Questionable policies

The reinsurance industry lost more money on September 11 than on any day in its long history. In the upside-down world of actuaries, however, the tragedy that cost more than 3,000 lives and caused an estimated $75 billion in losses set the stage for a boom.

The reinsurance industry lost more money on September 11 than on any day in its long history. In the upside-down world of actuaries, however, the tragedy that cost more than 3,000 lives and caused an estimated $75 billion in losses set the stage for a boom.

The logic was simple. Demand for coverage would soar, and with less capital backing the business, so would depressed premiums. For two decades, as the bull market raced along, reinsurers and insurers made pots of money on their investment portfolios while losing their shirts on underwriting because of chronic overcapitalization. Life soured further in 2000; the stock market slump cut into investment gains and premiums remained at bargain-basement rates.

But the World Trade Center catastrophe changed all that. The losses - an estimated $35 billion of which were covered by reinsurers - sent panicked corporate buyers rushing to purchase more coverage on just about everything, allowing insurers and reinsurers to hike rates across product lines. To take advantage of the quick change in the market, investment consortia of insurance companies and blue-chip private equity shops launched or substantially recapitalized nine reinsurance companies, and existing reinsurers tapped the capital markets. Altogether some $20 billion was raised for the industry.

By the all-important January renewal season, when at least half of policies typically expire, reinsurance premiums recorded sharp jumps. Rates at Munich Reinsurance Co., the world’s biggest reinsurer, rose by 17 percent last year, while Swiss Reinsurance Co., the second-largest reinsurer, recorded average rate increases of more than 15 percent. Many major players did report big losses for 2001 (Munich Re was an exception, with expected profits of more than $475 million), but even that bad news couldn’t dampen the industry’s relief over the new rate environment.

“The price increases were beyond our expectations. In some cases, it was more than we were looking for,” says Jacques Blondeau, chairman and CEO of French reinsurer Scor, which suffered a net loss of $246 million last year.

“We think there will be a very strong recovery and that it will last a very long time,” predicted John Fitzpatrick, chief financial officer of Swiss Re, after announcing in February the company’s first annual loss in 135 years - $118 million.

Exactly who will benefit and for how long remain open questions, however. Some industry watchers fret that years of sloppy underwriting may come back to haunt the business. Financial stability and probity are the watchwords for reinsurers, but investors, analysts and the media are scrutinizing corporate balance sheets for slipshod accounting as never before. And the insurance industry is beginning to draw close attention, as a group that historically has been a little too clever with its bookkeeping. “Nonlife insurers have not, as long as we’ve been analysts, been thought of by investors as paragons of virtue in financial reporting,” noted Morgan Stanley’s highly regarded insurance analyst Alice Schroeder in a recent report, “Bonfire of the Beancounters.”

One result of the new focus on the numbers: In the past two months, scores of insurers and reinsurers have announced “reserve strengthening” measures, setting aside money for future claims while booking a loss on their income statements. Some of these hikes in reserves are simply a reasonable response to the riskier environment since September 11. But no one doubts that some reinsurers are using the cover of an already bad quarter to add reserves that should have been booked in previous years.

“I don’t mean to suggest in any way that there’s any criminal activity involved,” says Donald Watson, chief insurance analyst for Standard & Poor’s. “But insurance accounting lends itself to the types of abuses you found at Enron. What’s a ‘reserve strengthening’ at an insurance company? It’s restating prior years’ earnings.”

In addition, two ongoing scandals may bring heightened scrutiny from credit agencies, investors and regulators. Nissan Fire & Marine Insurance Co., a Japanese insurer, sued Fortress Re in February, according to press reports, alleging that the North Carolina-based reinsurance agent had earned excess commissions by artificially inflating the profits on reinsurance pools it managed. Attorneys for Fortress Re and Nissan did not return phone calls. And in Australia, Berkshire Hathaway, the parent company of the world’s third-largest reinsurer, General Re Corp., faces allegations that its National Indemnity Co. subsidiary wrote a reinsurance policy that allowed a company that became part of Australian insurer HIH Insurance to falsely boost its profits. HIH failed last year in one of Australia’s biggest bankruptcies ever. Berkshire Hathaway says the contract contained a clause requiring all conditions to be disclosed to regulators and HIH auditors.

“Enron, Fortress, the Australian trial - I think these events are going to have a big impact on the reinsurance business this year,” says a senior executive of one reinsurance company. “It’s not just September 11.”

