The current hard market in the reinsurance industry looks set to continue for at least two years according to a special report on the industry written by A.M. Best.

The main article in the report, "Reinsurers move forward with cautious optimism," was written by vice president Elizabeth Farrell. She wrote: "The reinsurance market is undergoing a severe price correction and, at the same time, experiencing a fundamental shift in underwriting practices."

Since the market turned in late 2000, and propelled forward by September 11, reinsurers have been retrenching operations and restocking their balance sheets to take advantage of current market conditions.

These include dramatically rising rates across all classes, while capacity is being restricted by lower limits and higher retentions - measures taken to return the industry to profitability.

The article continued: "Despite market optimism, though, there is an undertone of uncertainty as reinsurers harbour lingering doubts regarding insurance-related issues and global financial concerns.

"As losses continue to emerge on prior accident years, many reinsurers are asking whether the current rate environment makes up for the pricing inadequacies of the past."

Issues affecting the industry include the lack of a buffer due to depressed financial markets as well as a low interest-rate environment, meaning it is critical that reinsurers get their pricing right.

"Terrorism also adds a new risk dimension that needs to be considered in the underwriting evaluation while the role of the government in these events is still debated. Add to all of this the effect of new capital entering the market, and the fundamental question is, 'How long will the hard market last?'"

Answering the question, A.M. Best said: "(We) believe that there continues to be significant upheaval in the market, driven by a number of factors that will keep competitive pressures at bay over the next two years, thereby sustaining the hard market."

Explaining their rationale for arriving at this conclusion, A.M. Best assessed the ongoing loss development of the 1997 to 2000 underwriting years which they said continues to wreak havoc on reinsurers' balance sheets.

This has led to reinsurers strengthening reserves for the past two years, and A.M. Best said they were concerned that those reinsurers lacking the deep pockets and commitment of a rich parent as further strengthening is believed to be needed to shore up the industry's reserves.

A.M. Best also assessed the changing risk dynamics of the industry and said: "As shown by the events of September 11, the insurance community had not recognised the potential for certain exposures to accumulate under a single loss scenario."

The article continued: "Underwriters must now think in terms of target events and consider the huge clash potential created by correlation of various classes of business - in addition to viewing loss exposure concentrations related to natural and other man-made catastrophes, both of which have increased exponentially in recent years. This environment has led the reinsurance industry to re-evaluate its risk management techniques and tools."

A.M. Best said weak financial markets were having a dual effect on the industry's balance sheet, with asset valuations declining and liabilities rising.

A.M. Best noted the US stock market is down 25 percent from the December 1999 high and on the liability side, "a rash of bankruptcies precipitated by economic conditions is fuelling litigation fires that, in turn, are increasing insurance losses."

During 2001, the number of public companies filing for bankruptcy increased by 46 percent over the prior year to 257 companies, and the amount of assets under court protection had risen to nearly $260 billion, including $63 billion of assets related to Enron Corp.

A.M. Best said accounting irregularities which led to the downfall of these companies now raises issues with other major corporations and said as a result of these conditions and changing legislation, shareholder lawsuits are increasingly leading to higher risk exposures in financial lines and professional liability coverages.

"A.M. Best believes that these factors, in combination with reported reserve weakness in other excess liability lines, will contribute to a further hardening in the casualty reinsurance market."

Despite the roughly $25 to $30 billion of new capital post September 11, the majority of which is based in Bermuda, A.M. best said even after this new influx, the industry has conservatively lost $35 billion of capacity.

"Further, demand for reinsurance protection has risen as insurers re-evaluate their exposures with a view toward the changing risk environment created by terrorism and other developing risks," said the article.

Concerning the effect of shareholder expectations, A.M. Best said globalisation, convergence and increased regulation of reporting are leading to greater financial transparency, enabling improved benchmarking among financial-services companies.

The article said: "Recognising the inherent volatility of the reinsurance business, reinsurers cannot provide their risk capacity at a cost lower than other capital market players, but instead must achieve even higher returns if they are to attract and retain shareholder interest."

Despite the expectation that 2002 will be marred by continued adverse development from prior accident years, A.M. Best said they anticipate dramatic improvement in 2003 as underwriting trends improve.

The article said: "Those that thrive in this new risk environment will posses unquestionable financial strength, supported by a disciplined operating strategy focused on the fundamentals of underwriting. Radical changes in the operating environment over the past several years - from the prolonged soft market to economic globalisation, financial services convergence and technological advancement - have challenged reinsurers to remain focused on these principles, costing the very existence of those that have failed to do so."

While A.M. Best said they believe market pressures will continue to challenge those companies with weaker balance sheets as historical underpricing emerges through additional reserve development, further eroding capital, they concluded: "Flight to quality trends in the market will further distance these companies from the industry's strongest players, which will disproportionately reap the benefits of the current hard market cycle."