Performance
Outlook for 2009
A changing rating environment
Compared to last summer, when we were expecting continuing downward pressure on rates through 2009, the rating environment has begun to improve and the outlook is much more positive.
The rating environment across our business in 2008 was mixed. Reinsurance classes remained adequately priced, particularly for US peak catastrophe zones. The marine account was also past its peak but still capable of returning a reasonable margin. Following a sustained period of competition, airline insurance and UK commercial motor were beginning to show signs of bottoming out.
In contrast the international property and casualty accounts were starting to become highly competitive and rates were falling sharply in some classes, particularly large commercial property insurance.
We believe that the toll of 2008’s catastrophe losses, both natural and financial, on the insurance industry will change the ability and willingness of insurers and reinsurers to compete for business at lower and lower prices. Hurricanes Gustav and Ike reminded everyone, after two years of relatively benign insured events, that windstorms can be devastating. The combined insured claims for these events is estimated to be US$31 billion. The cost was borne by the reinsurance industry; both primary reinsurers and retrocessional reinsurers.
On their own, we believe that this would have been enough to halt the decline in US reinsurance pricing. However the financial impact of the credit crunch on the industry increased the pressure in dramatic style. Modest investment performance in the first three quarters of the year turned into poor performance in the final quarter, particularly following the collapse of Lehman. Almost simultaneously, AIG, the world’s largest insurance company, suffered a dramatic liquidity squeeze and had to be bailed out by the US government. Both equity and non government bond investment returns collapsed. Given the capital intensive nature of insurance, it was inevitable that the industry would be put under pressure, despite relatively conservative investment strategies adopted by many non-life insurers.
Insurance pricing cycles are driven by capital supply; pricing falls when capital is oversupplied and pricing rises when capital is scarce. The industry was adequately supplied at the start of 2008 – hence the pressure on prices described above. The combined impact of natural events and the credit crunch is estimated to have reduced capital in the non-life industry by more than US$100 billion.
Equally importantly, capital market activity in reinsurance went into reverse. We had seen increasing hedge fund involvement in reinsurance following Hurricane Katrina, through participation in temporary reinsurance vehicles, so called sidecars. The direct involvement of hedge funds through their own reinsurance companies also increased with many operating in the retrocessional market. As these vehicles provided letter of credit collateral to provide financial assurance to clients, substantial amounts of debt leverage was needed to allow adequate returns to be made. The withdrawal of leverage through the year, coinciding with the impact of Hurricane Ike, saw a withdrawal of much of this capital from the retrocessional market. It also meant that sidecars were unlikely to emerge to fill the temporary capital gap.
Finally the potential future returns from low risk investment, through government bonds or cash, fell sharply as interest rates were reduced to historic lows in many Western economies. This increases the pressure on insurers to seek higher margins from their core underwriting business.
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