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First the good news: Reinsurer profitability has rebounded. In 2006, the industry posted $9.68 billion in net income, up from just $2.51 billion in 2005, according to figures compiled by the Reinsurance Association of America. Return on equity in 2006 cleared 13 percent, up from less than 4 percent in 2005.

Now the old news: Reinsurer profits tanked in 2001 after the Sept. 11, 2001, attacks. They posted a loss of $2.98 billion, and a return on equity of -6.3 percent. Between 2002 and 2005, profits and returns stayed within a fairly narrow range. Profits hovered between $1.3 billion and $2.5 billion. Return on equity remained between 3 percent and 5.8 percent.

What's it all mean? For investors, many of whom believe the reinsurance industry ought to be earning a return of 15 percent annually at least, not all that much. "I'm not sure it's a positive or a negative," says Philip D. Campbell, senior vice president in the Minneapolis-based office of reinsurance intermediary Benfield. "It is, kind of, what it is."

"If you were the buyer of reinsurance, the potential for more volatile swings in reinsurance pricing is there, I think," adds Campbell. "You do have credit quality, third-party risk issues."

Some companies position themselves as specialists with a focus on reinsuring mainly the property-catastrophe business, diversification be damned. Those companies typically are at greater exposure to pricing volatility.

"Some companies want to assume that volatility," says Damien Magarelli, a director at Standard & Poor's. But others may take a more prudent approach. It comes down to how companies decide to cede their risk, he says.

Reinsurers can limit their exposure to hurricanes and other disasters through catastrophe bonds, financial structures known as sidecars and a type of derivative contract known as industry loss warranties.

But these products, which appeared in the marketplace more than a decade ago, tend to be available primarily to retrocessionaires, or reinsurers of other reinsurance companies, and not buyers from primary insurance companies.

As a hedge against volatility, they're no surefire guaranty either. Catastrophe bonds, of which 20 were issued worth a total of $4.69 billion in 2006, according to Swiss Re and data from MMC Securities, Guy Carpenter and the Insurance Information Institute, are not immune to default by the issuer, for example.

Sidecars, a "flexible tool to create capacity collateralized to exposure," in the words of Thomas Holzheu, senior economist with Swiss Re Economic Research & Consulting, can hardly be considered diversified financial vehicles. Renewal options are also limited.

And the capital that has flowed into the reinsurance market through sidecars can just as quickly disappear from the market, according to A.M. Best & Co., in its 2006 Annual Global Reinsurance Report.

Reinsurance buyers, reminds Campbell, need to do their homework. "You just want to make sure they (reinsurers) have a good aggregate management program," he says. "There's really no way for the buyer to know that. So that's potentially a concern."

In general, Magarelli says prices have moved up over the past few years as catastrophe risk has increased for the reinsurance industry because of the frequency and severity of storms making landfall.

"As the catastrophe risk has increased, it has basically increased for the industry, and the separation of primary, reinsurance and retrocession has gone through a lot of changes in the past couple of years," he says.

Some companies have decided to offer more coverage to the market to take advantage of the price increases. Some other reinsurers, however, have done the opposite and decided to cut their capacity.

"The risk is being sliced and diced differently," he adds.

CONSOLIDATION AND CLUSTERING

Other dynamics are at work as well in the reinsurance marketplace to make it more sensitive to catastrophes than it was a decade ago, and not just because the damage inflicted by catastrophes is more severe than in the past.

Take, for example, the consolidation among the top 10 nonlife reinsurers writing business. In 1990, global market volume was $60 billion, according to Swiss Re Economic Research & Consulting, with the top four nonlife reinsurers commanding 22 percent market share. The next top five largest nonlife reinsurers had a market share of 11 percent. Lloyd's had a 7 percent market share, and Bermuda's share was almost nonexistent. The remainder of the marketplace, 60 percent, was split among the rest of the world's reinsurers.

But by 2006, with global market volume having blossomed to $137 billion, or up 128 percent since 1990, the top four nonlife reinsurers had a 29 percent market share, up seven percentage points. The next five largest nonlife reinsurers saw their market share increase two percentage points to 13 percent over the same period. While Lloyd's market share dropped by one percentage point to 6 percent, Bermuda's mushroomed to 16 percent. The remainder of the marketplace, which amounted to just 36 percent, was split among the world's remaining resinsurers. (See the table below.)

So there's consolidation at the top, but the changes are not something buyers on the whole have to worry about.

"I don't think that there's anything sinister or of great concern to a buyer from that perspective," says Campbell. "To a certain extent, one can argue that the growth in market share by the top 10 is the result of merit. They are doing business the right way so people want to do business with them. So that's a good thing."

Holzheu concurs. Buyers, both on the primary and reinsurance sides, needn't be unduly alarmed at concentration of market share, so long as they understand that the market has changed from what it looked like in 1990.

If reinsurance earnings volatility is sensitive to catastrophes in 2007, just how sensitive might earnings be five or 10 years from now?

With the North Atlantic in a warming phase, catastrophe models are changing to account for the greater damage from more frequent and powerful storms. The 2004 and 2005 hurricane seasons alone, with 13 hurricanes to make landfall in the United States, according to information compiled by the Insurance Information Institute, cost more than $81.4 billion in insured property losses.

And that caused havoc on the reinsurance sector. Reinsurers overexposed to property-catastrophe coverage ran into trouble. From the end of August 2005, when Hurricane Katrina slammed into Louisiana, until July 31, 2006, A.M. Best downgraded or withdrew ratings of 17 reinsurers.

"In total, 15 of the 17 net ratings changes were influenced by hurricane catastrophe losses," noted A.M. Best, in its 2006 Annual Global Reinsurance Report issued last August. In addition, in assessing the global outlook for the industry, the stability of the reinsurance market is "tenuous," the report said.

Even the largest diversified reinsurers like Swiss Re took a hit as the entire sector was downgraded to credit watch by Standard & Poor's. Prices for catastrophe coverage subsequently went through the roof.

Reinsurers large and small suffered, though the large ones less so as their surplus was still growing. The problem with the smaller startup reinsurers is that "they are on the weaker side when it comes to capital strength," says Holzheu.

That means they suffer the most when it comes time to pay back catastrophe losses. The collapse was stunning. Reinsurers with ratings in the A category in August 2005--Rosemont Re, PXRE Group Ltd., Quanta Capital Holdings Ltd, Olympus Re, Alea Group Holdings and Western General--all had their ratings withdrawn by A.M. Best analysts a year later.

"With the startups of the (Bermuda) Class of 2001, for some the losses wiped out their equity," Holzheu says. Alea, Quanta and Rosemont Re are in runoff, according to the A.M. Best report.

While some of the reinsurers were able to find fresh capital very quickly after their capital depletion by the hurricane season, Holzheu notes that the new capital is fragmented with some companies, again, being weak on capital strength.

"That's not something completely new either," he adds. "But the market has changed."

CYRIL TUOHY is managing editor of Risk & Insurance®.

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September 1, 2007

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