Here’s a fact your local sell-side reinsurance analyst probably hasn’t told you. If you take:
a) the higher rates most property cat reinsurers writing business in the U.S. lately find themselves being able to charge, and combine them with
b) the effect of new higher levels of capital those reinsurers now must carry,
it turns out that
c) the companies are set to earn a materially better return on the risk they are taking under a wide spectrum of expected cat losses.
What? Good news for the reinsurers? That’s not the message you’ll hear from a lot of experts on Wall Street these days. But it’s true just the same.
I’ll go through some numbers in a minute, but first, a little background. It’s no secret that in the wake of the 2004 and 2005 storm seasons, the two most destructive on record, property-cat insurance rates in coastal areas of the Southeastern U.S. have soared. Why? It’s mainly economics: industry capacity fell significantly in the wake of Katrina, Rita, and Wilma last year, as reinsurers’ capital was decimated by claims. Demand, meanwhile, is surging. Many insurers and reinsurers, fearing the worst for the 2006 storm season and beyond, are buying more coverage than they have in the past.
Beyond that, there’s a growing perception among insureds that hurricanes have inherently become more frequent and severe. Some observers blame the effect of global warming. Others cite a natural multi-decade cycle of change in hurricane frequency. Regardless, demand for storm coverage has increased, perhaps permanently.
Add it all up, and property cat rates in the Southeastern U.S., notably in coastal areas, have jumped by 100% or more from a year ago. One might safely imagine, therefore, that if the 2006 storm season is even remotely normal by historical standards, the industry stands to make an enormous amount of money, right?
Well, yes—only the story isn’t as straightforward as you might think. Higher rates aren’t the only big change in reinsurance economics lately. Capital requirements have ballooned, too. In particular, the rating agencies—reinsurers’ de facto regulators—have become much more demanding in the capital levels they insist on in return for their seal of approval. A.M. Best, for one, now requires that carriers be able to survive two 1-in-100-year hurricanes; prior to last year, a reinsurer’s capital was only stress-tested to a second event of a 1-in-50 year magnitude. Further, thanks to adjustments upward in modeling firms’ frequency and severity assumptions, the projected losses under such scenarios have soared. Result: reinsurers now must carry double or even triple the amount of capital per dollar of normalized expected loss than they used to, in peak zones.
So while premiums are up, capital costs are up, too. What’s the effect on overall profitability? Over the entire range of possible outcomes, it’s a meaningful net plus for the reinsurers. For example, if the 2006 storm season ends up being a high-cat year, ROEs should rise materially from where they would have been otherwise. In an average year, returns would rise modestly, as well. Ironically, only in the event of a benign storm season would returns fall from where they would have been under the old pricing and capital regime. Take all these scenarios together, and in 2006 industry returns figure to rise—and become much more stable and predictable, as well.
Let’s go through some numbers, and you’ll see the effect. Start, first, with a hypothetical “high-cat” season for a hypothetical reinsurer, and see what a difference a year makes
So higher prices help bring the combined ratio down from 225%, where it would have been under last year’s pricing and capital structure, to a not-nearly-so-bad-but-still-awful 127.5%. But that underwriting loss gets absorbed by a capital cushion that’s three times bigger than what it would have been a year ago. The effect on profitability is huge: a minus-56.8% Insurance ROE turns into minus-8.3%. Add to that much higher investment income, thrown off by the higher capital and premiums written, and even in an extreme cat year like the one being postulated here, our reinsurer would generate a return on equity of just minus-3.1%. Under the earlier pricing structure, ROE would have been a whopping minus-51%–a big enough loss to threaten the company’s very survival.
The new structure does more than bail out companies from the most gruesome scenarios, though. In a typical year for storms, ROEs would rise, too. Take a look:
In this case, higher prices have the effect of sending the combined ratio down to 55%. Under the bigger capital requirements, that works out to an Insurance ROE of 13.6%, compared to just 9.1% under the old structure. Add in investment income (which, again, is substantially larger now since there’s a bigger pot of money to invest in the first place) and total ROE jumps to 18.8% from 14.9% under the prior pricing structure.
Oddly, the only instance in which higher prices and more capital causes ROE to fall is under the storm scenario most reinsurance investors likely hope for most devoutly—a low-cat year. Here’s how the numbers work:
In this scenario, underwriting was so profitable in the first place that that the incremental required capital in the new scheme turns out to be ridiculously redundant. Result: total ROE drops by over 500 bps.
But, again, the over a broad range of possible scenarios, overall return rises per unit of risk. The chart below shows how the numbers work
Moral of story: despite widespread expectations to the contrary, the reinsurance industry seems set to earn very attractive returns in 2006 and beyond, under all but the most extreme scenarios. For an industry that’s under a death watch in certain quarters of Wall Street, that is very bullish news

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