By JONATHAN KENT, a business reporter in Bermuda
Bermuda reinsurers are facing growing challenges from deteriorating fundamentals, and their respectable profits this year have been heavily dependent on unsustainable loss-reserve releases. That was among the findings of a special report on the Bermuda market by ratings agency A.M. Best Co. Inc., which also found that conditions are "ripe" for consolidation in the market.
"Broadly speaking, pricing pressures persist, investment portfolios lack sufficient yield, and loss-reserve releases which are masking the symptoms are likely drying up," A.M. Best reported. "On top of that, insurers face potentially industry-changing financial regulation and taxation."
The 18 publicly traded companies that comprise the Bermuda composite followed by A.M. Best achieved an annualized return on equity (ROE) of 11.6 percent during the first nine months of 2010 and a 93.5 percent combined ratio, apparently indicating healthy underwriting profitability.
Scratching below the surface, however, A.M. Best reported: "The real story, however, is revealed by adding back the 7.1 percentage points of favorable loss-reserve development, increasing the combined ratio to 100.6 and cutting the ROE to the mid single-digit range."
Arthur Wightman, a partner at PricewaterhouseCoopers' Bermuda office, said that companies had been afforded some financial relief from the more severe 2010 events, such as the earthquake in Chile and the Deepwater Horizon oil rig explosion, by prior-year reserve releases.
"In a stage of the cycle often referred to as the 'cheating phase,' such releases inevitably dry up," he said referring to the soft cycle in property/casualty insurance underwriting, in comments published in his white paper titled "Unfamiliar Times Displacing Familiar Strategies."
"While the tail is relatively short on much of the business written within the Bermuda market, future events now have the potential to cause a more dramatic impact to quarterly earnings--as does future adverse development on prior-year reserves if releases go too far."
One way companies have been boosting their earnings per share in this "cheating phase" has been to buy back shares that are predominantly trading well below book value. Stock repurchases through the first nine months of the year amounted to more than half of net income, A.M. Best found.
The report indicated that net premiums written had trended downward since 2006, and investment income had also suffered from the effects of low interest rates. Some firms were holding more capital to cushion themselves against further market instability.
According to A.M. Best, "This phase of the cycle is akin to swimming in a riptide: the path to safety is to swim parallel with the shore until the current is cleared"--with the aim being in good shape to capitalize on the next hard market.
Alterra Capital Holdings CEO Marty Becker agreed that growth should not be the priority in the current challenging conditions.
"In our industry there are times to grow and times not to grow," Becker said at the Ernst & Young Property/Casualty Yearend Outlook conference in Hamilton this week.
"Growth is going to be penalizing at certain stages of the market cycle and, in reality, that's where we find ourselves today. And particularly with companies down here being heavily reinsurance animals. Reinsurance is a much more accordion-like business. It expands quickly in good times and shrinks pretty quickly in tougher times.
"It's counterintuitive for underwriters to manage their portfolio to not necessarily grow, but to look for that bottom-line profitability. What you find in this market is the temptation to do things you wouldn't otherwise do, and usually that doesn't end up well, but the toughest discipline in our business is to stick to our core principles at a time when all the headwinds are against you."
The Best report also discussed the challenges the Bermuda market faces in the future: the importance of gaining regulatory equivalence with the Solvency II rules due to take effect in Europe in 2013, and responding to the threat of potentially harmful U.S. tax legislation.
The report concluded: "A.M. Best expects the Bermuda market to stay relevant even if U.S. legislation is passed. The Bermuda market will continue to be innovative and, depending on the severity of the Neal Bill, may even attract more companies."
December 10, 2010
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