On “Uncertain” Ground

As recently as 2009, Holborn and other analysts reported that the industry had many billions more in capital than the level where reinsurers’ leverage ratios would begin to affect market capacity and pricing. We estimated $60 billion in excess capital at the beginning of 2010. Reinsurers’ after-tax loss from Hurricane Katrina was near $20 billion, and thus it might take the equivalent of three Katrina-sized events in 2010 - 2011 to move prices.

Since then, reinsurers have sustained a Katrina-sized loss in Japan, and an equivalent-sized adverse combination of other losses over the last fifteen months. The second quarter in the U.S. has been at record levels for tornado losses, as well. For U.S. coastal property exposures, the recent model changes (RMS version 11 and to a lesser degree AIR version 12) have required many reinsurers to assign more capital. Thus, for U.S. coastal property business, the market’s capital has, in fact, felt “Three Katrinas” and begun to move, although with capacity tightening more than pricing. Other classes of business that have not had model changes or do not rely as much on capital levels have not shown this stress and remain more stable.

The overall pricing environment at year-end will depend on the experience in this coming wind season and financial factors. The market will be different across the various lines of business and regions.

Overview
• Despite avoiding a U.S. hurricane landfall in the 2010 season and with 2011’s just begun, reinsurers had far worse than average catastrophe experience in both 2010 and 2011.
• In the year prior to the Japan earthquake and tsunami on March 11th, the worldwide industry had already sustained losses on a record number of multi-billion dollar events (Chile earthquake, a windstorm in France, Deepwater Horizon explosion and spill, New Zealand September earthquake, Western Queensland floods, Brisbane floods, Cyclone Yasi, and New Zealand February earthquake). That was already the worst 12-month block for large losses since Katrina, and represents over 15 points on the professional reinsurance industry’s annualized loss ratio, and nearly 10 points above long-term averages.
• The U.S. had a very severe first half for large weather-related losses, with two multibillion dollar tornado outbreaks, several floods, and ice and collapse losses earlier in the year. We estimate U.S. second-quarter weather losses at more than $20 billion. Relative to premiums, it has been the worst second quarter for U.S. catastrophes since Hurricane Agnes in 1972.
• Reinsurers’ reserves weakened by well over $10 billion during 2010, overstating income. In addition to Casualty reserve savings on prior years, the Chile and earlier New Zealand earthquakes and December Australian floods had not been booked to their ultimate values during 2010. Some reinsurers have also not recognized their liability exposure to the Deepwater Horizon spill.
• The Japan March 11th loss was likely smaller than Katrina on a direct basis, but may be larger to reinsurers. Together with the earlier losses and U.S. losses in the second quarter, 2010 and 2011 are already the worst ever two-year block for large losses to the reinsurance industry in dollars, and as a percent of both premiums and surplus, worse than 2004 and 2005. Depressed values and “soft market” policy terms are part of the reason, and despite some recent increases, both will continue into 2012.
• In the medium-term, we expect an increase in U.S. inflation rates that will raise the cost of future losses, for both property and casualty, and increase casualty loss reserves, especially on WC and umbrella business. In the short-term, the EU’s response to Greek and other sovereign debt problems may raise interest rates and depress some European reinsurers’ asset values, especially on affected government and bank bonds. We also expect Solvency II requirements to limit some reinsurers’ capacity, perhaps as soon as 2012, depending on the final effective date.

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