1 November 2011Re/insurance

'Class of 2001' outshine their peers

Bermuda reinsurers have always been a breed apart from their international counterparts, with their emphasis on property catastrophe, speed to market and enviable underwriting results all acting as signifi cant differentiators. And it would seem that difference has brought with it rewards, including Standard and Poor’s (S&P’s) fi nding that Bermuda’s ‘Class of 2001’ have outperformed a bench of global reinsurers when it comes to return on equity.

This is undoubtedly good news for Island players who continue to grow their global footprint, but there may yet be concerns lurking on the horizon as troubled investment returns, depressed book values and the threat posed by catastrophe events will be a feature of the coming years.

With many global reinsurers’ common shares continuing to trade at a discount to book value, the question is: are reinsurers producing adequate returns to cover their cost of equity capital and meet investors’ expectations?

Reinsurers have, in general, produced disappointing results over the past nine years, with average returns on equity (ROEs) that only equalled the companies’ estimated cost of equity capital. Nonetheless, S&P’s research showed signifi cant differences among the best and worst performers in the sectors. Some companies produced healthy excess returns during this period, while others barely managed to cover their cost of equity.

The current valuations for most global reinsurers refl ect, in S&P’s view, investors’ relative scepticism about the reinsurance sector’s future operating performance and whether the results will exceed the modest returns produced over the past decade. Reinsurers are facing several challenges, including:

• Reduced potential profit margins because of declining premium rates for property and casualty reinsurance coverages in recent years. This trend has abated recently for property and property-catastrophe risks, following the large catastrophe loss events–the earthquakes in Japan and New Zealand and the catastrophe losses in Australia–in the first quarter of 2011

• Prospects for dampened investment returns in the near term, given current low interest rates

• Continued significant frequency and severity of man-made and natural catastrophe losses in recent years and the potential that this trend may extend into the future

• The recent increase in reinsurers’ cost of equity capital, which may refl ect the uncertainties noted above and the shift in investors’ risk appetites and investment strategies following the financial crisis in 2008

• Over-reliance on favourable loss reserve development for prior years to bolster the sector’s current earnings; and

• Continued uncertainty regarding global macroeconomic conditions and the potential negative impact on reinsurers’ investment portfolios and loss reserves if inflation surges in coming years.

Modest returns

S&P’s analysed the nine-year (2002–2010) return on equity (ROE) for a select number of publicly-owned global multiline reinsurers formed in 2001–2002 following the terrorist attacks of September 11, 2001 (the ‘Class of 2001’) and other reinsurers formed before that period (the global multiline reinsurers) (see Table 1). The average ROE for these companies during this period was a modest 9.9 percent. This was about equal to these companies’ estimated cost of equity capital, based on Bloomberg’s capital asset pricing model methodology, which derives the cost of equity based on market volatility, treasury rates, and an equity risk premium.

Although the average returns for the nine-year period were disappointing, the reinsurance sector performed more strongly duringthe past fi ve years (2006–2010). The sector reported an average ROE of 12.2 percent and a modest estimated average return in excess of the cost of equity capital of about 1.6 percent.

Two factors primarily explain reinsurers’ improved operating performance from 2006 through 2010. The fi rst is lower natural catastrophe losses during this period relative to earlier in the decade. Reinsurers reported depressed ROEs during 2008 because of the signifi cant investment losses from the global capital market crisis and, to a lesser extent, Hurricanes Ike and Gustav. But the sector’s average ROEs were generally strong in 2006, 2007, 2009, and, to a lesser degree, in 2010 because of moderate levels of catastrophe losses during these years. In contrast, the nine-year average ROE includes the steep losses reinsurers incurred due to US Hurricanes Katrina, Rita, and Wilma in 2005. Hurricane Katrina alone represented the sector’s largest catastrophe loss in history, with $47 billion in total insured damages.

