Roger Crombie

As accounting scandals continue to make headline news, all businesses are under closer scrutiny. Bermuda's insurance sector, though, shows its strength by doing what it does best: bringing innovative solutions to the market.

In the year following the events of September 11, 2001, Bermuda's stock first soared to unheard-of heights, with the re/insurance sector leading the way and, in a sense, saving the world. Lately, like a character in a classical tragedy, Bermuda has unexpectedly become a victim of political intrigue and the greed of others. The island now finds itself in dangerously choppy and treacherous waters, its reputation--its only real asset--unfairly sullied.

In none of this drama was Bermuda a lead player, but, one might argue, merely a fortunate and then hapless bystander. Any damage done to the reputation of Bermuda might take years to undo. The only comparable example, the Cayman Islands of a decade ago, has yet to recover fully from the damage wrought by unfair and erroneous outsiders.

The last 12 months began in Bermuda, as they did in so many other places, with a deep sense of loss. Two Bermudians were in the World Trade Center that monstrous day. Quickly enough, however, we were distracted, or at least allowed our thoughts to be diverted, by what 9/11 meant for Bermuda's re/insurance sector. The first issue was whether the industry could deliver on the grand promise that underpins its very existence. Another question quickly arose: Could Bermuda companies meet the claims arising from the loss of the WTC?

We know now that it could. Pre-tax claims from that awful day are now estimated in the region of $40 billion, about $24 billion after tax. Around the world, some companies staggered under the weight of their share of claims, and one or two smaller companies failed, but the insurance industry, in the main, continued its forward motion. Bermuda's losses, now estimated at perhaps $4 billion gross, will be met in full.

Cat #48, as the terrorist attacks are known, was the largest single insured loss in history in dollar terms. The previous record was Hurricane Andrew, which hit Florida and the Gulf Coast in 1992. Andrew changed the shape of the reinsurance industry. As a result, eight new cat companies were formed in Bermuda, with $4 billion in capital. The loss of the World Trade Center, however, changed more than the shape of the industry; it changed the perception of risk.

Before September 11, the insurance industry had been in a curious form of stasis. Continuing overcapacity in the property/casualty sector meant that coverage was plentiful and still relatively inexpensive, despite the end of a 13-year soft market. The life and annuity sector was adversely affected by 40-year-low interest rates and indecisive stock markets.

A single morning in New York City changed everything. Many major insurance companies, notably in Europe and to a lesser extent in the United States, simply shut up shop for the rest of September. When they reopened, the fear of a potential second terrorist attack was keenly felt (and still is). Many property/casualty lines were either expensive and limited or, as in the case of terrorism coverage, unavailable at any price. The wisdom was that without such insurance, capitalism could not survive. Banks will not lend and commerce must perforce grind to a halt.

The great benefit of alternative risk transfer, we have always been told, is that it provides solutions to intractable problems. With traditional insurance executives stunned into incapacity, the alternative providers went to work. They undertook a complete reassessment of the market, the mood, and their own financial condition.

Urgent action was needed. The impending January 1 renewal season was upon the market. In the normal course of things, September is the start of a busy period. With September spent in stunned reflection and paralysis, an enormous quantity of global insurance and reinsurance had to be negotiated and put in place in a shortened time frame.

A staggering catastrophe brought forth an equally stunning resolution. In the four months that followed September 11, the chance to invest in the insurance and reinsurance markets attracted the largest movement of capital in the history of the world. The Marshall Plan to rebuild Europe cost $13 billion over a four-year period. The moon landing cost $20 billion over a 10-year period. The reconstruction of the global insurance and reinsurance industries raised more than $25 billion, in more or less 100 days flat. The relative value of those dollars differed, but the enormity and speed of the commitment did not.

Suddenly, insurance, initially through its dearth, had become central to the continuation of the global economy. In boardrooms in New York City, Hamilton, London, and the other money capitals, executives put aside their shock and laid plans to save the world. Bermuda was to be the key player.