One immediate impact may be seen in the business of financial reinsurance, which accounts for perhaps 10 to 15 percent of reinsurance industry profits. More akin to financial engineering than to traditional insurance coverage, financial reinsurance contracts allow insurers to smooth their earnings by converting premiums and claims into profits and losses as needed. A number of reinsurance executives believe that this business will shrink as companies rush to avoid any hint of earnings manipulation. “There is going to be much more scrutiny,” says Scor’s Blondeau. “I think it’s going to kill some of the financial reinsurance business.”

On a more positive note, Enron’s failure, which cost reinsurers an estimated $2 billion in claims, may drive up premiums in some of the markets that haven’t benefited as much from post-September 11 increases. Prices on some lines, such as directors’ and officers’ liability, are expected to soar as reinsurers hike rates for insurance covering the potential fallout of corporate scandals. The surety market is also being repriced.

“Enron is a significant [event],” says Patrick Thiele, CEO and president of PartnerRe, which took a $47.3 million fourth-quarter charge on surety reinsurance contracts related to Enron. “It will have a big impact on the surety market and hopefully lead to a restructuring. There has not been acceptable pricing in that business for some time.”

Still, such glad tidings aside, insurers are paid to live with a sense of dread, and today there is plenty to go around. One reinsurance CEO worries that the cumulative effects of years of undisciplined pricing, September 11, Enron losses and stricter balance-sheet scrutiny could set the stage for developments more serious than earnings restatements and scandals. “I think there is something big coming,” says James Stanard, chairman and CEO of Bermuda-based RenaissanceRe Holdings. “Some of the balance sheets aren’t as strong as they appear on paper. If we have some big losses this year, it could take some companies down. And if you had one major reinsurer going down, you could have a chain reaction of insolvencies.”

To be sure, most executives aren’t predicting a wave of reinsurer insolvencies. But there is considerable debate about how long the current good times will last. Much of the discussion centers on the effect of all the new money that came into the market after September 11.

New capital started pouring into the business just weeks after the attacks. And the tap has yet to be turned off. Nine new reinsurers were set up in Bermuda with funding from a variety of financial sources, from insurers like American International Group to investment banks like Goldman, Sachs & Co. The nine: Allied World Assurance, Arch Re, Axis Specialty, DaVinci Reinsurance, Endurance Specialty Insurance, Goshawk Reinsurance, Montpelier Reinsurance, Olympus Reinsurance and Queens Island Reinsurance. Established reinsurance powerhouses, from Swiss Re to XL Capital, also raised new capital. In February RenaissanceRe filed a shelf registration for a securities offering that would add a further $568 million to the pot.

“After [Hurricane] Andrew in 1992, it took two years to bring in $8 billion,” says Sean Mooney, chief economist of reinsurance broker Guy Carpenter, a subsidiary of Marsh & McClennan Cos. “After September 11 it took four months to raise $20 billion or $23 billion.”

That’s a lot of new capital, but in theory, the market should be able to absorb it without causing supply to outstrip demand and sink rates again. Between September 11 claims and stock market losses, reinsurance surplus capital, even with the new money, is still down about $100 billion from its peak in 2001, according to Swiss Re.

“The capital conditions of companies have deteriorated for two years in a row,” says Swiss Re CFO Fitzpatrick. “And that hasn’t happened since 1973-'74.”

Reinsurance experts also note that the Bermuda start-ups are headed by prudent, veteran managers who know the dangers of undercutting on price. Without broad direct-marketing operations, say some competitors, the Bermuda reinsurers will largely be limited to filling business from brokers rather than competing in all parts of the market and softening rates.

To others, though, that’s wishful thinking. They argue that the influx of new capital has the potential to limit the size and the duration of the industry’s recovery. “The handwriting is on the wall,” says Standard & Poor’s Watson. “September 11 was a big enough event to bring fundamental improvement to the industry. But people got greedy.”

Indeed, skeptics saw disturbing signs even in the very strong renewals in January. Though premiums rose, they failed to reach the highest range of expectations, especially at the start-up companies. “The price jumps were not as egregious as people expected,” says an investor in one of the Bermuda reinsurance start-ups.

Guy Carpenter’s brokers are split down the middle on whether prices will go up from here, says economist Mooney. He suspects that the market will show a newfound discipline. “I don’t think prices will soften as much as they did in the past,” he says. “You have parent companies saying, ‘We will punish managers who don’t get high returns.’”

Adding to the uncertainty is the fact that many of the Bermuda start-ups, despite initial expectations, barely got up and running in time for January renewals.

Jumping into the reinsurance market after a catastrophe has been a smart move in the past. In the mid-1980s Marsh & McLennan and other backers formed the successful excess-liability insurers Ace and Exel (now XL Capital) to take advantage of a serious shortage of liability coverage for corporate boards as well as for environmental hazards like asbestos. And eight Bermuda reinsurers were launched in 1992 after Hurricane Andrew to write p/c reinsurance.

Investors in last year’s start-ups have compared the current opportunities to these earlier markets, but there is one significant difference. In the 1980s excess-liability coverage couldn’t be purchased by insurance companies at any price. Reinsurers say there was no evidence of a similar capacity crunch in this year’s January renewals, even after $30 billion of capital was taken out of the market by insured losses. At least for the private equity investors who pumped billions into the start-up Bermuda companies, the absence of a full-blown crisis might present problems.

“At year-end you did not have a capacity crunch in most lines of business like you had in previous time periods,” says RenaissanceRe CEO Stanard, citing the catastrophe insurance shortage after Hurricane Andrew. “That put a lid on the reaction. You didn’t get the excessive price jumping you had in other periods. Some of the new capital may have been hoping for a spike back to 1993 levels. That didn’t happen. The question is, How do the start-ups react to that going forward?”

Nonetheless, some reinsurance executives believe that capacity will be constrained in the future. A number of insurance companies are expected to sell, close or dramatically scale back their reinsurance operations, potentially withdrawing more capital from the industry. CNA Financial Corp., Hartford Financial Services Group and St. Paul Cos. have announced plans to pull back on their overseas reinsurance business. Word surfaced last month that General Electric Co. was considering spinning off its reinsurance operation because of concerns about excessive risk. And reinsurance executives say that they expect more traditional insurers to exit as a result of unexpected September losses, possibly setting the stage for tighter reinsurance supply and higher premiums.

“The conventional wisdom a year ago was that reinsurance companies should be part of larger financial services firms,” says Dirk Lohmann, CEO of Converium Holding, the world’s eighth-largest reinsurer. “But the appetite of many large insurance companies for reinsurance volatility these days seems to be nil.”

Selling reinsurance operations, or taking them public, won’t be easy in the near term, however. Few noninsurance companies are thought to be interested given newly prominent risks like terrorism. And the biggest firms are near the market share limits that buyers would find acceptable. The result may be that some insurers end up shutting down their reinsurance units. “There are more sellers than buyers,” says Scor’s Blondeau.

But a countervailing force driving potential consolidation is a flight to quality among reinsurance buyers. Reinsurers have long suffered from volatile earnings swings, because losses - whether from airplane crashes, toxic mold or hurricanes - can’t be controlled or predicted. But the financial risks of man-made catastrophes like terrorism attacks seem even more threatening to balance sheets, in part because they cross all lines, from p/c to workers’ compensation. Shortly after September 11 there was even talk that large numbers of reinsurers could fail. Morgan Stanley analyst Schroeder famously warned investors in primary carriers to discount the reinsurance claims because of the likely insolvencies.

One result of this increasing nervousness may be an insistence by insurance companies that all reinsurers become bigger and stronger to withstand future catastrophes. The obvious approach is merger, and some experts expect a pickup in acquisitions of firms with less than $1 billion in capital.

“Post-September 11 there was a flight to quality,” concurs Gary Parr, the veteran Morgan Stanley insurance industry banker. “It’s not clear that the smaller companies have been beneficiaries of the price increases as much as they might have expected.”

To be sure, some people doubt that many of these deals will actually get done, because many of the likely merger candidates have suspect underwriting commitments still on their books. “I don’t think you are going to see a lot of sales of these toxic companies,” says one active insurance investor, pointing to the sloppy underwriting of the past decade. “Doing the due diligence on them would be a bear.”

If these consolidations play out, taking billions more in capital out of the industry, then this period of increasing prices - what reinsurers call a “hard market” - could last some time. “We are moving toward quite a consolidation in this industry,” predicts Scor’s Blondeau. “I think in the end we will have a solid dozen companies in competition.”

That, of course, is the optimistic scenario. Other longtime reinsurance watchers believe the industry may yet fall back into its overcapitalized, price-undercutting ways. As the new start-up companies strive to put billions of capital to work, predicts S&P’s Watson, the industry will inevitably lapse into its classic boom-and-bust cycle, with prices probably sinking by 2004. “All that these start-ups have to offer is cheap capacity,” concludes Watson, who says anecdotal evidence suggests that the new companies are already falling short of their projections in writing catastrophe business. “Some of these start-ups are going to go to insurers and say, ‘These property/cat reinsurers are raping you. We’re going to give you a discount of 25 percent.’ That’s where the soft market begins.”

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