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It wasn't quite a perfect storm, but a combination of adverse developments on old business and new catastrophes made 2004 a rough year for U.S. reinsurers.

Hurt by reserve additions for casualty business written before 2001, losses on hurricanes and losses on old asbestos and environmental claims, U.S. reinsurers turned in a poor underwriting performance last year.

Although prices started to decline in 2004, increases in 2001, 2002 and 2003 should have led to strong results for 2004, according to Standard & Poor's. But adverse developments continued to cause big problems for reinsurers in 2004.

"Results continued to be very poor," says Laline Carvalho, a director at Standard & Poor's. "We expected difficulties in 2003 and 2004, but it was still surprising to see the numbers for 2004 and see how disappointing they really are."

Reinsurers added a total of about $4 billion to reserves in 2004, which contributed an estimated 16 points to the industry's 2004 combined ratio, according to S&P.

The big four direct writers--General Re, Swiss Re, American Re and GE Insurance Solutions--all made major additions to reserves in 2004 and reported large underwriting losses.

"The primary players are the large traditional writers, and they continued to report adverse development," says Yvonne Bernard, managing senior financial analyst at A.M. Best. "The Bermuda market is doing very well, but the traditional writers tend to overshadow the rest of the industry," she says.

Adverse development continues to be a problem in 2005.

In July, Munich Re said it would increase reserves at American Re by a pretax amount of $1.4 billion, net of $203 million in retrocessions to Munich Re, and would make a capital contribution of about $1.1 billion to American Re.

XL Capital also announced in July an increase in net reserves in its North American reinsurance operations of $191 million pretax.

More material charges may be on the horizon for other reinsurers that have not been as aggressive as XL in addressing the legacy issues related to the 1997-2001 business, according to A.M. Best.

Although net premiums written were roughly flat in 2004, they were down more than 10 percent in the first quarter of 2005 compared with the same quarter last year.

Net premiums written at Everest Re, GE Insurance Solutions, General Re and National Indemnity declined by more than 20 percent in the first quarter. American Re, Swiss Re and XL Reinsurance America, however, posted higher net premiums written.

S&P's Carvalho says this divergence may be evidence of a growing bifurcation of the market, with some reinsurers retreating from certain lines and others seeing opportunities for profit in those same lines.

The overall decline in premium volume, however, can be attributed to several factors. Some of it is simply the result of a decrease in the number of U.S. reinsurers reporting to the RAA.

Reinsurers also have turned down business as premium rates, terms and conditions began to soften in 2004.

"In general, there is a very disciplined approach," says Thomas Holzheu, senior economist for Swiss Re. "Companies try to really look for business and write business for profits," he says. This is a change, he says, from the past when business was often written for growth, not profits.

WHAT CAN BUYERS EXPECT?

Property reinsurance rates appear to be softening at the margins, but casualty rates are still relatively firm, according to one large U.S. insurer.

"I think the market is still disciplined," says an executive with the insurer. "I think with respect to the property market, to some extent, it was the 'Tale of Two Cities.' Ceding companies that had significant losses ceded to reinsurers as part of the hurricanes last year probably saw more pressure on pricing than companies that didn't," he says. But, he says, property rates were flat to down overall.

Despite its vows to the contrary, the industry has a history of eventually abandoning price discipline and competing for business on price.

Rates have already started to trend lower in some lines, and new entrants into the market may put further pressure on prices.

Although some U.S. reinsurers left the market in the last year or two, hedge funds have jumped in.

Take Glacier Re, for example, a $300 million Swiss-based reinsurance startup backed by Soros Fund Management, HBK Investments and Benfield Investment Holdings Ltd. The fund was launched late last year in response to favorable conditions in the specialty-lines market.

Or, take Citadel Investment Group, a $10 billion Chicago hedge fund that, also last year, started CIG Reinsurance Ltd., a Bermuda-based reinsurer.

On the other hand, poor underwriting results and escalating costs as a result of the legal and regulatory investigations into reinsurers' finite re operations may keep pressure on rates.

"The probe into finite reinsurance is going to be paid for by the buyers of reinsurance," says Andrew Barile, an independent reinsurance consultant in Rancho Santa Fe, Calif.

Many reinsurers, for example, have had to hire teams of expensive lawyers to respond to subpoenas related to the various investigations, and the reinsurers have had to spend a lot of time and money beefing up their Sarbanes-Oxley compliance.

In addition, heavy catastrophe losses would give reinsurers even more reason to stay firm on pricing.

THE OUTLOOK FOR 2006

Although there may still be some adverse development in 2005, the problem appears to be winding down and should be less of a problem in 2006, Holzheu says.

"If you look at the year 2005, if you get a better Cat year than last year--last year was extraordinarily high in catastrophes in the United States, and assuming adverse development is winding down, then the year 2005 should be good, or better than last year," Holzheu says.

January renewals should not bring any major changes in industry trends, says the insurance-company executive.

"Barring an external catalyst, a rash of hurricanes or unusual adverse development, I don't see that we're at any kind of inflection point in the cycle in the primary market or in the reinsurance market," he says.

For 2006, adverse development may be less of a factor. But longer term, softening rates will decrease profitability, Holzheu says.

Investment income may start to improve with increases in interest rates, but the industry cannot rely on a booming stock market to finance its underwriting operations the way it did during the last soft market, Holzheu says.

The most recent hard market has been so short that reinsurers have still not had enough time to rebuild their balance sheets, analysts say. This may mean that the next soft market will be shorter and not as deep as the previous ones. With their balance sheets still in a weakened condition, reinsurers are in no position for extended price competition.

"There are so many reasons why (reinsurance) companies should be more prudent now," Carvalho says.

In the end, a strong, stable reinsurance industry is also good for the primary market as well.

"I adhere to the philosophy that a disciplined, rational reinsurance market is good for the long-term viability of the primary market," says the insurance company executive.

PATRICIA VOWINKEL is a freelance writer and frequent contributor to Risk & Insurance®.

September 1, 2005

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