By January 1, the new capital had been split three ways: existing Bermuda re/insurers, new Bermuda companies, and other existing global re/insurers each received an infusion of between $7 billion and $9 billion. The capital came from existing insurers and venture capitalists. It had been languishing on the sidelines, earning ever more woeful interest rates. When Marsh, Aon, AIG, and the others hit the road and started asking for money to fund the recreation of the re/insurance sector, their presentations and ROE forecasts must have been received like manna from heaven.

Bermuda attracted the lion's share because of its unparalleled efficiency. Establishing an insurance company in Europe or the United States takes six to nine months. To a man (and one woman, in the case of Olympus Re), the chief executives of the start-up companies said they gave no thought to anywhere other than Bermuda as a locus for their new operations. The right company, with the right resources (blue-chip billions with a solid provenance and impeccable management) can be set up in Bermuda in roughly three weeks.

Bermuda is one jurisdiction unlike the 50 in the United States or the dozen or more in Europe. The keys for success for a new Bermuda company are: it has no history; its capital is clean; and its executives, certainly in this case, are tried and tested. The only other prerequisites, a sensible business plan and a pliant market, were presumably givens. One other advantage is that Bermuda was being asked to incorporate reinsurers, in the main. Although several of the new companies announced that they would write primary coverage in several lines, including terrorism under certain conditions, the majority of money subscribed to Bermuda was for reinsurance, whose customers are insurance companies, not (at least directly) the general public.

With what turned out to be $25 billion of new capital replacing what turned out to be estimates of $24 billion in after-tax losses, the continuation of capitalism was assured. Although the industry's global capital and surplus was therefore much the same after September 11, it was now spread quite differently. Bermuda had lain to rest any lingering qualms as to its claim to be a serious player.

Terrorism Issues

The insurance industry winter was dominated by a fierce debate over a single line: terrorism insurance.

About 70 percent of all reinsurance contracts expire at the end of the calendar year, making it virtually impossible last year for primary insurers to obtain backup coverage for future terrorism losses. Without this reinsurance, it was assumed that Congress would have to provide federal terror insurance backup. A broad consensus that federal assistance was necessary was accompanied by disagreement on how to provide it. In fact, the pressure waned and no such federal law has yet been passed.

AIG organized a pool to provide $1 billion of terror cover per airplane. Eight insurance companies offered to write limited terrorism coverage. Bermuda companies, including Ace and XL Capital, were in both camps. The price for such cover was high and availability limited, requiring higher deductibles and lower aggregate limits. Beside the issue of high premiums, very large commercial risks experienced enormous difficulty in getting coverage in amounts similar to the levels enjoyed in previous years.

As fast as they could, Bermuda's underwriters, old and new, were trying to match their new capital to demand. Working six-or seven-day weeks, the industry saw January 1 come and go with considerable coverage unbound. January, usually a time to exhale, was as insanely busy as December, only more so. One new Bermuda company did not close the last of its January renewals until late in April.

Brokers more or less marched clients in and out of Bermuda. Private jet traffic at Bermuda International Airport quadrupled and the commercial carriers flew to and from the Island with hardly an empty seat. Throughout the winter months and into spring, Bermuda's re/insurance sector was jumping.

Stock Market Effects

The collapse of confidence in the American corporate world that marked the summer of 2002 drove stocks down so far that this year looks set to be the third year in a row of the bear market that has dominated the new millennium. Three down years in a row is rare; such a period last began in 1939. Since 2000 dawned, the Dow has fallen by a third and the Nasdaq is off by three-quarters. The cyclical nature of markets dictates that corrections of this nature occur from time to time, but they are never an enjoyable experience.

Talk of deflation is in the air. No one suggests that the developed world is approaching a depression (barring unforeseen consequences of an invasion of Iraq), but there is potential for a double dip recession.

