Reinsurance takes on the risk profile of the insurers that they reinsure. Put simply, reinsurers pay a portion of the claims reinsured in excess of a threshold, in exchange for a premium paid to assume the risk.

Ten years ago, the major European reinsurers, together with Lloyd’s of London dominated reinsurance. Many major US companies had significant reinsurance operations. These statements are less true today. The European reinsurers have been downgraded because of past poor underwriting, reducing their current reinsurance capacity. US firms have tended to specialize over the last decade. Many companies closed, sold, or spun off their reinsurance operations.

There has been a tendency for reinsurers to migrate to Bermuda over the past ten years. There is a combination of professionalism, favorable regulation, and low taxation that encourages reinsurers to set up shop in Bermuda. A great deal of opportunistic capital shows up and forms new companies after major disasters, in order to take advantage of the higher premium rates available. This has had the effect of making it hard for older reinsurers to heal after a major catastrophe, such as Hurricane Andrew or 9/11. They bear the claims, but get less of the benefit of higher premiums because of all of the new competition.

This makes the character of a reinsurer’s management team all the more important. It is very difficult to bounce back from big underwriting losses, so conservatism in reserving and rate-setting is required for long term financial success. One key to assessing conservatism is whether a reinsurer will slow down in a soft market, and return capital to shareholders. It takes humility and discipline to sit back when market conditions aren’t favorable, and your competitors are growing their premium volumes rapidly.

In one sense, because of opportunistic capital, the reinsurance industry resembles a series of Lloyd’s syndicates. After a major catastrophe, new companies form that have no legacy liabilities, and write fresh business at high premium rates. They are similar to Lloyd’s syndicates at their start. Old reinsurers tagged with claims from the catastrophe resemble Lloyd’s syndicates with open years that they can’t close, because the claims have not settled, or the claims impair their capital. The older reinsurers, once hobbled, will have a tendency to slow down, and perhaps merge their way out of existence.

One more new issue is reinsurance receivables. With all of the credit downgrades, many insurers find themselves with reinsurance receivables from claims that they submitted, but have not settled yet. There are quite a few insurers and reinsurers that have reinsurance receivables greater than their capital and surplus. In a crisis, where prompt payment from reinsurers is needed, a high degree of reinsurance receivables from low rated insurers could result in ratings downgrades, and possibly insolvency. This has led many insurers to request collateralization of reinsurance when dealing with lower rated reinsurers. To the extent that reinsurers agree to collateralization, it makes their assets less flexible, and reduces the degree of leverage that they can operate at. Most reinsurers are resisting posting collateral, but so long as reinsurance receivables don’t get paid rapidly, and credit quality is low, the demand for collateral can only grow.

Investment policy for reinsurers is similar to that of the companies that they reinsure. Most reinsurers run conservative portfolios, because they take enough risk underwriting reinsurance. Some newer reinsurers are using hedge funds as part of their investment strategy, thinking that they can earn more investment income, but with lower risk. The jury is still out on this approach. We fear that some of the reinsurers are taking on what we call “too smart for your own good” risk, and that hedge fund investments will prove to be less diversified than they expected in a crisis, perhaps even a crisis with insurance claim applications, like 9/11.

Reinsurers mirror the hard and soft P&C markets globally, but with greater volatility. The hard market 1994-1997, gives way to a soft market 1998-2000, followed by the 2000-present hard market. Property reinsurance rates are slowly falling at present, but rates are adequate for profitability. Casualty and Life reinsurance rates are rising but at slowing rate; the amount of rise varies considerably by line of business. In general our outlook for reinsurance stocks is positive, but highly selective. Stick with conservative management teams and you will do well over the full underwriting cycle.

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Bringing it to the Present

This was written before the hurricanes of 2004 and 2005.  Think about it.  After 2005, there was a belief, supported by the concept of global warming, that hurricanes would be far more than in the past.  I did not buy that.  Two years of bad hurricanes is not a trend; four might be.

Cut to today.  Five wimpy hurricane seasons.  No earthquakes. Few huge European Windstorms. Few hurricanes hitting Japan.

That doesn’t mean the future will be good.  In fact for reinsurers, because surplus is so adequate, premiums may be too low.  But valuations of reinsurers are low, reflecting that risk.  I ind the sector reasonable but not cheap.

Full disclosure: long PRE, RGA