Where Has Traditional Reinsurance Gone?
August 2008
With renewal rates down and a soft market
seemingly upon us, many reinsurers find themselves facing a challenging environment
in 2008 and beyond.
by Larry
P. Schiffer *
Dewey
& LeBoeuf LLP
The run up in catastrophe losses in the first half of 2008 and the write
downs from the subprime mortgage debacle have put additional pressure on traditional
reinsurers. Yet, decreases in reinsurance prices and strong capacity have not
significantly increased the demand for reinsurance, and in many sectors demand
has actually decreased.
The extent to which reinsurance arrangements are changing depends in part
on the type of risk being covered. While the property and casualty sector remains
a reliable purchaser of reinsurance, the top 10 purchasers of professional liability
coverage now reinsure 60 percent less risk than in 2004. Clearly, something
is occurring to dampen the market for traditional reinsurance.
This Commentary will examine a number of factors behind this trend and consider
whether they portend a shift away from the traditional reinsurance structure.
Self-Insurance Options
Several years of strong results have contributed to a surplus of capital
and a desire by primary insurers to boost their own underwriting profits by
retaining the risk of their more profitable lines of their business. The use
of various forms of self-insurance has proven to be a popular alternative to
traditional reinsurance. In fact, Congress is looking to extend this trend by
expanding the reach of the Risk Retention Act to lines of business not previously
authorized.
According to a study by Conning Research & Consulting, self-insurance now
accounts for almost 20 percent of the overall commercial insurance market, a
figure that seems likely to rise in the coming years. The movement toward increased
self-insurance is particularly evident in the workers compensation industry,
where the use of large deductible programs has enabled the realization of strong
underwriting profits in 2006 and 2007. This marks the first time that industry
has achieved back-to-back profits in more than 30 years.
The past decade has also witnessed the formation of over 1,500 captives,
another popular tool for insureds to retain more risk. Indeed, many of the same
trends affecting the larger reinsurance industry have coalesced in the world
of captives. A survey by the Captive Insurance Companies Association found that
since 2006, there has been a decrease of almost 20 percent in the number of
captives purchasing reinsurance. Marsh Inc., in their 2008 Global Benchmarking
Report, found that of the captives formed on or after January 1, 2004, the number
formed as pure insurance entities has increased approximately 40 percent from
those formed before that date.
For some companies, increasing retentions through the use of a captive has
been a response to insurance market cycles. When faced with a substantial increase
in reinsurance premiums several years ago, Harvard Medical Institutions chose
to use the good history of its captive to increase retentions and gain more
coverage flexibility. The Marsh benchmarking report suggests an increasing willingness
on the part of captives to assume more risk if market conditions become unfavorable,
finding that many companies are "significantly" better capitalized than required
by their current levels of risk.
Other companies have used their captives as a means to earn additional profits
by underwriting significant amounts of third-party business. Verizon Communications,
through their "Verizon Advantage" program, offers discounted personal lines
coverage to employees, a practice that has the added benefit of allowing Verizon
to take tax deductions on the premiums it pays for many of the company's other
lines. The gains from its outside lines of coverage have in turn decreased the
incentive for Verizon to reinsure Employee Retirement Income Security Act (ERISA)-regulated
employee benefits.
Despite the advances of the past decades, there is evidence that the use
of increased retentions as an alternative to reinsurance may have peaked. A
2006 study by Conning & Company found that the overall retention levels of single-parent
captives suggest they have reached maturity, resulting in little additional
financial gain in taking on additional risk. Instead, many risk bearers are
seeking new ways to increase their risk capacity and are frequently circumventing
the traditional reinsurance markets in doing so.
Alternative Markets
Recent years have witnessed the development of a variety of new alternative
risk transfer mechanisms that are already shifting the balance of reinsurance
market power toward cedents. The growth of government reinsurance programs,
particularly in the areas of catastrophe and health reinsurance, has contributed
to a softening of demand for traditional reinsurance. Of particular interest
is the continuing development of the Florida Hurricane Catastrophe Fund (FHCF)
(discussed in greater detail in the June 2007
Commentary). While the FHCF has certainly introduced additional competition
into the market, the fund's impact on demand for traditional reinsurance appears
to be less than originally predicted.
Risk retention groups (RRGs) have also seen their popularity increase in
recent years, although they still account for only around 2 percent of the overall
commercial liability market. A 2007 study by A.M. Best found strong risk management
by RRGs led to significant gains in profitability. Growth in this area has been
particularly strong in the healthcare sector, with medical malpractice insurance
accounting for 43 percent of A.M. Best-rated groups. If the Risk Retention Act
amendments are signed into law, further expansion in more traditional lines
of business will be seen.
Another alternative to traditional reinsurance that has gained significant
momentum in recent years is the use of alternative risk transfer via the capital
markets. Primary insurers are increasingly exploring the use of investment vehicles
such as catastrophe bonds (also known as cat bonds) as a way to offset risk.
