David Sandham outlines the issues that matter


The past three months in reinsurance have been tumultuous. The market has hardened. And the fallout from the credit crisis is being felt across the sector – not least at Swiss Re, where the chief executive resigned last month after the company reported a net loss of CHF864m (£518m) for 2008. Add to this worries about increased regulation, inaccurate estimates of catastrophe losses and the low volume of new cat bonds, and you have a doleful picture. There are bright spots, however: higher rates are helping reinsurers and those with conservative investment strategies – including Lloyd’s – are looking strong.

Hardening rates

Reinsurance has turned from a softening to a hardening market. Guy Carpenter’s World Rate on Line Index for property catastrophe rose 8% at the January renewals.

The picture should not be oversimplified, however. The hardening was not uniform. Much of the peak zone catastrophe pricing in the USA increased by 20% but the rise in European wind accounts was smaller, about 5% to 10%. Other renewals – those not affected by catastrophe losses during 2008, for example – did not increase at all.

The losses from last year’s hurricanes and other catastrophes were higher than expected – hurricane Ike turned out to be the third most costly in US history. This dented confidence in the abilities of the current generation of cat models; some of the initial loss estimates fell far short.

Many insurers also suffered investment losses in the financial crisis. Weakened balance sheets have made them keener to transfer risk; companies turn to reinsurance to maintain capital ratios. Also, little new reinsurance capacity has come in to meet the extra demand and retro capacity (where reinsurers themselves shed risk) has lessened. So a confluence of factors has forced up rates.

Are cats coming back?

Last month, the ice was broken on a frozen-over cat bond market by the issue of a $200m (£137m) bond, Atlas Reinsurance V. The bond, notable for its tight collateral structure, was issued by SCOR via Deutsche Bank and BNP Paribas. Collateral may be invested only in a defined list of secure assets, such as government bonds. Future cat bonds are likely to be designed like this to withstand events such as the Lehman bankruptcy.

Atlas Reinsurance V was the first cat bond new issue since August last year. In contrast to 2007, a record year in which $7bn (£4.7bn) of cat bonds were issued, only $2.7bn were issued in 2008, all in the first six months. The market was closed for the second half of the year.

Few industry observers will make a prediction for 2009 – not least because most got it wrong last year. In summer 2008, many expected about $5bn of new cat bonds to be issued for the full year. If a prediction must be made for 2009, it looks like the amount issued will be similar to last year.

What went wrong in the second half of 2008? And does the shortfall mean there is $2.3bn ($5bn minus $2.7bn) of cat bonds waiting in the wings?

The secondary market for these bonds is a crucial factor. This market – where already-issued cat bonds are traded – has been weakened by non-specialised investors troubled by the general financial crisis liquidating their cat bond positions, although these bonds turned out to be some of the best-performing assets in their portfolios. Nevertheless, their actions depressed bond prices, making it possible for investors to obtain higher yields in the secondary market than in new issues.

Whether the secondary cat bond market bounces back depends on any general improvement in the economy and on sector-specific factors, such as redemptions.

More than $1bn of cat bonds have been redeemed since December last year; more are due. Redemptions make more money available to investors, which could lead to an improvement in the secondary market.

Potential issuers had a good alternative in the softening traditional reinsurance market last year. However, the recent hardening could lead to renewed interest in cat bonds.

A third factor to consider is the effect of the Lehman bankruptcy last September. Willow Re Series 2007-1, on which Lehman guaranteed interest payments, recently defaulted. However, only four cat bonds out of 100 have been directly affected. Cat bonds still offer good uncorrelated risk and have outperformed both equity and bond markets.

More rules

Offshore centres such as Bermuda are important to the world reinsurance market. But one of the likely consequences of the financial crisis is a new wave of regulations hitting these territories. During his election campaign, President Barack Obama criticised “corporations that hide their profits offshore” – and specifically mentioned Bermuda.

Angela Merkel, the German chancellor, also has offshore in her sights. “We can no longer stand passively by as individual small countries attract financial institutions by ignoring internationally agreed upon rules,” she said during a recent trip to Washington DC.

In the UK, Gordon Brown has promised “very large and very radical changes” in financial regulation and Alistair Darling, the chancellor, has spoken of “potential problems with overseas territories and crown dependencies”.

The UK government has launched a review of British offshore centres. In announcing the move, Darling referred to the Icelandic banking collapse, which affected British investors who had money with Landsbanki’s Guernsey branch or with Kaupthing Singer & Friedlander on the Isle of Man. Many who lost money probably did not understand that these banks were outside the UK supervisory system.

But the UK review is much wider in scope; it will investigate all crown dependencies and overseas territories with significant financial sectors – an example of how regulatory change can snowball. The offshore territories affected include Jersey, Guernsey, Isle of Man, Bermuda, Cayman Islands, Gibraltar, Turks and Caicos Islands, British Virgin Islands and Anguilla.

Thus Caribbean financial centres are caught up in regulatory change that was occasioned by a collapse in Iceland. That’s globalisation for you.

What exactly will the UK review cover? Darling has said: “Overseas territories and crown dependencies … attract banking customers with lower taxes – without contributing to the UK exchequer. At times of stress, depositors need to know who will compensate them. The British taxpayer cannot be expected to be the guarantor of last resort.”

The government says the review will not look at changing constitutional arrangements, including the independence of the offshore centres in fiscal matters and the setting of their own tax rates.

The exclusion of fiscal policy must have come as a great relief to the territories concerned. And as for the UK government being guarantor of last resort, investors in the Isle of Man and Guernsey may have misunderstood the rules, but surely no investor in a Caribbean financial institution could make the same mistake.

It is difficult to say at this stage what the government wants from this review. It may want to increase taxation disclosure obligations on offshore centres to help hunt UK citizens attempting to evade tax.

The tax advantages of offshore financial centres may remain unaffected, but their confidentiality advantages would be reduced. This would be a long way from Darling’s statement, but a perfect example of how political rhetoric ossifies over time into a strengthened bureaucracy.