Reinsurance companies looked forward to 2002 as a welcome respite from a decadelong succession of costly catastrophes. Certainly, they could anticipate little that could be worse than the World Trade Center attacks: At $50 billion and counting, the estimated damage from that disaster alone far exceeded total worldwide insurance losses in any previous year. (The record had been $35 billion in 1992, the year Hurricane Andrew struck the U.S. Southeast.)

Moreover, demand for property/casualty insurance boomed after September 11, 2001, and reinsurers, which underwrite the risks taken by primary insurance companies, were poised to share the wealth.

But they had a problem that festered even as they tried to get beyond 9/11: Many of the biggest companies in the business, and particularly the giant European reinsurers, were reeling from sagging investment portfolios that were overweighted in stocks.

This was bitter irony indeed. For years the insurance industry was unable to turn a profit on premiums; its earnings had been driven -- propped up -- by investment income. The steep plunge in equity valuations meant that, rather than finally cashing in on improved underwriting conditions, some companies had to scramble to shore up weakened capital positions. In April, for example, Munich Reinsurance Co., the biggest reinsurer in terms of premium revenue, raised E3 billion ($3.5 billion) and £250 million ($408 million) in a two-tranche subordinated debt offering.

The nadir came last September when Gerling Global Reinsurance, the Cologne-based affiliate of Gerling Insurance Group and the industry’s seventh-biggest player, stopped underwriting altogether. Controlled by the Gerling family and Deutsche Bank, the reinsurer was unable to raise sufficient capital after paying out massive claims and had been struggling since the World Trade Center tragedy. Gerling came under renewed pressure in March when Warren Buffett, whose Berkshire Hathaway holding company controls Stamford, Connecticutbased General Re Corp., told a German magazine that one of the world’s largest reinsurers “has all but ceased paying claims, including those both valid and due.” Market observers and analysts assumed that the unnamed company was Gerling, which denied the accusation. Its owners have been looking for a buyer, and in a preliminary step Deutsche Bank wrote off its Gerling investment in the first quarter. Deutsche followed that move in May by transferring its 34.6 percent stake to company founder Rolf Gerling and supervisory board chairman Joachim Theye.

In ordinary times reinsurers would be thriving in what practitioners call a “hard market.” That’s one where premiums are rising -- to, in fact, their highest levels in a decade. Last year net premiums jumped 15 percent, to $114.4 billion, estimates Credit Suisse First Boston. But the combination of collapsing stock portfolios and bigger-than-expected payouts from policies written in the late 1990s took a heavy toll: In 2001 the property/casualty reinsurance industry -- which accounts for more than 80 percent of the total reinsurance market -- lost a whopping $18.5 billion, according to CSFB. That improved last year to a thin $590 million profit, which CSFB projects will grow to $13 billion in 2003 and $14 billion in 2004. Still, the companies are hindered by weakened capital positions that could prevent them from opportunistically expanding. Aggregate industry shareholders’ capital fell 11 percent in 2001, to $245 billion, and 10 percent in 2002, to $220 billion, estimates Standard & Poor’s Corp., which over the past year has downgraded several of the top reinsurers’ financial strength ratings.

The pain is widespread among the seven firms that analysts follow most closely, which account for the bulk of the industry’s net premium income, ranging from Switzerland’s Converium ($3.3 billion in premiums) to Munich Re (E22.4 billion).

The European giants have been hit hardest by the declines in stock markets, because they have tended to hold more of their assets in equities. U.S. reinsurers, led by Berkshire Hathaway and General Electric Co. unit Employers Reinsurance Corp., the third- and fourth-biggest reinsurers in the world, respectively, have been hurt more by liability miscalculations, stemming from workers’ compensation and other policies written in the late 1990s, that have forced them to bolster their prior-year loss reserves. European reinsurers with U.S. subsidiaries were hit, too. Munich Re, for example, shored up its U.S. unit, American Re Corp., with $2 billion in reserves in the first half of 2002.

