Waiting for the hard market

Three of the top 10 costliest natural disasters for the insurance industry occurred in 2011. The hit to the operating performance of reinsurers points to higher rates in 2012, but long-term relationships between insurers and reinsurers might suffer and price increases would be difficult to pass on to consumers, say Garth MacDonald of Island Heritage and Bart Hegdes of Greenlight Re.

Globally there were more than 240 catastrophic events in 2011, including severe flooding in Australia, the earthquake in New Zealand, the earthquake and tsunami in Japan, tornadoes in the US, Hurricane Irene and flooding in Thailand.

The extreme political and macroeconomic uncertainty in addition to an unusually high number of natural disasters turned 2011 into a very difficult year for reinsurers, according to Bart Hedges, CEO of Cayman reinsurer Greenlight Re.

Speaking during a panel debate at the Cayman Captive Forum on how this year’s events will affect the market in 2012, Hedges compared the combined financial data of four reinsurers in 2010 and 2011 from a CEO’s perspective to make a case for higher rates in 2012.

Reinsurers generate return on equity both through investments and underwriting, with the vast majority of profits typically coming from investments, he explained. In that respect 2010 was an acceptable year with a 13 per cent return on equity, which included a 1.5 per cent return on equity from underwriting.

In the first three quarters of 2011, however, the same four companies posted a negative return on equity of -4.58 per cent, as reinsurers lost money on the underwriting side due to an exceptionally high number of catastrophe events.

Generally people are looking at the combined ratio, an indicator of profitability, which measures the sum of incurred losses and expenses relative to the intake in premiums, to determine whether the situation is bad enough for reinsurers to raise their rates, he said. And combined ratios for all four companies are very high, meaning the companies are losing money on their underwriting.

Investment returns at the same time nearly halved from 4.47 per cent to 2.47 per cent (annualised 3.29 per cent) as some reinsurers had to write off European sovereign debt and yields on new money were generally lower.

Other than to hope that there will be no catastrophe events in 2012, the options for CEOs of reinsurance firms to raise return on equity next year are limited, said Hegdes. Maximising the investment return by taking more risk will be monitored critically by regulators and rating agencies and mean higher regulatory capital requirements and capital costs, limiting the amount of risk that can be taken on.

The alternative, to generate the same return on less capital, is also constrained. Some people would like to buy from companies that are big, credit ratings will come under pressure when a reinsurer holds less capital and regulators also expect to see a high capitalisation, he noted.

Hedges reminded the audience that reinsurance companies are big pools of assets that are combined with risk-taking functions and that return on equity is heavily influenced by the investment return. Traditionally reinsurers would have a portfolio with 85 to 95 per cent invested bonds mainly US Treasuries and US government bonds because that is considered safe money.

“[Right now] you have low yields and high risks and holders of big bond portfolios cannot generate the return that they need. So in order for the combined ratios to come down, the rates at some point will need to go up,” he said.

Garth MacDonald, CEO of Islands Heritage, said he could not disagree with Hedges based on the results of the industry.

MacDonald emphasised that reinsurance is beneficial to traditional insurers. “Reinsurance has a strong track record supporting the insurance industry that allows us to move risk off our balance sheet, allows us to write more business than we normally would, leaves lower prices with consumers, which is a win-win situation,” he said.

However, insurers need to have a long-term relationship with reinsurers to make that work.

“Right now the focus of the conversation seems to be strictly on price,” he said. This endangers the partnership between insurers and reinsurers.

Three of the top 10 costliest natural disasters occurred this year and nine of the top 10 happened in the last seven years, MacDonald noted, which would point to price increases. But the amount of capital in the industry has not changed significantly despite the losses.

The price argument has to take into account the level of losses over the past years, the fact that model changes increase the amount of capital required to support the business, higher regulatory capital requirements as a result of Solvency II, low interest rates and a lot more risk on the asset side of the balance sheets of the reinsurers, MacDonald said.

However, the arguments against the price increases are that pricing should be based on a long-term basis and not on short-term results. In addition he said the lingering economic recession makes it extremely difficult for insurers to pass on any increase in the cost to consumers and there is a lot of reinsurance capacity in the market.

“We have been thinking every year since 2004 that the hard market is going to come and every year it did not happen,” he said.

Pressed on whether he sees reinsurance rates going up or down he said: “I would say, percentage-wise, you could see a double digit increase.” But he stressed that consumers in the Caribbean are already stretched and to pass on price increases would be extremely difficult.

Michael Gayle, general manager of Cayman First Insurance Company Limited, in December confirmed that in his meetings with reinsurers the message was the same leading him to believe that the Caribbean region is going to be hit with increases in reinsurance costs, anywhere from 10 to 50 per cent.

In the US property insurance policies renewed in the fourth quarter of 2011 have already shown price increases. According to brokerage Marsh, 48 per cent of policies had been renewed at rate increases of 1 per cent or higher and nearly 20 per cent showed increases of more than 10 per cent. While the market is not classified as hard, it is increasingly difficult to achieve cost savings and more insured are faced with modest increases at renewal, the brokerage said in its benchmarking report in December.