REINSURERS' REPRIEVE MAY BE RUNNING OUT LOW CAT LOSSES AMONG FACTORS MASKING UNDERLYING WOES

Reinsurers' days of good results may be coming to an end.

Results continue to be good for the reinsurance industry for a variety of reasons, despite the competitive market. Among the reasons are the absence of catastrophes and the prevalence of excess-of-loss business, which largely decouple reinsurer results from those of the primary industry.

Sooner or later, however-and perhaps as soon as next year-the business' underlying deterioration is likely to catch up with reinsurers, observers warn.

In addition to finally feeling the impact of dropping rates, the industry could be running out of the redundant reserves that have helped bolster results, some say.

On the other hand, many believe it will take several catastrophes, not just one, to have a significant impact on the reinsurance market (see story, page 32).

Meanwhile, merger and acquisition activity is expected to continue, albeit perhaps with smaller players, even as new reinsurers continue to be formed to meet perceived needs in particular market niches (see story, page 34).

For surviving reinsurers to generate even more premium in an increasingly mature U.S. market, reinsurers are turning more to international business, though financial reinsurance programs, including securitization and catastrophe bonds, hold promise as well.

For the first six months of the year, the 45 reinsurers surveyed by the Reinsurance Assn. of America reported a 101.5% combined ratio, compared with a 104.8% combined ratio by a comparable group for the same period in 1996 (BI, Sept. 8).

Observers say the reasons for the good results include the absence of catastrophes, the emphasis on excess-of-loss business and the takedown of reserves from previous years.

One "quick and easy" reason reinsurers have done well is that "any reinsurer that's written a reasonably large cat book of business since Andrew has made a ton of money," pointed out John Berger, president and chief executive officer of F&G Re Inc., a Morristown, N.J.-based unit of USF&G Corp.

In a year like 1997, "where not much happens, that drops right to the bottom line," said Mr. Berger.

With little activity in the catastrophe area, "property is sort of supporting the results of the rest of the business," said Steven Bolland, senior vp with reinsurance intermediary Gill & Roeser in New York.

Even with the dramatic rate reductions of the past two years, he added, Bermuda catastrophe insurers are reporting very good earnings, with loss ratios of less than 10% not unusual, said Mr. Bolland. "That's terrific business, but it has to be viewed as being unusual in the scheme of things," he added.

Another factor influencing results has been reserves. "There has (already) been a lot of reserving that has taken place with respect to some of the larger, more distinct casualty classes so that there hasn't been any need as of yet to make appreciable adjustments to these reserves on the part of reinsurers," said Tal P. Piccione, president and CEO of reinsurance intermediary U.S. Re Corp. in New York.

But some reinsurers "just may not be as well-reserved as they were in prior years, shall we say," said Mr. Bolland.

Phil Ben-Zvi, a consultant with Coopers & Lybrand L.L.P. in New York, also pointed to reserves. "I would say both primary companies and reinsurers are probably still enjoying some favorable development on their old reserves and in some cases may also be getting a little behind in their current reserves, so there may be some future prices to pay."

Executives and analysts also cite the continuing prevalence of excess-of-loss business as having helped results, though some perceive a current trend toward more pro rata business.

"Most reinsurers have a significant amount of business on an excess-of-loss basis, which allows them to be somewhat decoupled from the pure primary results," said Jerry Karter, president and CEO of SCOR U.S. Group in New York.

At the same time, "primary companies have increased retentions steadily, and so to the extent that they do that, reinsurers take less of the business. If the basic business is underpriced, then theoretically the primaries ought to be feeling it first, and the reinsurers, writing on an excess-of-loss basis, should have actually better results," said Mr. Karter.

Gary Ransom, senior vp at Conning & Co. in Hartford, Conn., agreed this is factor. As primary companies increased their

retentions, reinsurers have moved up into covering higher layers, "kind of keeping above the working layer," and so they have been less likely to be hit with losses.

With the shift toward excess-of-loss business, "the reinsurer was able to regain control of the pricing function of the risk that it was accepting, rather than hand his pen over to somebody who really didn't give a damn and was willing to abuse the relationship in order to gain market share," said Michael Smith, an analyst with Salomon Brothers in New York.

