aren't warranted. Frequency is still high. Reinsurers are being pretty tough on D&O, asking for tighter terms, conditions, and rates are going up," Lescault said. "It's honestly more difficult for primaries to fill out their programs, and some ceding companies have to fully take on some of the loss participation."

What drives the reinsurers' attitude in these lines, particularly in higher layers of coverage, are concerns about the possible impact of additional financial scandals, or scandals hitting industries that so far have escaped such problems, Mooney said. Litigation, such as shareholder lawsuits, is also a big concern. According to a study by Cornerstone Research, security class action filings in 2004 increased 17% from 2003, and approached the highs seen in 2000 and 2002.

"There is concern that there is activity going on out there that insurers on the primary side don't know about and aren't pricing appropriately for" said Mooney.

Workers' Comp Worries

Reinsurers also are keeping a close watch on workers' compensation insurance, especially the excess layers.

"I wouldn't put it in the difficult category yet, but it's a line to watch," said Johnson. "On the insurance side, it's heavily regulated. But on the reinsurance side, there's a significant divergence in opinion in views on loss development and medical inflation trends."

She said it's surprising, but "some really smart actuaries draw different conclusions on what a difficult price is. My gut is that on the lower levels, workers' comp is a very good place for reinsurers right now. But in the excess layers, the higher you go up in the program, the more competitive the programs are."

Historically, the upper layers of workers' comp have been extremely profitable, at least until Sept. 11, 2001. "Other than that, there have been very few losses there," Johnson said.

Before Sept. 11, life reinsurers were active in the workers' comp catastrophe business, Lescault said. After Sept. 11, many life reinsurers fled the market, leaving it to property/casualty reinsurers.

"When the P/C returned to the business, it was under tighter terms and conditions. That has been maintained, plus significant rate increases that truly reflect the risk and exposure have been maintained. We've see a little rate deterioration, but it's mostly at strong, adequate levels," Lescault said.

Also, reinsurers may see less demand for their products as ceding companies increase their retentions, Willis Re said. And as "structured" reinsurance deals come under greater scrutiny, reinsurers may decide to redeploy capital to more traditional risk transfer products, which would expand the supply and put additional pressure on prices, terms and conditions, Willis said.

"We believe the market will continue to give back some rate and expand/loosen terms and conditions for most casualty clients" Willis said.

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--David Pilla contributed to this article.