Converium’s Conundrum: Reserve Requirements Hit Reinsurer

When Zurich Financial Services (ZFS) spun off its reinsurance operations into Converium in September 2001, the new company had a bright future. Initial capitalization exceeded $1.6 billion; ZFS had agreed to retain liabilities on business written in 1986 and prior years and an initial public offering in December was a success, raising $1.1 billion net of expenses.

The attacks of Sept. 11 had only a modest impact on the newly formed company, as ZFS agreed to cap liabilities for WTC related losses at $289 million. Earlier it had agreed to retain most of Converium’s potential asbestos related exposures. Standard & Poor’s (S&P) gave Converium its “A+” rating and assigned a stable outlook.

Despite some bad news—a $71.2 million loss in the third quarter of 2002, triggered by the need for some $60 million of additional reserves, followed by $70.3 million more in the fourth quarter—the company was otherwise doing well. Most of the reserving was required due to losses in the years 1997-2000 in the reinsurer’s U.S. subsidiary Converium Reinsurance North America Inc. (CRNA).

At the end of April 2004 Converium reported its “best quarter operating income so far”—$77.2 million, up 192.4 percent over Q1 2003. Net earnings were $65.7 million, up 157.6 percent. 2003 had been a good year too, as the company boosted its net earnings by 73.3 percent to $185.1 million, compared to $106.8 million in 2002. A.M. Best affirmed the Group’s “A” (Excellent) rating in June. Then, you-know-what hit the fan.

Neither Charley nor Frances were responsible, just the skeleton that pops out of the closet all too frequently in the reinsurance business—inadequate loss reserves. On July 20, Converium revealed that its “second quarter results will fall short of expectations due to higher than modeled U.S. casualty loss emergence primarily related to the underwriting years 1997 to 2001.” It cited particular problems in “umbrella, professional liability and excess and surplus lines casualty.”

While strengthening reserves isn’t unusual, the amounts were “up to U.S. $400 million.” It also said, “this reserve action triggers net impairments of up to U.S. $289 million of Deferred Tax Assets and U.S. $ 94 million of Goodwill in the balance sheet of Converium Reinsurance (North America) Inc.” It further noted that some strengthening had already taken place during the first quarter, and indicated that it expected “that the volatility of longer-tail risks was likely to persist for some time.”

Converium went on to state: “In response to the loss developments observed in the last quarters,” it was initiating “additional reviews of the U.S. casualty business in order to examine the adequacy of prior years’ provisions from an integrated actuarial, underwriting and claims perspective. It put the actuarial consulting firm Tillinghast-Towers Perrin in charge of the review and promised to provide the results before the end of August.

The damage was done, however; Converium’s future had dimmed considerably. Both A.M. Best and S&P downgraded their ratings from “A” to “A-” on the company and its operating subsidiaries—notably CRNA. All of the issuer credit ratings and related debt issues were lowered as well, and both rating agencies indicated they would review Converium’s situation further when Tillinghast had completed its review. The outlook on the company was decidedly negative.

Converium duly published the results of the external reserve review on Aug. 31, accompanied by the announcement that it plans a share issue of the Swiss Franc equivalent of $420 million, more than had been expected. Tillinghast confirmed that the reserves were “within a reasonable range of actuarial estimates for the segments reviewed.”

Commenting on the study, the company said it had concentrated on its Zurich and New York originated businesses, “which amount to $ 6.8 billion and represent 94.9 percent of the company’s total reserves.” It stressed that Tillinghast had “concluded that Converium’s overall net reserves as of June 30, 2004, in total, for the segments reviewed, are below their point estimate, but fall within a range of reasonable actuarial estimates. Tillinghast’s point estimate for the relevant businesses exceeds Converium’s carried reserves as of June 30, 2004 by U.S. $ 212.9 million or by approximately 3.2 percent.”

It also said it was taking the review into account in formulating plans to strengthen its reserve position, and pointed out that it had already “commuted $176.8 million in loss reserves related to prior years’ business assumed by its North American operation.” It’s currently negotiating “with several clients for offers of commutations, and it is pursuing these diligently.” If successful these would further reduce “the difference between Tillinghast’s point estimate and the company’s current level of reserves.”

Converium also noted that it had “entered into a retrospective retrocession agreement with National Indemnity Company, a S&P AAA-rated member of the Berkshire Hathaway group of insurance companies. The retrospective retrocession agreement includes two layers, a U.S. $150 million out-of-the-money layer, and a U.S. $235 million in-the-money layer. The out-of-the money layer provides an additional U.S. $150 million of cover against potential adverse reserve development on the underwriting years 2003 and prior, for all business written by Converium AG, Converium Reinsurance (North America) Inc. and Converium Insurance (North America) Inc.”

The $420 million in additional capital is more than the $250 million to $400 million estimate Converium indicated at the end of July. It plans on submitting the proposal to an Extraordinary General Meeting of shareholders to be held before the end of September, who will be asked to approve the proposed capital increase. It hopes to issue the new shares in October.

Converium said it “remains committed to underwriting for profit. In regards to pricing, Converium’s after-tax target return for each line of business is 11 percent plus the higher of 4 percent or the local risk-free rate (i.e., at least 15 percent in total) on allocated risk-based capital in each market. Meeting these targets requires a constant management of the underwriting cycle including the avoidance of under-priced business.”

It also plans to reorganize its North American business to implement changes to the way it is executed. It aims to reduce exposure to highly capital-intensive lines of business in the U.S., and “will discontinue the local writing of long-tail specialty lines reinsurance from North America. Going forward, these lines will be written using Converium AG, Zurich, and its Bermuda branch as carrier. These steps are expected to result in a reduction of North American gross premium volume by up to U.S. $500 million.” Essentially U.S. business will now be written from Zurich and Bermuda and the remainder of CRNA is effectively in run-off.

CEO Dirk Lohmann commented: “These organizational changes reflect a series of painful lessons learned from prior year casualty underwriting in the United States. A centralization of underwriting responsibilities for the long-tail specialty lines is expected to facilitate the implementation of rigorous and globally consistent underwriting standards.” Although he didn’t mention it, Converium inherited most of the problems from business written by ZFS prior its 2001 formation, i.e., prior to the stock market crash, Enron, WorldCom and other financial disasters.

Commenting on the share issue Peter Colombo, chairman of the board of directors, indicated that the decision had been unanimous, and was in the best interest of shareholders “as it will help safeguard Converium’s strong franchise.” He noted that the “size of the share issue takes into account an independent assessment of Converium’s reserve position as well as the various measures which reduce the Company’s capital requirements.”

The other shoe fell when S&P and Best both announced further downgrades.

S&P lowered its long-term counterparty credit and insurer financial strength ratings on CRNA to “B+” from “A-.” However, it maintained its “A-” ratings on Converium AG and its other operating subsidiaries, while keeping them on CreditWatch with negative implications. S&P singled out Converium’s plans to put CRNA into runoff as the primary reason for the downgrade. It noted: “CRNA was previously considered core to its parent, and was therefore rated at the same level as Converium’s other operating subsidiaries,” however S&P “now considers CRNA to be non-strategic, and the company is therefore rated on a stand-alone basis.” It also pointed to Tillinghast’s conclusion that there is potentially an additional need for some $213 million to further strengthen the group’s non-life loss reserves.

Best downgraded the financial strength rating of both Converium AG and certain rated subsidiaries to “B++” (Very Good) from “A-” (Excellent). It also downgraded the issuer credit rating to “bbb” from “a-“. The actions reflected Best’s analysis of Converium’s “overall ability to meet its senior obligations, which are insurance policies; hence both ratings (issuer credit and financial strength ratings) are at the same level.” The ratings remain under review.

Best downgraded CRNA’s financial strength rating all the way to “B-” (Fair) from “A-” (Excellent) and the issuer credit rating to “bb-” from “a-.” It also removed the rating from under review and assigned a negative outlook. Moody’s Investors Service took an even dimmer view of CRNA’s debt ratings, downgrading some of them to “Ba1,” the highest junk rating.

Converium’s not the first insurance company to be hit by the need to dramatically increase loss reserves, nor is it likely to be the last. The circumstances, however, set off some alarm bells. The world’s 10th largest reinsurer (based on 2002 premiums) is a well-capitalized and well-run company, protected by a number of agreements with ZFS. Yet it was forced to seek $420 million in additional capital, due to a massive increase in claims arising from business written before it even existed. The industry has to be wondering how many other companies might have similarly large holes in their reserves that will eventually need to be filled.