Some expect the good times to continue for reinsurers indefinitely. The flight to quality during the past 12 years has resulted in a "core universe of companies" that have a "very high degree of price leadership coupled with a high degree of price discipline," said Mr. Smith.

"As long as you have that macro underwriting environment, the superior underwriting results will continue to exist," he said.

Pointing to last month's stock market downturn, John L. Ward, CEO of the Ward Financial Group in Cincinnati, said reinsurers do tend to be a little more heavily invested in equities than the industry overall, so any longer-term impact on the stock market "may have a greater impact on their performance."

However, there is a good chance the reinsurers' steady results will continue, Mr. Ward said. "It's a fundamentally solid, well-capitalized segment," he said.

"A well-run reinsurer has enormous flexibility to continue to produce earnings growth despite cyclical fluctuations," said Weston M. Hicks, an analyst with Sanford Bernstein & Co. in New York.

"The reinsurer in many cases can afford to essentially keep the reserves that they have, let the investment income compound, return free cash flow to stockholders and wait until demand comes back," he said.

Others say the favorable results will not necessarily last long, however.

"I think, going forward, loss trends aren't going to disappear" and catastrophes will happen, said F&G Re's Mr. Berger. "I don't think the good times will continue."

William L. Munson, chairman, president and CEO of Morristown, N.J.-based Toa-Re Insurance Co. of America, said that assumptions on future losses are overly optimistic. He added that inadequate pricing will catch up with reinsurers "quicker than most people think," at the tail end of next year.

It is hard to see how the industry can go on as it has much longer without a "pretty negative cash flow," said Mr. Munson. "That's a hard thing to manage over long periods of time," he said.

"I believe strongly that this is the last year we're going to see good results in the business," said Bard E. Bunaes, chairman and CEO of Constitution Reinsurance Corp. in New York. Pointing to estimates of asbestos and environmental losses, he asked, "Where the hell are they showing up, and when are they showing up?"

"I think it's one of the toughest climates I've ever seen in the business, and I've been in it over 30 years," added Mr. Bunaes.

Part of the problem is inexperienced underwriters, Mr. Bunaes said. "Most of the underwriters in the reinsurance business today weren't even out of school in 1982, 1983, 1984 when we had the old problems. I'm sure they're smarter than we were when we underwrote in those years, but they don't know how bad it can get," he said. "They certainly don't have the experience of having seen it before."

If current trends continue, "there will be increasingly unprofitable results showing up in '97, '98, especially if catastrophes return in '98," said Cooper & Lybrand's Mr. Ben-Zvi.

Gill & Roeser's Mr. Bolland said, "It doesn't take a genius to realize when you have had reinsurance rates and premiums dropping 10% to 15% a year," you cannot "hope to continue to achieve the same results."

If there are a number of catastrophes, this business cannot continue to support other lines, he said. Furthermore, "if you are not as well reserved as you were in prior years, that has to come to an end."

"You can't keep on reducing the level on which you're reserved, but that would obviously vary by company and by how profitable you are" and the lines of business the company is in, said Mr. Bolland.

Kaj Ahlmann, chairman, president and CEO of Overland Park, Kan.-based Employers Reinsurance Corp., also pointed to the differences among reinsurers. How long good results continue will depend on the particular reinsurer, including whether it is only in property and casualty, if it writes on a pro rata or an excess-of-loss basis and how involved it is in health care and alternative risk, he said.

More M&A on the way

Meanwhile, merger and acquisition activity is expected to continue. Most recently, Tokyo-based Toa Fire & Marine Reinsurance Co. Ltd. agreed to purchase the outstanding common stock of The Mercantile & General Reinsurance Co. of America from Swiss Reinsurance Co., in a deal valued at about $200 million (BI, Nov. 3). The operation will be merged into that of Toa-Re Insurance Co. of America.

"I believe that merger activity will remain hot and heavy for some time to come," said Philip W. Mitchell, senior vp at Towers Perrin Reinsurance in Philadelphia. "There are still several reinsurers who do not have the size to compete in the long term, which will force them to merge or be acquired."