“Reinsurers have definitely been stress-tested the past two years,” says Wilhelm Zeller, chief executive of Hannover Re Group, a subsidiary of German mutual insurer HDI Haftpflicht Verband de Deustchen Industrie and the world’s fifth-largest reinsurer. “All those companies that have survived have been able to prove that their business model works.”

Misdirected portfolio strategies wounded the European reinsurance giants. Some had been keeping as much as 40 percent of their assets in stocks. That served them well when markets were rising; during the 1990s boom European reinsurers booked gains that were denied their U.S. counterparts. U.S. regulations on capital requirements, mainly enforced by the states, generally prevent domestic insurance companies from holding more than 10 percent of their assets in stocks.

Now the fortunes are reversed. While the Europeans have had to take losses and scramble to adjust their portfolios, their U.S. rivals’ investment assets are relatively unscathed. Some analysts warn that the historically rock-solid Europeans are in danger of losing some of the financial strength that is essential to attracting new business. Swiss Reinsurance Co. and Munich Re lost their AAA S&P ratings in October and December, respectively; Swiss Re is now at AA+, Munich Re at AA. General Re retains a AAA, while Employers Re is at AA.

“The size of the Europeans’ equity holdings has made them less competitive, because their capital had been destroyed faster,” says Andrew Pitt, a European insurance analyst at Smith Barney Citigroup.

Who’s shouldering the blame for the poor investment performance? There hasn’t been much corporate bloodletting; the hardest hit companies say that they got hurt by events that were beyond their control, observes Merrill Lynch & Co. European reinsurance analyst Brian Shea. But Shea sees that as a cop-out. “You don’t need to have made the right call on the stock market to have prevented the losses,” he says. “You just need to have exercised more discipline in asset-liability management, and there’s really no excuse for that discipline not to have been exercised a year or so ago.”

To be sure, some European reinsurers began to adjust their asset mix as the market cycle turned. Zurich-based Swiss Re, second only to Munich Re in reinsurance premiums, says it has been rebalancing systematically, though how much of the reduction in its equity exposure comes from market price declines rather than stock sales is unclear. But the results have been dramatic; it cut its equity exposure from 36 percent in 1998 to 14 percent by year-end 2002.

Swiss Re does say that in 2000 it unloaded more than 85 percent of its U.S. stocks. “We felt they were the most overvalued in the world,” says John Fitzpatrick, who now runs the insurer’s Life and Health Business Group but who was then chief financial officer.

Since the beginning of this year, Swiss Re has taken equities down even more. “Net of hedges it’s just under 9 percent. We’re much more comfortable now,” says CEO John Coomber. The company is targeting equity exposure of 10 percent between 2003 and 2005 and a return on all investments of 5 percent. Swiss Re lost Sf91 million ($67 million) in 2002, only the second loss in its 140-year history. (It cut its dividend for the first time since the San Francisco earthquake of 1906.) Coomber doesn’t anticipate a repeat of last year’s 40 percent decline in investment income, to Sf5 billion: “The worst is past,” he says. “We expect a profit this year and improved results in future years.”

A number of reinsurers were caught out trying to time the market. They anticipated stocks would rebound in 2002, but instead their pain worsened. Hannover Re, rated AA, didn’t start reducing the equity portion of its portfolio until the first quarter of 2001, when it stood at 18 percent. By midyear equity holdings had fallen to 11 percent. Then, expecting a rally, the company began to buy stocks again. It soon reversed course.

Today just 6 percent of its assets are in stocks. And CEO Zeller has turned optimistic. Hannover Re was one of the few top-ten reinsurers to post a profit for 2002, at E267 million. “Long term, we still believe equity beats fixed income, and therefore you will see us an investor again,” Zeller explains. His target: 17.5 percent publicly traded stocks and 7.5 percent private equity.

Swiss Re executives say their reduction in equity holdings is both a tactical response to falling markets and a more fundamental shift in approach. “The strategy now is to put the capital to work in the core business, including property and casualty,” says Swiss Re chief financial officer Ann Godbehere. “We don’t have a current strategy to grow the equity portfolio because I cannot get the same return on the equity portfolio that I can get from the core business.”

The world’s tenth-largest reinsurer, Converium, chose to follow the American model of lower equity levels. It had 10 percent of its portfolio in equities when it was spun off by Zurich Financial Services in December 2001 and has since reduced that figure to 7.5 percent. “With regard to our strategic asset management allocation, we are much more a North American reinsurance company than a European one,” says CFO Martin Kauer. “From the beginning we had a very conservative approach and even increased the conservatism in our invested assets in the past 18 months or so.”

Although the bulk of its reduction in equity holdings was the result of share price declines, Converium also stopped investing in stocks and has put all new funds into fixed income. Total invested assets grew from $4.9 billion at the end of 2001 to $6.1 billion a year later. “We continue not to invest in equity securities and we continue to experience substantial cash flows, so the percentage of our equity securities in relation to total invested assets continues to go down,” says Kauer. “We are a reinsurance company and not a hedge fund.”

Giant Munich Re entered 2002 with big -- and vulnerable -- equity holdings. They plunged from 41 percent of assets at year-end 2001 to 16 percent at the end of 2002. Nearly all of the company’s reduction in net assets, from E34.2 billion to E14.9 billion, came from market losses. Munich Re earned E1.1 billion in 2002, but only because it booked a E4.7 billion gain on the sale of part of its stake in German insurer Allianz.

Indeed, Munich Re’s difficulties were compounded by its cross-ownership arrangements with other big German companies. Besides its approximately 15 percent interest in Allianz, the reinsurer owns 26 percent of HVB Group and 10 percent of Commerzbank -- all members of Germany’s struggling financial services elite. Reinsurance industry analyst William Hawkins of Fox-Pitt, Kelton (a Swiss Re subsidiary) thinks that by having to keep those holdings, Munich Re has weakened not only its finances, but also its leadership position. “They’ve watched as the equities have fallen in value,” he says. Smith Barney Citigroup’s Pitt is more blunt: “Effectively, they were fiddling while Rome was burning. It is a massive blow to their relative competitive position.”

Clement Booth, the Munich Re management board member responsible for investor relations and strategic planning, maintains that the company took necessary action when it could. He says that in the second half of 2001, Munich Re and other German companies held off on stock sales as they waited for a repeal of capital gains taxes. By early 2002 the company was expecting a market recovery, and it again held off on selling. The bulk of 2002’s market declines occurred in the second half -- and Munich Re got hammered.

Munich Re reduced its stake in Allianz from 25 percent to 20 percent in the first half of last year, and more recently to about 15 percent when Munich Re didn’t subscribe to a E4.4 billion rights issue. But Allianz’s share price continued to plunge, from E181 at the end of June 2002 to E39 in late April, before rebounding to E84 by mid-July. “It’s not making any excuses, but we didn’t really think that Allianz would reach the levels that it did,” says Booth.

With Munich Re’s stake in Allianz now below 20 percent, and with Allianz cutting its holding in Munich Re to the same range, neither will have to report a portion of the other’s net results with its earnings (as companies owning 20 percent or more of another firm are required to do in Germany). Booth concedes that, depending on market conditions, further sell-downs could take a while: “It doesn’t make sense to sell into a nonexistent market unless you have to.”

Meanwhile, Munich Re’s financial strength looks wanting to Smith Barney Citigroup’s Pitt. “We do a solvency test on them, and they barely appear to be A,” he asserts.

Still, Stephen Searby, S&P’s lead global reinsurance analyst, says Munich Re’s April ratings downgrade to AA, following a reduction from AAA to AA+ in December, shouldn’t be too damaging. “It’s only when companies fall through the ratings thresholds that there are serious implications,” he says.

