Reinsurers: Survivors of the Storm
Despite depressed markets, big reinsurers are holding up relatively well.
Banks and insurers have been badly burned by the economic firestorm they helped ignite. But at least one financial industry — reinsurance — has managed to sidestep the worst of the carnage.
Reinsurers, like just about everyone else, are suffering from lower profits and investment returns. For the most part, though, their business is in relatively strong shape because of rising demand for their services and their ability to raise prices in a weak economy. “If this is going to be a prolonged recession, then reinsurers definitely stand to profit,” says Wilhelm Zeller, chief executive officer of Germany’s Hannover Reinsurance, the industry’s fourth-largest player in terms of gross premiums.
Zeller’s optimism reflects soaring demand for the industry’s services. Primary insurers are buying more reinsurance because their capital is tight and they are more averse to risk. The nonlife insurance sector in the U.S. lost about $90 billion in capital last year, close to 20 percent of the total available before the onset of the global financial crisis, according to Hannover Re.
At the same time, with their own investment income dwindling, reinsurers are demanding — and getting — higher underwriting fees. “Prices will have to go up to increase underwriting margins and make up for lower returns on assets,” says Nikolaus von Bomhard, chief executive of Germany’s Munich Reinsurance Co., the market leader in gross premiums. In January, when roughly 60 percent of European reinsurance renewals took place, Munich Re increased its underwriting prices by 3 percent, in line with the industry average. Price increases across the industry are expected to hit double digits for April renewals covering Asian earthquakes and tsunamis, and for July renewals of natural catastrophe coverage in the U.S. Prices in the U.S. market are also benefiting from a tightening of supply caused by the retreat of hedge funds, which had teamed up with Bermuda-based reinsurers in recent years to boost the industry’s underwriting capacity.
In addition, the crisis has caused leading players to reevaluate the complex products and strategies of yesteryear. Earlier this decade some reinsurers began to move into riskier, nontraditional markets such as financial services. The move didn’t pay off, and firms are in various stages of pulling back from that strategy.
Swiss Reinsurance Group, the world’s No. 2 player by premiums, still has a lot of recovery work ahead. It behaved more like an investment bank than a classic reinsurer and lost billions of Swiss francs on toxic securitized assets, such as mortgage bonds that it insured with credit default swaps, and on private equity and hedge fund investments. Those losses forced the company to turn to Warren Buffett’s Berkshire Hathaway Group for costly capital infusions in February. That month Swiss Re replaced its chief executive, Jacques Aigrain, a champion of securitization, with a career underwriter, Stefan Lippe. The new CEO issued a statement saying that Swiss Re intends to end its forays into structured financial products and trading activities and instead will emphasize underwriting.
Now the question facing the industry is whether reinsurers can return to their roots and re-create a business model in which underwriting fees generate consistent profits, instead of depending on investment income — assuming they can produce any — for earnings. “You need at least 5 percent rate increases across the board to stem a loss in investment income this year,” says Raghu Hariharan, a London-based insurance analyst for Fox-Pitt, Kelton. Although that seems attainable, other analysts aren’t yet convinced that a long-term shift is in progress in the way the industry makes money and attracts investors. “Reinsurance rates won’t rise nearly enough to make up for collapsing investment income,” says Kevin Ryan, London-based director of equity research for ING Wholesale Banking.
A business model relying mainly on underwriting fees would require investors to accept returns on equity of 12 percent or less over the long run. Such returns are well below the 20 percent-plus ROEs that investors expected from banks and other financial institutions in the go-go years, but they look great by today’s humble standards.
Munich Re’s relative success suggests that investors may be willing to accept lower returns in exchange for reduced risk. When von Bomhard, a veteran underwriter, became chief executive in January 2004, the group was coming off a €434 million ($575 million) loss for 2003 because of huge write-downs at HypoVereinsbank, the German bank in which it owned a 25.7 percent stake. Von Bomhard’s turnaround strategy — much like the one now promised by Lippe at Swiss Re — stressed greater reliance on underwriting profits than on investment income and has led to five straight profitable years. “They have learned their lessons and have done most things right,” says Jürgen Hawlitzky, a Frankfurt-based senior analyst for global insurance at Allianz Global Investors. Adds Markus Engels, a Frankfurt-based insurance analyst with Cominvest Asset Management, “Munich Re is the best example that investors want underwriting income and no funny games on the asset side.”
The company saw its net income decline by 61.1 percent last year, to €1.53 billion from €3.92 billion in 2007. The combined ratio of the reinsurer’s property/casualty business, a key metric that compares the cost of claims plus expenses to premium income, rose to 99.5 in 2008 — near the break-even level of 100 — from 96.4 a year earlier. The company suffered €832 million in natural catastrophe losses, including €560 million in claims from Hurricanes Ike and Gustav in the U.S.
Munich Re’s investment portfolio is among the most conservative in the industry, with an exposure to equities of only 1.7 percent at the end of 2008 — down from 10.8 percent a year earlier. Even so, the company took €200 million of write-downs on its equity holdings for the year and €500 million on its fixed-income positions, charges that weighed on profits but leave Munich Re better positioned for the future, von Bomhard contends. “We are loaded with fixed-income securities — especially government bonds,” he says. “The question is when and how to switch out of this overweight position.”
At €92 at the end of last month, the company’s share price was down by 17 percent from the beginning of the year; that outperformed the DJStoxx insurance index by 9 percentage points for the period. Investors seem to have accepted a slowdown in Munich Re’s ambitious plan, announced in May 2007, to return €8 billion to shareholders by 2010 through buybacks and higher dividends. Of the remaining €3 billion due shareholders, €2 billion was supposed to come through buybacks and €1 billion through dividends. The group says it intends to continue with the dividends but will withhold at least part of the promised buybacks to finance organic investments and possible acquisitions.
In the U.S., where Munich Re racked up overall losses of more than $2.5 billion before 2003 because of claims following the 2001 terrorist attack on the World Trade Center as well as asbestos claims, the group is expanding both organically and through acquisitions. The company’s takeover targets are specialty primary insurers. In December, Munich Re paid $742 million for the HSB Group, a subsidiary of troubled American International Group, the hemorrhaging insurance giant. HSB is a U.S. market leader in insurance and reinsurance premiums written for plant and equipment breakdown.
But Munich Re’s biggest gains in the U.S. are coming from organic growth in reinsurance underwriting. “Our underwriting strategy is shifting toward those businesses where prices are most attractive,” says Peter Röder, head of global clients and North America. That means reducing exposure to liability insurance products — such as D&O (personal liability coverage for a firm’s directors and senior executives) and PI (professional indemnity coverage for negligence), which tend to be less profitable during recessions — and focusing instead on higher-income businesses, like coverage for hurricane damage and offshore oil drilling platforms. “We have no constraints to expand in these businesses, given our financial strength,” notes Röder.
That strength is magnified by the reduced role of hedge funds in natural catastrophe coverage. In previous years, especially following Hurricane Katrina in 2005, spikes in reinsurance rates prompted hedge funds to invest heavily in Bermuda-based reinsurers that promised average annual returns of 20 to 25 percent. A prominent investment vehicle was the “sidecar,” an arrangement by which a Bermuda reinsurer agreed to share with hedge fund and private equity investors a percentage of all premiums and losses arising from a book of business. “Sidecar capital is way down,” says Frank Majors, a founding partner of Bermuda-based Nephila Capital, which manages hedge funds that invest exclusively in natural catastrophe reinsurance. “Some well-known hedge funds have pulled out of the reinsurance market.” The most prominent is Chicago-based Citadel Investment Group, with almost $11 billion in assets under management; it shuttered its four-year-old Bermuda reinsurer, CIG Re, in November because the unit’s cost of capital was deemed too high.
Smaller reinsurers are also counting heavily on higher underwriting income to offset falling investment returns. Hannover Re suffered a 75.2 percent drop in investment income last year, to €278.5 million. That decline was a major reason the company swung to a net loss of €127 million in 2008, compared with net income of €721.7 million in 2007.
Hannover Re executives hope that higher prices will boost underwriting income in 2009. The company implemented a 5 percent price increase in January renewals in Europe and predicts a 30 percent hike in July renewals in the U.S. Hannover Re’s share price, at €24 at the end of last month, was up 6 percent from the start of the year and beat the DJStoxx index by 33 percentage points for the period.
