With renewal rates down and a soft market seemingly upon us, many reinsurers find themselves facing a challenging environment in 2008 and beyond.
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.
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.
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.
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 toward 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.
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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