The second factor is the sector’s shift toward a stronger loss reserveposition in the second half of the decade. Over the past fi ve years, reinsurers have generally reported loss reserve releases related to better-than-expected frequency and severity trends in reinsurance claims related to their casualty reinsurance lines of business. This represented a significant change from 2002 to 2005, when many of the longer-standing reinsurers saw adverse loss reserve development for the US casualty reinsurance business they wrote during the soft cycle in the late 1990s.

Class of 2001’s clean slate

Unlike the global multiline reinsurers, which saw signifi cant reserve deterioration earlier in the last decade, the Class of 2001 reinsurers began operations with a clean slate. They had no exposure to the business written prior to their inception in the late-2001 to early-2002 period. This allowed these companies to outperform the global multiline reinsurers during the past decade. The nine-year and five-year average ROEs were 14.2 percent and 17.7 percent, respectively, compared with the signifi cantly lower 8.9 percent and 10.7 percent (see Table 2). The Class of 2001 also produced markedly higher returns in excess of estimated cost of equity capital. Its nine- and fi ve-year excess returns were 5.0 percent and 7.8 percent, respectively, compared with -1.2 percent and 0.0 percent for the other reinsurers in our selected group.

Chart 1 shows ROE of the Class Of 2001 versus global multiline reinsurers. The reinsurers’ average ROE continued to decline from the 2006 peak. Global multiline reinsurers started the past decade with relatively poor returns due to substantial losses from the September 11 terrorist events and adverse loss reserve development for previous years. However, the sector’s operating returns improved during 2002–2004, partly because of the signifi cant premium rate increases in the property and casualty reinsurance lines of business following the steep losses in 2001.

Although Hurricanes Katrina, Rita, and Wilma disrupted the positive trend in 2005, the sector’s average ROE peaked in 2006 at 18.1 percent(see Chart 2). This reflected a light catastrophe year and strong pricing conditions in most reinsurance lines of business. Thereafter, weakening pricing conditions and other factors contributed to the sector’s average ROE’s steady decline–interrupted by a sharp drop to 2.8 percent in 2008–to 11.4 percent in 2010. For the reinsurance sector 2008 was a difficult year: the low average ROE reflected both the downturn in the global capital markets and the US Hurricanes Ike and Gustav.

As the sector’s average ROE declined during the second half of the decade, the cost of equity capital began a modest but steady upward trend. As a result, some reinsurers are finding it more difficult to report operating returns that meet or exceed their cost of capital (see Charts 2 and 3).

Although the Class of 2001 mirrored the trends for the overall group, the Class’s average ROE outperformed global multiline reinsurers by an average of 5.5 percent over five years and 4.4 percent over nine years (see Table 2).

Also, the differential between the group’s best and worst performers is substantial. The nine-year average ROE for individual companies ranges from as high as 17.5 percent to as low as 1.3 percent, with most reinsurers falling in the 10 percent to 15 percent range (see Table 3).

All in the same boat

Regardless of performance, reinsurers’ common shares are trading, on average, at substantial discounts to their book values. In fact, although the Class of 2001’s common shares historically have traded at higher valuations relative to those of its global multiline peers, the Class’s common shares have been trading at a similar discount since 2009– despite their higher returns and lower capital costs. For the overall sector, the current book value discounts are a part of a long-running trend of declining valuation since 2002 (see Chart 4).

S&P’s believes that the lack of differentiation between the Class of 2001 and the global multiline reinsurers’ valuations could indicate thatinvestors are sceptical about whether the Class of 2001 reinsurers will be able to sustain their relatively stronger operating performance. The steep discounts to the reinsurers’ book value may also indicate that investors recognise that the reported earnings reflect large amounts of favourable loss reserve development in the casualty lines written in accident years 2003–2007 and are not likely to be sustainable.

Some Class of 2001 reinsurers have experienced particularly strong favourable loss reserve development, which has reduced their calendaryear combined ratios, a key measure of underwriting profitability or losses, by as much as five to 20 percentage points in recent years. Excluding the favourable impact of these loss reserve releases on earnings, many of the Class of 2001 reinsurers’ combined ratios–as with other reinsurers–are 100 percent or higher. This translates into single-digit ROEs and reflects significant decreases in profit margins, given the competitive market conditions in recent years.