"I think we're going to continue to see consolidation," said John Wicher, managing director of San Francisco-based investment firm Russell Miller Corporate Finance Inc.

"We are truly in a global marketplace where a significant capital base is required and (must be) coupled with new expertise and talent, which is beyond the reach of many smaller reinsurance companies," he said.

"I still think there's a lot more consolidation that's going to occur in the broker market," said Steven J. Bensinger, president of Stamford, Conn.-based Chartwell Reinsurance Co.

"There are still a very significant number of players, not all of whom can necessarily afford to continue provided that their shareholders are demanding a reasonable return on capital," he said.

Pointing to the major direct writers in the United States, Mr. Ahlmann said, "I still don't think it makes a lot of sense to put any of those guys together."

He added, however, "ERC continues to look at deals every week around the world" that can support what the company is doing "one way or the other."

Some observers say there will not be any more major merger activity.

"I've got to believe the big ones are done," said Heidi Hutter, chairman, president and CEO of the Swiss Re America Corp. in New York. But there may be more consolidation among small and medium-sized reinsurers, she added.

"I've got to believe managements of these companies are each looking at one another. Probably each one wants to be a consolidator and not consolidatee," she said, adding, "It's a puzzlement to me that more hasn't happened." Perhaps the offers are not high enough, she suggested.

"The major transactions have already occurred," agreed Sanford Bernstein's Mr. Hicks. "While there may be additional transactions in the future, I don't see it as a major industry theme going forward."

Some modest consolidation may take place, but there "does not appear to be a driving reason for more," said Mr. Ward. "I don't see a compelling reason why there should be more of it."

In search of growth

Aside from the merger and acquisition activity, to grow in an increasingly mature market, more reinsurers are turning to international business and in some cases financial reinsurance programs. More primary program business is another option they are pursuing as well.

"I think the move nowadays is overseas," said Gill & Roeser's Mr. Bolland. "It's kind of dumb to be killing one another over increases in premium volume in the United States at the moment," he said. "You'd have to slash prices even further and quicker to gain income."

With the current rate decreases, "merely standing still" means "you're probably going to lose 10% of your income this year," said Mr. Bolland. The only way to grow is to go overseas, he said.

"I think there's still a lot of opportunities in North America, but I do think the big companies will have to be global," said Employers Re's Mr. Ahlmann.

"I think the small companies trying to be global without critical mass to do it can be suicidal because it takes too much attention away from what they have to do," Mr. Ahlmann said.

"I think we're all scrambling everywhere we can to look for business that makes sense," said F&G Re's Mr. Berger. "We're being forced to because in the U.S. market except for Southwest wind (exposures) everything else is crowded. Even California earthquake is getting crowded again," and Southeast Asia and Latin America are tiny markets, though they do have "long-term prospects."

Indonesia, for instance, has 200 million people but per capita annual income of about $500. "It is going to take a little while before those people are buying a lot of insurance," said Mr. Berger.

Growth is going to be difficult to come by, said Mr. Hicks. "The problem is that the U.S., Japan, continental Europe are all mature markets. There's only so much business that can be written in Southeast Asia.

"I think that the smarter reinsurers are recognizing they have to shift towards higher value-added products, which might mean writing less premium, such as less proportional business in Europe and more non-proportional business, but earn a higher return for each dollar of capital employed," Mr. Hicks said.

"A lot of the companies are really exploring some of the non-traditional kinds of reinsurance," such as securitization, said John Bailey, who heads the insurance industry practice group for Coopers & Lybrand L.L.P. in Hartford, Conn.

"Maybe we need a paradigm shift," said Swiss Re's Ms. Hutter. "People should get away from the idea of increasing premium," she said, noting Swiss Re has successfully cut its volume, while increasing its profitability.

"I think the first problem is people have gotten accustomed to thinking premiums equal profits," but this is not necessarily true, said Ms. Hutter.

"I still see tremendous innovation on the horizon," she said, pointing to new products, such as catastrophe bonds and derivative-type products.

"The traditional way we've done business and grown is going to change," predicted Toa-Re's Mr. Munson. "I would not interpret that to mean there's no opportunity here. What it means is. . .if we're creative and run a good company, there are huge opportunities.'