Allstate, Chubb, Travelers, and State Farm each entered the market in 2007,
collectively issuing a total of $2 billion in cat bonds. A February 2008 study
by Guy Carpenter found that despite softening rates for traditional reinsurance
in 2007, the value of publicly disclosed cat bonds issued rose to nearly $7
billion, an increase of 49 percent over 2006, which was itself a record year.
Cat bonds have also undergone a fundamental increase in size. Prior to 2005,
there were no cat bonds issued larger than $500 million. Since that year, at
least five transactions have exceeded that figure.
Although the creation of insurance-linked securities slowed during the first
quarter of 2008, they remain popular with institutional investors because they
provide high returns in a way that is largely independent of economic conditions.
Sidecars, a type of investment vehicle often used to provide retrocessional
coverage to reinsurers, are particularly appealing to entities like hedge funds
and private equity funds and have helped redirect additional capital away from
traditional reinsurance and toward the capital markets. Although some of the
2- and 3-year sidecars developed in the aftermath of Hurricane Katrina have
not been renewed, the short-term flexibility sidecars provide means they are
likely to remain an option.
The demand for insurance-linked securities has also begun to expand into
areas other than property/casualty. Life reinsurers in particular are adjusting
to declining policy lapse rates stemming from the growth in mortality securitizations.
Bonds based on the probability of pandemic disease and reverse mortgages, a
method of securitizing longevity risk, have grown in popularity. A 2005 move
by the French insurer AXA to offer auto insurance securitizations is especially
interesting because it represents one of the first securitizations of a high
frequency, low risk event. Given the increasing market acceptance of these types
of securitizations, it is apparent that the emergence of a deep secondary market
for the insurance industry as a whole will likely have a long-term effect on
the bottom line of reinsurers.
Structural Changes
Changes occurring within the insurance industry as a whole are also playing
a part in determining what form new reinsurance arrangements take. The wave
of industry consolidation that began earlier in the decade has also played a
role in altering demand. This phenomenon is particularly apparent in the area
of life and health reinsurance, where the top five reinsurers now hold a combined
market share of over 75 percent, resulting in tougher pricing and decreased
capacity for both reinsurance and retrocessional coverage. As a result, cession
rates for life insurers declined from 61.5 percent in 2002 to 40 percent in
2006.
In Europe, the specter of Solvency II is already driving changes in the European
insurance market. Although not scheduled for implementation until 2012, unresolved
questions regarding the proposed framework continue to leave many insurers uncertain
of how best to cope with the coming regulatory changes. In particular, concerns
over how to calculate minimum capital requirements have made some small and
medium-sized insurers wary of depleting their capital reserves, potentially
discouraging reinsurance purchases. Other, larger European insurers are looking
to use their capital to pursue merger opportunities as a means of diversifying
their businesses, thereby decreasing capital requirements and enabling greater
financial flexibility. Despite these trends, the full effect of the Solvency
II legislation on the reinsurance market remains to be seen.
On a more fundamental level, A.M. Best notes a greater understanding by primary
companies of the event-driven price sensitivity of traditional reinsurance,
which has led some companies to reevaluate the way in which they use reinsurance.
Enhanced enterprise risk management programs, combined with pressure from rating
agencies and investors, have contributed to an awareness of the need to invest
in future advancements and sound underwriting instead of simply buying more
reinsurance when prices are low.
At the same time, an unstable investment environment has led many primary
companies to seek alternative sources of profit. Unlike in past soft markets,
primary insurers appear unwilling to loosen underwriting standards and are instead
using capital that might otherwise have gone towards the purchase of reinsurance
to expand into new business lines and geographic areas.
The example of Boeing, the world's largest purchaser of insurance for aviation
risks, demonstrates the effect of industry-driven changes. After the events
of September 11, 2001, Boeing faced sharply increased rates for aviation products
liability as nearly 25 percent of aviation insurers left the market. Boeing
responded to these market changes by refocusing their risk management approach
to emphasize flexibility. Boeing's high capital reserves have enabled large
deductibles for property liability. The company's two captives, which were previously
used only in order to access the reinsurance markets, are now part of a larger
deductible buy-down program and increasingly retaining more of the company's
risk. Boeing has also assumed third-party risk by participating in a workers
compensation pool.
Conclusion
The demand for traditional reinsurance continues to evolve as the industry
adapts to new economic and regulatory pressures. The emergence of substantial
alternatives to the traditional reinsurance market, particularly the growth
of insurance-linked securities and the movement toward increased retentions
by primary companies, indicates that the future of reinsurance may be fundamentally
different from its past.
* The author gratefully acknowledges
the valuable assistance of Luke McCloud in the research and drafting of this
Commentary. Luke, who will be attending Harvard Law School starting in the fall
2008, was an SEO intern at Dewey & LeBoeuf LLP during the summer of 2008.
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