Because many reinsurers track growth in book value per share as a signifi cant performance metric, many companies have been using the stock price discount relative to book value opportunistically to buy back shares, thus boosting the book value per share growth and reducing the reinsurers’ equity base. However, equity base reductions could result in future capital shortfalls which, in turn, could increase the cost of capital and partially, or entirely, offset valuation gains from previous share repurchase activity.

Do returns reflect risk?

Most global reinsurers have generally targeted an ROE in the 13 percent to 15 percent range over what reinsurance management teams generally refer to as a full underwriting cycle, which includes a period of more competitive (or soft) pricing conditions, followed by other years of strong pricing conditions. But only a few companies have been able to achieve this target over the long run. Many reinsurers entered 2011 targeting a significantly lower ROE of about 8 percent to 10 percent because of the generally low interest rates and the competitive market conditions through the end of 2010. But if they allow pricing to erode to the point where the expected ROE for their modelled books of business enters the single-digit range (assuming a normalised level of catastrophe losses), these companies run the risk that such returns may easily turn into losses if above-average levels of catastrophe losses occur as the year unfolds.

The heavy catastrophe losses in the fi rst quarter served as a poignant reminder of the magnitude of risks reinsurers assume and the sector’s continued exposure to catastrophe losses. Assuming a normal level of catastrophe losses in the second half of the year, we expect that most reinsurers will report, at best, single-digit ROEs for full-year 2011. S&P’s believes that single-digit operating returns over the long term aren’t consistent with the signifi cant degree of uncertainty and volatility reinsurers are exposed to. Therefore, to the degree that any one year (or several years) of heavy catastrophe activity can lead the sector to report steep losses, reinsurers need to achieve solid doubledigit ROEs in years of light catastrophe activity if they are to meet their long-term operating targets.

While S&P’s does not rely heavily on ROE as a measure of core operating performance, we consider the metric to be one indicator of financial fl exibility, and we may become concerned if management teams accept returns that are inadequate to attract support from the capital markets.

Given the significant catastrophe events in the fi rst half of the year and the recent revisions in RMS’s catastrophe model, which is likely to lead to an increase in estimated probable maximum losses for a number of insurers and reinsurers with risks based in the Gulf of Mexico and the US Atlantic coast, we have observed improved premium rates in many pockets of the property and property catastrophe reinsurance market in recent months. This included increased premium rates in several countries in the Asia-Pacific region as well as in Florida.

We expect that these price increases will continue into the January 1, 2012 renewals season. However, while this turn in pricing is good news for reinsurers, not all property markets have shown improvements. In addition, casualty reinsurance premium rates, which have been under increasing pressure since 2004, have yet to show much-needed signs of significant premium rate increases.

The going will get tougher

Global reinsurers have had mixed performance results over the past decade. The sector’s improved returns during 2006–2010 are an encouraging development since the decade’s earlier years. Nonetheless, reinsurance management teams will have a tough road ahead–with continued exposure to catastrophe losses and low interest rates, uncertain global macroeconomic conditions, and shrinking profi t margins, to name but a few.

Reinsurers, ultimately, are at risk of losing support from the capital markets, and face weakened liquidity and credit quality if they don’t improve their profi tability through core operations. The challenges reinsurers face will continue to test their ability to manage catastrophe activities, the strength of their enterprise risk management and risk mitigation and underwriting capabilities, as well as their ability to push for further improvements in reinsurance premium rates to appropriately cover (and exceed) their cost of capital and provide a healthy return to their shareholders.

But just as some reinsurers have managed to post stronger than average performance results in recent years despite the challenging macroeconomic and sector conditions, it’s possible that global reinsurers could still beat investors’ expectations in the years to come.

Laline Carvalho is a credit analyst at Standard and Poor’s. She can be contacted at:

Jason Porter is a credit analyst at Standard and Poor’s. He can be contacted at: