Last week's column concentrated on what the reinsurance industry adds to the insurance industry. This week we will focus on what has happened to the reinsurance industry in the aftermath of the terrorist attacks in the United States.

Results in the reinsurance industry have been marginal over the last few years due to a prolonged soft market and the development of old year losses particularly asbestosis, pollution and workers compensation. A soft market occurs when the number of insurance companies exceeds the number of customers wishing to purchase. This causes insurance premiums to reduce and coverages to be broadened. Old year losses are losses that have taken a long time to develop from the time they occurred. Results were further deteriorated in 1999 by an unusually high frequency of nine $1 billion insured catastrophes. Now to add fuel to the fire, the reinsurance industry is reeling from the magnitude of the terrorist attacks in the United States. All these factors are presenting a very trying environment for the reinsurance industry.

The terrorist attacks are challenging the majority of the principles of why reinsurance is needed. The losses are so large that they have impacted many different lines of business and layers of insurance at the same time, which has the effect of minimising the risk sharing principle. The vast majority of reinsurers have been impacted at the same time thus sending the loss exposure curve to an all time high creating a destabilisation of loss exposures rather than stabilising them as reinsurance is meant to do. Though the catastrophe has been spread amongst many different reinsurers from many different geographic locations, it is concentrated amongst 20 insurers and reinsurers who will be responsible for paying 80 percent of the loss. Despite the fact that these 20 companies are purported to have an estimated $300 billion in assets combined, it will still cause many companies to reexamine their underwriting approach in the future.

The one reinsurance principle that has worked is catastrophe protection because it will allow several direct insurers to be able to pay their significant shares of the terrorist attacks and at the same time protect their balance sheets because of the cash inflow from the reinsurers. However, because of the huge payout by the reinsurers, there will be significant increases in premiums for insurance companies wishing to purchase catastrophe cover in the future.

The reinsurance industry is uncovering a significant additional problem known as 'accumulation'. Many reinsurers are also providing coverage as direct insurers and retrocessionaires. In some cases, the effect of spreading the risk amongst many risk bearers has been negated because a significant portion of the risk has actually remained concentrated within the same reinsurance companies. This accumulation problem is a very complicated situation for the reinsurance industry and one that will take quite some time to sort out. A.M. Best believes loss payments will be split as follows: 50percent paid by the direct insurers and 50percent by the reinsurers. What this statistic does not show is how many of these insurers are direct insurers, reinsurers and retrocessionaires all at the same time. And because of the small number of reinsurers and retrocessionaires compared to direct insurers, the losses amongst the reinsurers and retrocessionaires will be more concentrated placing a huge strain on these companies' capital and surplus.

Lloyds of London is one of the leading insurance and reinsurance markets in the world and is one of the groups, which is the direct insurer, reinsurer and retrocessionaire because Lloyds has always traditionally reinsured a significant portion of its own account. Trying to find out whether there is enough in loss reserves to fund the loss will be a very messy and complicated problem for some of the Lloyds syndicates. This is why we are seeing several syndicates being closely monitored by the rest of the industry and the insurance rating agencies. Lloyds is also one of the major reinsurers being challenged by the development of asbestosis, pollution and workers compensation claims due to its long history in the insurance industry. The additional strain on Lloyds' capital and surplus is very significant to the future viability of some of its syndicates.

Two of the largest reinsurers, Swiss Re and General Re have taken hard line positions on their underwriting philosophy almost immediately following the loss confirming Standard and Poor's recent report that 'client relationship underwriting' by reinsurers will change dramatically. Whereas, in the past, reinsurance underwriters were more apt to take on exposures they were not happy with to maintain favourable client relationships, they will not be inclined to do so in the future. In an effort to protect their balance sheets, reinsurers will now be scrutinising the financial strength of their clients (direct insurers) to make sure they will not become insolvent.

General Re has issued cancellation on treaties already in place prior to September 11, 2001. Both companies have stated that they will only accept Fortune 500 companies on a facultative basis (refer to column dated November 19, 2001 for explanation). The probable reasoning behind this decision is they believe Fortune 500 companies are at greater risk of becoming terrorist targets due to their high profile, diverse locations and significant number of workers and customers worldwide. Additionally, pharmaceutical companies will be excluded from all treaties because of the deteriorating claim history in this class of business.

Despite taking these steps and excluding terrorism on a go forward basis, reinsurers will still have to raise rates because they will have to recoup some of the capital they have paid out as a result of September 11, 2001. Therefore, they need to raise their premium rates to increase income so they can start rebuilding their assets. Remember reinsurers and insurers need significant capital and surplus to be able to pay for future losses. The terrorist attacks in the United States are so large they have wiped out a sizeable amount of investment income gained from profitable years to leave many reinsurers in a breakeven to negative position. Some reinsurers will have to exit the market due to cash flow problems and as such demand will exceed supply giving reinsurers the ability to charge higher rates and have the ability to dictate the terms and conditions they feel they need to adequately underwrite treaties or facultative business forcing the industry into what is known as a 'hard market'.

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Next week, we will explore how the actions of the reinsurance market are affecting the Bermuda insurance market.

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Cathy Duffy is a Chartered Property Casualty Underwriter (CPCU) and is now a freelance writer. She is a former executive of Zurich Global Energy and has 15 years experience in the insurance industry. She writes on insurance issues in the Royal Gazette every Monday. She welcomes feedback and questions are e-mail crduffyibl.bm.