Booth concedes that the downgrade “doesn’t help.” But he hastens to add that he doesn’t expect it to affect the company’s activity: “We don’t expect to lose any business as a result. We’re in an environment where downgrades are generally taking place.”

A.M. Best credit analyst Michael Zboron, who has an A++ rating with a negative outlook on Munich Re, says the company remains strongly capitalized and benefits from the healthy demand for reinsurance. But, he notes, it badly needs the benefits of a sustained bull market. “There is obviously potential that if markets remain weak and if some further reserve strength is necessary in the U.S., there may be an issue with capitalization,” he says.

Despite Swiss Re’s downgrade from AAA, CFO Godbehere sees the bright side of having an AA+ rating from S&P and A++ from A.M. Best. “The capital markets have been tight,” she says, “but it’s a much more severe thing for a lowly rated company than for a highly rated company.”

Raising capital could be more of a concern for Hannover Re, which, because it is 75 percent owned by German mutual insurer HDI, lacks access to public markets. “If they need more capital, it may be more difficult for them than, say, for Munich,” says Best’s Zboron. But Hannover CEO Zeller says that the unit can raise cash through securitizations and hybrid debt vehicles if necessary. “If the management isn’t totally stupid, they consider where they can get more capital before they load on additional business,” says Zeller.

Should the Europeans feel threatened by Berkshire Hathaway’s General Re and GE’s Employers Re? The U.S. firms certainly aren’t bogged down by similar balance-sheet concerns: As of year-end 2002, General Re had less than 7 percent of its portfolio in equities, Employers Re less than 3 percent.

However, the U.S. firms’ increases in prior-year loss reserves put a lid on their aggressiveness. Says Fox-Pitt, Kelton’s Hawkins: “They both have owners that would not put up with big losses. Warren Buffett would rather have a profitable organization than a big one.”

GE has been scaling back some of its less-profitable insurance operations, and reinsurance is one of them. The company has been actively seeking a buyer for the life portion of Employers Re. In June, A.M. Best lowered Employers Re’s rating to A from A+, citing “increased uncertainty as to GE’s longer-term commitment to the reinsurance business in general.”

Munich Re’s Booth contends that regardless of how the sector shakes out, his company is still its powerhouse. “General Re is in the same market as American Re [Munich Re’s U.S. subsidiary] and really can’t afford to charge any less for its reinsurance than we can,” Booth says. “As to whether General Re writes any more business as a result of being AAA, I doubt it. The relationships in reinsurance are quite strong, and as long as our financial rating is adequate, which AA clearly is, then there shouldn’t be too much of a problem.”

Analyst Hawkins doubts that Bermuda-based reinsurers, such as Renaissance Reinsurance and PartnerRe, will take much market share away from the bigger players. He says many buyers are simply more comfortable doing business with a big company than with a smaller one. “For a number of global primary insurance clients, size definitely matters,” says Hawkins. “Global operations want a global service. The Bermudans can come in and give some very attractive niche quotes, but they can’t be a one-stop shop.”

As the stock market recovers, and as the next cycle unfolds, the European firms with their restructured investment portfolios could emerge even stronger. The Big Two will also go forward with new leadership: Swiss Re’s Coomber, a 55-year-old U.K. native and an actuary by training who has spent 30 years with the firm, became CEO in January, succeeding Walter Kielholz, who served six years. At year-end Munich Re’s CEO for the past 11 years, Hans-Jürgen Schinzler, will give way to the company’s top European and Latin American executive, 46-year-old Nikolaus von Bomhard.

Of course, a bull market might tempt the Europeans to repeat old mistakes, but Hannover Re’s Zeller is undaunted. He says he’s willing to put up to E100 million back into stocks -- particularly in Germany, where many companies are trading below their book value.

Is that smart timing, or a foolish bet? “Up until two years ago, everybody would have told you that the European approach is the better one,” Zeller says, referring to the stock investing bias. “Today everybody will tell you the European approach was the wrong one. Five years down the road, I’m pretty sure the answer will be more balanced.”