France’s SCOR, the No. 5 player, boosted its premiums by 22 percent last year, to €5.8 billion, but had a 23 percent decline in net income, to €315 million, because of a drop in investment income. The company raised its January renewal prices by 3.3 percent. SCOR’s share price was down 5 percent at the end of last month from the start of the year, but it still outperformed the DJStoxx index by 22 percentage points over the same period.
No reinsurer has suffered more from the financial crisis than Swiss Re. Its coveted AA– credit rating was cut to A+ by Standard & Poor’s in February, hiking its funding costs by Sf1.5 billion ($1.3 billion). Slammed by Sf6 billion in investment write-downs, Swiss Re reported a net loss of Sf864 million in 2008, compared with a net profit of Sf4.2 billion the year before. “The magnitude of their write-offs, particularly related to their structured credit portfolio, took us by surprise and required the group to raise additional capital,” says S&P’s London-based analyst Peter Grant, who co-authored the downgrade report.
Fears concerning capital adequacy have driven Swiss Re further into Berkshire’s embrace. Berkshire’s four reinsurance and insurance units — General Re Corp., Berkshire Hathaway Reinsurance Group, GEICO and Berkshire Hathaway Primary Group — had combined premiums of $25.53 billion in 2008, down from $31.78 billion in 2007, making the Buffett operation the world’s third-largest reinsurer. Revenues were boosted in 2007 by a one-time $7.1 billion premium on a reinsurance agreement with Lloyd’s of London.
In a January deal, Berkshire bought a 3 percent stake in Swiss Re for Sf893 million and wrote a reinsurance contract that gave it a 20 percent share of Swiss Re’s p/c business through 2012. Swiss Re asserted that the transaction freed up capital to help the group meet its commitment to shareholders to continue a hefty buyback program (which was ultimately discontinued), and that Berkshire was offering capital at a significantly lower cost than Swiss Re could get elsewhere.
A subsequent deal with Berkshire didn’t come cheaply, though. In February, Berkshire purchased a convertible perpetual bond with a face value of Sf3 billion and a 12 percent coupon that can be paid in cash or in shares at a 5 percent discount. When combined with its previous 3 percent stake, the current deal could eventually leave Berkshire owning more than 20 percent of Swiss Re.
In yet another agreement, Berkshire will provide Swiss Re with as much as Sf5 billion in reserves to cover possible losses in its p/c business. If this proves necessary, Berkshire will receive a whopping fee of Sf2 billion. “By entering such an agreement, they are giving away the investment return on Sf2 billion of premiums and all their potential reserve surplus,” says Allianz analyst Hawlitzky.
Of more immediate concern to existing Swiss Re shareholders is the deal’s potentially dilutive effect, which analysts estimate at about 11 percent of earnings and book value. If the bond is fully converted, it will require Swiss Re to issue as many as 160 million new shares to Berkshire Hathaway at Sf25 per share. At the end of last year, Swiss Re had 373 million shares outstanding.
The dilution could rise above 15 percent because, under the deal’s terms, if Swiss Re announces a new rights issue but raises less than Sf2 billion in new capital by September 2009, the conversion price for Berkshire Hathaway will drop to the level of Swiss Re’s share price. Those shares were trading at Sf18.60 at the end of last month, down 63 percent from the beginning of the year and underperforming the DJStoxx index by 36 percentage points.
“The Berkshire convertible is not a cheap form of capital and is clearly damaging to existing shareholders,” says William Hawkins, a London-based insurance analyst for Keefe, Bruyette & Woods. “But it may be the best thing Swiss Re could have negotiated at the time.” Swiss Re has postponed a decision on whether it will seek to raise further capital, but it has left the door open to a Sf2 billion rights issue by receiving authorization at its March 13 annual general meeting to issue as many as 180 million new shares.
As unsettling as Swiss Re’s situation is, the reinsurer can take heart from the turnaround at rival Munich Re. According to von Bomhard, his group’s good financials today are a direct result of the setbacks earlier in the decade that prompted a return to a sound underwriting strategy. “I doubt we would have pushed it so hard if we hadn’t gone through the previous crisis,” he says.