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By Graham Buck

Hurricanes Isaac and Leslie were certainly no pussycats, but in contrast to the mauling that natural catastrophe losses inflicted on the reinsurance industry in 2011, they caused no more than a few scratches.

The reinsurance industry's continuing success in attracting new investors, offset by the fact that the capacity it can offer outstrips demand, saw Lloyd's of London's CEO Richard Ward turn to Charles Dickens as his muse.

To summarize its current predicament Ward quoted the lines, "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness," that open the Charles Dickens novel, "A Tale of Two Cities."

Opening this year's central debate at the conference, which focused on the reinsurance industry's capital management and allocation of capacity, Ward stressed that members could regard the past five years as "a proud time."

"We withstood the financial crisis and proved resilient in the face of the natural catastrophes of 2011," he said.

Ward also noted how an "extraordinary amount of capital" left the industry, "yet no one questioned its ability to pay claims and no company was forced to go cap in hand to the government."

The industry had played a key role in helping the economies of Australia, New Zealand, Japan and Chile to rebuild. Of $8 billion of losses from flooding in Australia, reinsurers had borne $3.5 billion, while reinsurers had paid $12.5 billion of the $17 billion losses caused by the New Zealand earthquake.

Ideally, there would be even greater demand for the product in mitigating economic loss. For example, the quake and tsunami that hit Japan in March 2011 caused a total economic loss estimated at $210 billion, but the industry paid out only $35 billion.

Its ability to pay a greater role was threatened by a regulatory environment that remains "in flux," as Ward pointed to a range of regulatory debates that were not yet concluded, such as Solvency II, ComFrame (Common Framework for the Supervision of Internationally Active Insurance Groups, being developed by the International Association of Insurance Supervisors (IAS)), Global Systematically Important Institutions (GSIIs) and statutory collateral requirements. Each carries the risk of higher regulatory, compliance and capital costs.

"When I speak with domestic regulators who are seeking to impose more restrictions on the industry, I respond by saying, 'Be careful what you wish for,' " said Ward. "Global reinsurance for the international market may no longer be there."

INDUSTRY LOSING RELEVANCE

An even bleaker prognosis of the industry came from Mike McGavick, XL Group PLC's chief executive officer, who suggested the past decade had seen a steady decline in the relevance of insurance and reinsurance to businesses and to society generally.

He pointed out that, over the period 2002 to 2011 global gross domestic product had averaged annual growth of 3.8 percent, and while the property/casualty industry had expanded from $1.1 trillion to $2 trillion over that time, its growth over the same period, at 2.5 percent, had lagged. As a result, the industry's contribution to total global activity had shrunk from 3.4 percent to 2.8 percent.

"The stark fact is that we are becoming less relevant," said McGavick. "We make less of a difference to the economy and, as this happens, we will attract less capital. This is a reality and a trend we must act to reverse."

The decline in relevance was particularly evident in two industry sectors, technology and power, and in the extended supply chains that have become an integral part of modern business practice. The world's top five companies are Apple, ExxonMobil, Microsoft, China National Petroleum and IBM; each with a market value far in excess of that of the entire reinsurance sector. The ability of insurers and reinsurers to cover their risks is limited, as was evidenced by the Gulf of Mexico oil spill, which revealed that BP's policy was to self-insure.

XL's chief noted that technology is all about the instant sharing of data, which has been made possible by the smartphone.

In 2010, a total of 1.15 billion smartphones were in use globally; by 2020, that figure is projected to rise to 4.3 billion -- when smartphones will account for four of every five phones used. "Watches, cameras, video cameras and conventional phones will all become obsolete and the industries will be destroyed," said McGavick. "Those same industries that we insured or reinsured will no longer exist."

The industry had made some response to the needs of the technology sector, developing the first cyber-liability policy back in 1998. By 2008, a total of 12 carriers offered the product and the total has since grown to 31, yet 72 percent of technology companies are opting not to buy cyber-liability cover.

Similarly, the reinsurance industry was also missing out on opportunities in the energy sector. "U.S. energy sector capitalization is $825 billion, or five times the size of U.S. property/casualty providers' capitalization," said McGavick. "Yet, we offer a lot more than just balance-sheet protection, such as the expertise and insights that BP would have found useful [after Deepwater Horizon/Macondo]."

On the issue of modern business practices, he noted that just-in-time supply chains have been in existence for more than two decades, yet many insurers and reinsurers appeared to be astonished by the interdependencies exposed last year by the Japan earthquake and, subsequently, the floods in Thailand. The temporary unavailability of a $90 component caused many companies to halt production and the price of computer chips rose tenfold.

"Our response to such losses is to impose a sublimit or exclude the risk, but we can't use it as a means of gaining greater relevance," said McGavick. "As an industry, we have to reclaim our space. We demand data from the past 10 years, but whole new industries will come and go while we wait for it. We have to use analytics in a new way, and also to recognize that our best talent can't always be allocated to the most profitable business."

McGavick concluded by warning that the advent of the Solvency II regime and its demands for greater capital buffers threatens to erode the reinsurance industry's returns, drive more merger and acquisition activity, and reduce the number of companies in the industry. "We'll hunker down, play safer and become less relevant," he warned.

SOLVENCY II SCORECARD

According to Dominic Crawley, global head of financial services ratings at Standard & Poor's, Solvency II will force much of the industry to adapt to elevated capital costs. Participants will have to review their business models and individual business lines, and the new regime will produce winners and losers. The advantage will be with insurers and reinsurers with well-diversified business models and products that don't carry investment guarantees. Losers will include those with products that still have attaching guarantees and companies dependent on the performance of equities.

"The industry has to contend with an environment in which investment returns are incredibly low, and could stay so not just for another year or two but for a further five or seven years," he warned.

Swiss Re CEO Michael Liès, who has a mathematical background, noted the growing importance for the industry of "economic navigation" in a period when its traditional instruments show contradictory signals. Its stakeholders hold differing perspectives on what its capital adequacy should be based on.

For clients, it was prompt payments of claims; for regulators, the protection of policyholders and financial stability; for rating agencies, the fulfillment of obligations to both policyholders and debt holders; and for investors, the provision of high risk-adjusted returns.

"These conflicting signals and different perspectives can lead to uneconomic decisions," he said.

For Swiss Re, as the world's second-biggest reinsurer, the way ahead for the industry during a time of low-interest rates, weak economic growth and regulatory changes is to focus on new and emerging markets.

"We will continue our execution to increase our business in the markets of Latin America, Africa and Asia, and focus on the most high growth markets in these areas," said Liès. The Zurich-based group has a 15 percent share of business in these markets and aims to increase it to between 20 percent and 25 percent by 2015.

It plans to do so by focusing coverage on five areas: agriculture, natural catastrophes, infrastructure projects, life insurance and health care coverage.

GRAHAM BUCK covers European risk management issues. He can be reached at riskletters@lrp.com.

October 11, 2012

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