Back in the game - casualty lines

Over the past decade, as casualty insurance rates have steadily softened, reinsurance companies have reduced their participation in the industry. By the same token, with strong capital bases, primary companies have substantially grown their retentions. As a result, business ceded to reinsurers by US casualty underwriters has fallen by half since 2004.

“Some of the big German and Swiss markets reinsurers have been very good at cycle management and since 2005–2006 they have cut back on their writings for US casualty reinsurance,” explained John Daum, executive director of Lockton Re. “They’ve maintained their positions but cut back the size of the lines or changed their participation, sometimes moving up a layer in the big excess casualty programmes.”

Now there are signs these same reinsurers are looking to get back in the game. At this year’s Rendez-Vous cedants indicated that reinsurers were showing greater interest in their casualty books of business. And on October 1, Amlin opened a new US casualty reinsurance business, Amlin Reinsurance Managers, to target general and professional liability. With the US market representing 70 percent of casualty reinsurance premium, this is a strong endorsement for the market overall.

“What’s happening is that reinsurance companies are trying to pick their spots,” said Daum. “They’re finding potential new cedants that they’ve done business with in the past and they’re looking to get back into their programmes with the anticipation that primary insurance rates will continue to go up. They’re getting in now rather than waiting until a more significant market shift.

“I had a conversation with one very large reinsurer whose reinsurance writings have decreased over the last five years, due to their cycle management,” he continued. “Now they’re positioning themselves to write more. When you’re doing casualty reinsurance there’s a lot more analysis required, so it does take a lot longer time to get comfortable with the portfolio.”

Green shoots

Rates are creeping up, albeit modestly, on the original side of the business. Commercial insurance prices increased by 6 percent during the second quarter of 2012. The largest increases were once again in workers’ compensation and commercial property, both in the high single digits. Results from directors and officers and employment practices liability showed price rises in mid-single digits, a departure from the flat pricing of the previous two quarters.

While the US economy is a long way from recovery, there have been a few green shoots—particularly for residential construction. New home construction rose by 2.3 percent in August, 29 percent higher than a year previously. “We’re not talking about a robust economy, but all the economic indications are showing improvements,” said Daum.

Any GDP growth will bode well for casualty insurers. The declining economy has been partially responsible for declining premiums in liability classes of business since the financial crisis peaked in 2008. A decline in insurable assets combined with claims inflation has taken its toll.

"When you're doing casualty reinsurance there's a lot more analysis required, so it does take a longer time to get comfortable with the portfolio."

“As large corporations faced budget cuts, insurance—at least part of insurance—was viewed as discretionary and some of those discretionary purchases were trimmed back as well,” explained Bryon Ehrhart, chief strategy officer at Aon Benfield. “Many casualty classes are based on exposures and if exposures are down, because the number of workers, automobiles and pure corporate activities are in decline, then insurance take-up also declines.”

In the low interest rate environment, with reserves declining, pricing can only move in one direction, explains Ehrhart. “Workers’ comp hasseen the first round of deteriorated reserves to the point where people are now adding to reserves in those classes. With reserve releases gone and actual adverse development in some of the classes, you’re seeing combined ratios that are in excess of 100 percent.

“There is a need for rate increases to make the combined ratio come into line with today’s realities, which are very low investment yields,” he continued. “There is a sustainable need for rates to go up on the casualty insurance side. Treaty casualty reinsurance business that is sustainable includes provisions that balance the benefits of continued decreases in claims frequency between the cedant and the reinsurer.

“Without these provisions, insurers will continue to raise retentions. Of course a change in demand for higher insurance limits from insureds would help both the insurance and reinsurance markets—both have more than ample capacity to take more risk at reasonable terms.”

The release of prior-year reserves has begun to slow and these can no longer be expected to prop up poor results. While the industry may start to see deteriorating reserves only in 2014 or beyond, according to Guy Carpenter, for some carriers that write specific lines such as workers’ compensation, net reserve deterioration has already begun (see graph). Other lines that have also started to show deteriorating results in the most recent accident years are general liability and products liability.

Beyond reserves, the inability to make a decent investment return is even more important for long-tail classes of business. “Losses on the casualty side take years to develop and ultimately settle out. The reserves that are set aside to pay these losses are not receiving the benefit of adequate investment returns. Therefore, margins on the underwriting side of the equation need to increase through original rate increases,” explained John Davis, head of US Casualty at Endurance.