Insurance relies on two main activities: underwriting and investing. Underwriters price their products to produce an expected return, often relatively small, to ensure that their pricing remains competitive. Earnings are boosted by a reasonably consistent income derived from a conservative investment portfolio. Traditionally, the re/insurance industry depends heavily on fixed income securities such as bonds and a mix of high-quality equities to boost the octane level. The return on the portfolio essentially underpins the more inherently volatile results of underwriting other people's risk. In bear market conditions, the quality of underwriting may become the dominant element of results. Looked at another way, in a climate such as today's, poor investment returns will not mask less-than-successful underwriting.

As investors now realize, a single financial statement can be more revealing than all the press releases and chief executive officers' optimism. The Bermuda companies, which reported their second quarter results in the summer, appear to have held the line on the underwriting side, although continuing problems at Lloyd's have had their effect on some of the Bermuda giants, who between them are the largest source of Lloyd's capital. Two quarters do not tell the whole story, since insurance is by its nature a long-term undertaking. In the first half of 2002, Bermuda wrote significantly more gross premiums, more net premiums and, hopefully, some very good business at hard market prices, following the events of the past year (see chart on page 26).

Four areas of weakness affected the global re/insurance sector through the summer and into fall.

One was a directors and officers crisis, which has affected the Bermuda companies. The second is a case of what U.S. Attorney General Griffin Bell described as "jackpot justice," asbestos-related suits that have been "inundating courts and dumbing down the U.S. legal system." More than 500,000 claims were pending at June 30, 2002, and estimated total losses so unpredictable that they ranged in total up to $275 billion. The Bermuda companies, which are mostly too new to have extensive exposure to the asbestos problem, will essentially duck that problem.

The third is the surety crisis highlighted by the Enron debacle. Again the Bermuda companies are not greatly involved. The fourth, the status of the financial guaranty monoline reinsurers, may in time become more of a Bermuda issue.

Established in the late 1980s, the monoline reinsurance industry has undergone extensive change in the past few years. Both of Bermuda's largest insurance companies, Ace and XL Capital, have stand-alone monoline subsidiaries (Ace Guaranty Re, formerly Capital Reinsurance, and XL Financial Assurance, respectively). Another player, RAM Re, founded in 1998, also operates from Bermuda.

Ratings agency Fitch has reported that the primary financial guarantors, which cede the monoline reinsurers most of their business, now have larger capital bases and greater financial flexibility than was the case a dozen years ago. Consequently, the primary reinsurers no longer need as much reinsurance themselves, and use it instead to mitigate large single risks, and enhance profitability by ceding commissions higher than the primaries' underwriting expenses.

In 1998, multiline insurer American Re, a subsidiary of Munich Re, entered the industry. Since 2000, it has been the leading financial guaranty reinsurer. Despite a reduction in the monoline reinsurers' participation in the development and success of their major clients, other reinsurers, monoline and multiline, have also started to offer financial guaranty insurance in the past few years.

The monoline reinsurers' business has grown and Fitch reports that their stress test performances continue to meet AAA. requirements, but increased competition has placed pressure on their earnings and made it more difficult for them to grow while writing business at risk levels consistent with AAA ratings.

Most treaty reinsurance in this area is now carried out on a surplus share basis, in which the primary insurer cedes only deals larger than an established amount. More business has also been conducted on a facultative basis for specific deals. The result is higher single risk concentrations and less diversified portfolios among these reinsurers, even if their highest risks are concentrated in relatively low-risk sectors.

Given the trends in competition and ceding company relationships and their impact on the reinsurers' businesses, Fitch has assigned a negative rating outlook for a one- to two-year horizon to Ace Guaranty Re and two other non-Bermudian companies, Radian Reinsurance and AXA Re Finance.

Enron Fallout

Since the start of summer, however, Bermuda has developed a larger problem, one that does not affect the Bermuda re/insurance sector directly, but that threatens the island's continued existence as the world's leading offshore financial services jurisdiction. Bermuda companies have become a victim of what Americans perceive as excessive greed on the part of certain corporations and their managers. Such activity has been equated with a lack of patriotism as President Bush tries to rally the world around the U.S. flag. The companies involved are not insurers, but Bermuda has become a victim of September 11 in much the same way as the families of those who died in the World Trade Center. Bermuda's problem is escalating and it may not go away.

What is called a "corporate inversion" occurs when a company relocates its U.S. headquarters to another jurisdiction. The move to Bermuda, at least on paper, reduces the liability to U.S. tax. The United States taxes its citizens and resident corporations on their worldwide income, but Bermuda, like Britain and other European countries, does not. In the past two years, Bermuda has attracted some 26 such companies, by best estimates.

With November elections drawing closer, Democrats in Congress identified and branded corporate inversions as unpatriotic. Although final details had yet to be worked out, both Houses passed legislation denying access to federal contracts to companies that had undergone inversions or, in one legislative case, companies located in any of 10 offshore jurisdictions including Bermuda. The shareholders of one company, Stanley Works, approved a move to Bermuda, which management abruptly cancelled at the last moment when the Democrats had their day.

The general counsel of the U.S. Treasury, David D. Aufhauser, in Bermuda in August to discuss money laundering, opened his comments with an apology: the problem of corporate inversions, "is not Bermuda's fault, it is the fault of the United States." Bermudians wish that his Republican party had the votes to back up his sympathy.

An FBI-led investigation later that month into financial impropriety and stock ramping was nicknamed "Bermuda Short," although officials conceded that it had very little to do with Bermuda (and more to do with shorting, which was at the root of the scam). Though only barely involved, Bermuda was again guilty by association. Apart from hiring a Congressional lobbyist, there has not been much the Bermuda government can do. This too shall pass, but not before it inflicts further damage, one suspects, on Bermuda's reputation.

Corporate inversions do not greatly benefit Bermuda (management tends to stay put, using Bermuda merely as a paper headquarters from which to bill management fees and other expenses), but further inversions are unlikely in the present climate.

The media spotlight that has settled on the business community in general, and Bermuda specifically, will ease, as it always does, when other issues come to the fore. An invasion of Iraq would take everyone's mind off the immediate economic situation. But despite the ripples still affecting the re/insurance community as the anniversary of the day that will live in infamy approached; despite Lloyd's' seeming inability to catch a break, or to resolve its structural problems; despite under-reserving and overestimating; despite accounting problems and the 2002 hurricane season; despite all this and more, the insurance industry has shown in the 12 months since September 11 that it will deliver on the great promise on which it is built: to be there when the chips are down with its checkbooks in its hands. A greater number of those checks are now drawn in Bermuda than ever before. Profits of Leading Bermuda Insurers 6 months to June 30, 2002 (unaudited) $ million Net Operating Income 2002 2001 Increase % ACE 452.0 279.0 62.0 American Safety Insurance Group N/A N/A N/A Everest Re Group 135.7 108.3 25.3 IPC Holdings 55.3 20.2 173.8 Max Re (5.5) 0.4 N/A Partner Re N/A N/A N/A PXRE Group N/R N/R N/A RenaissanceRe Holdings 179.9 74.7 140.8 Scottish Annuity & Life 15.3 7.6 102.0 Trenwick Group (7.6) (38.7) N/A White Mountains Insurance Group 648.6 (92.5) N/A XL Capital 235.4 316.8 (25.7) Allied World Assurance Arch Capital Group ** AXIS Specialty Endurance Specialty Insurance Montpelier Re (partially included in White Mountains) Net Income 2002 2001 Increase % ACE 302.0 250.0 20.8 American Safety Insurance Group 3.9 2.8 36.9 Everest Re Group 114.5 107.4 6.6 IPC Holdings 92.2 44.7 106.3 Max Re (2.4) 1.1 N/A Partner Re 129.8 149.1 (12.9) PXRE Group 37.3 7.5 394.6 RenaissanceRe Holdings 180.4 85.2 111.6 Scottish Annuity & Life 12.8 7.6 69.0 Trenwick Group (50.8) (31.9) N/A White Mountains Insurance Group 648.6 (477.1) N/A XL Capital (2.3) 347.5 N/A Allied World Assurance 44.0 Arch Capital Group ** 23.2 16.4 41.5 AXIS Specialty 62.0 Endurance Specialty Insurance 34.6 Montpelier Re 46.2 (partially included in White Mountains) Combined Ratio 2002 2001 ACE 92.2 97.5 American Safety Insurance Group 85.3 88.4 Everest Re Group 98.4 102.8 IPC Holdings 32.3 49.2 Max Re 101.6 99.5 Partner Re 93.5 98.8 PXRE Group 63.9 103.4 RenaissanceRe Holdings 52.5 72.6 Scottish Annuity & Life N/R N/R Trenwick Group 109.2 124.4 White Mountains Insurance Group N/R N/R XL Capital 101.0 93.1 Allied World Assurance 87.7 Arch Capital Group ** 94.0 N/R AXIS Specialty 87.7 Endurance Specialty Insurance 82.0 Montpelier Re 72.0 (partially included in White Mountains) N/A Not applicable N/R Not reported * Non-life ** In existence prior to 9/11/01 but recapitalized since Source: Compiled by Risk & Insurance from company reports Premiums of Leading Bermuda Insurers 6 months to June 30, 2002 (unaudited) $ million Net Premiums Written 2002 2001 Increase % Ace 6,047 4,964 21.8 American Safety Insurance Group N/A N/A N/A Everest Re Group 1,230 904 35.7 IPC Holdings 207 93 123.7 Max Re 465 514 (9.5) Partner Re 1,415 1,037 36.4 PXRE Group 167 127 32.1 RenaissanceRe Holdings 731 320 128.3 Scottish Annuity & Life N/A N/A N/A Trenwick Group N/R N/R N/A White Mountains Insurance Group N/R N/R N/A XL Capital 4,397 2,157 103.9 Allied World Assurance 405 Arch Capital Group ** N/R N/R N/A AXIS Specialty 526 Endurance Specialty Insurance 395 Montpelier Re 340 (partially included in White Mountains) Gross Premiums Written 2002 2001 Increase % Ace 3,861 3,205 20.5 American Safety Insurance Group N/A N/A N/A Everest Re Group 1,170 806 44.7 IPC Holdings 202 89 126.6 Max Re 415 356 16.6 Partner Re 1,388 1,009 37.6 PXRE Group 124 93 33.5 RenaissanceRe Holdings 578 214 169.7 Scottish Annuity & Life N/A N/A N/A Trenwick Group N/R N/R N/A White Mountains Insurance Group N/R N/R N/A XL Capital 3,352 1,561 114.7 Allied World Assurance 398 Arch Capital Group ** 503 10 N/A AXIS Specialty N/R Endurance Specialty Insurance N/R Montpelier Re N/R (partially included in White Mountains) Net Premiums Earned 2002 2001 Increase % Ace 2,936 2,754 6.6 American Safety Insurance Group 30 30 0.0 Everest Re Group N/R N/R N/A IPC Holdings 103 49 108.6 Max Re 151 202 (25.3) Partner Re 1,045 776 34.7 PXRE Group 105 91 14.9 RenaissanceRe Holdings 335 159 110.1 Scottish Annuity & Life 69 21 231.2 Trenwick Group 543 427 27.1 White Mountains Insurance Group 1,837 549 234.7 XL Capital 2,151 1,183 81.8 Allied World Assurance 100 Arch Capital Group ** 181 7 N/A AXIS Specialty 150 Endurance Specialty Insurance 93 Montpelier Re 118 (partially included in White Mountains) N/A Not applicable N/R Not reported ** In existence prior to 9/11/01 but recapitalized since Source: Compiled by Risk & Insurance from company reports

Roger Crombie can be reached at crombie@northrockbm.

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