“So if you can invest that dollar over time at an attractive interest rate, when that loss does occur you will have built up enough reserve capital to pay that loss and hopefully still make a profit,” he continued. “If you’re investing that money at 1 or 2 percent, it’s not providing an acceptable return.”

An eye on the tail

For reinsurers with shrinking margins the uptick in original casualty rates is enough to attract attention. And in a business where regulatorsand rating agencies continue to favour a diversified business model, there is often a capital credit attached to writing longer-tail lines of business.

But reinsurers looking to grow their participation in casualty business are likely to size up potential treaties with more scrutiny than they did in the past. With cedants retaining more of the ‘pure vanilla’ risks there is a concern the business is becoming more volatile.

“A concern for the industry is that capital remains strong and companies continue to retain more of their business,” said Davis. “If this trend continues reinsurance opportunities become more leveraged and insurance companies will seek out severity protection while they retain the more predictable exposures. The reinsurance market needs diversity of peril, whereby they balance the risk scale across multiple levels of exposure.

“There’s greater volatility as you move up in retention making it much more difficult to price your product because there may be years when there are no losses and years when there are substantial losses,” he added.

The role of reinsurance is to take the peak exposures off cedants’ balance sheets, argued Daum, particularly in excess of loss programmes. “The leveraging impact exists, but if people price it properly thecomfort exists too,” he said. “In the world of reinsurance umbrellas you don’t know how things are going to play out until 12 years after you’ve priced it. It’s naturally going to be more volatile as retentions go up, but that’s the nature of reinsurance.”

While portfolios appear to be taking on more tail risk, claims frequency and severity over the past decade has been fairly benign. Not since asbestos pollution and health (APH) peaked in the late 1980s— early 1990s, or September 11, has casualty re/insurance been hit by capital-eroding claims. As a result, rates have been steadily softening.

Even the financial crisis was not the behemoth many had predicted, despite an increase in professional liability claims. In addition, recent major catastrophe losses have not had much impact on casualty lines of business. “Recent cat events, including those from last year and even back to KRW, were not capital events—they were more of an earnings event for most companies,” said Davis. “Until the industry faces a true capital event, I don’t think we’re going to see any vast improvement in the marketplace.”

Nevertheless, major casualty catastrophe losses such as Deepwater Horizon in 2010 continue to weigh heavily on the minds of casualty reinsurance underwriters. While the majority of losses from the oil platform explosion and subsequent oil spill were retained by BP, it was a reminder of the potential cost of an event on this scale.

“I know that’s where people are paying a lot more attention to the whole knock-on effect of casualty catastrophe losses,” said Daum. “The questions are much deeper as to who the original clients are, and aggregates done on a particular insured are monitored much more carefully than in the past.”

There was a spike in energy pricing following Deepwater Horizon with a move at the time by reinsurers and brokers to seize the opportunity. Various industry bodies suggested ways of increasing capacity of offshore energy projects, but the expected increase in demand for extreme liability cover has not materialised, according to Ehrhart.

“Recent very large uninsured losses could have ushered in a new dawn for corporate risk managers, CFOs and treasurers,” he said. “These uninsured corporate losses that total more than $120 billion are new highs in corporate liability catastrophes. CFOs, treasurers and risk managers certainly understand that insurance offers a more valuable tool to mitigate the potential consequences of corporate liability catastrophe than previously considered.

“But while we’ve seen some uptick in demand for mega casualty cats, the increase in demand isn’t really significant enough to change the dynamics of the industry for insurers or reinsurers. It is clear that it will take more time for corporate demand to grow into the available capacity.”

Ehrhart declared that the only way demand will shift significantly is if the rating agencies factor the potential impact of casualty catastrophes into their rating processes. “Growth in demand may be tied to the value attributed to insurance and risk financing schemes by rating agencies thatrate the debt securities of corporations. If there were a more specific credit given to those companies with sound risk management, risk transfer and risk financing programmes, then you’d see companies act to protect their debt ratings and a greater appreciation for insurance of corporate liability. Multiple notch downgrades followed the recent uninsured losses.”

Ehrhart argued that innovation is needed from reinsurers in order to create a viable market going forward. There is a suggestion that in order to win back casualty business reinsurers will have to demonstrate they are ready to follow the fortunes of their cedants more closely. “Casualty treaty terms that strike a better balance between the cedant’s outcome and the reinsurer’s outcome are necessary innovations for the future,” he concluded.