Market conditions remain tight at midyear for property/casualty reinsurance as reinsurers deal with an emerging trend: demand by ceding insurers for additional security to back reinsurance recoverables.

Ceding insurers, led by American International Group Inc., are increasingly requiring reinsurers to post collateral for outstanding balances, or are demanding contract language that requires reinsurers to take various steps if the reinsurers' financial strength ratings are downgraded.

These steps can include posting letters of credit or other collateral to secure a ceding company's recoverables; allowing the ceding company to demand commutation of the contract; or requiring that the downgraded reinsurer be replaced by another reinsurer on the program, sources report.

Reinsurer reaction to the security demands has been mixed, with some refusing to go along with the demands, others acquiescing and still others studying the matter.

While some contend that so-called "downgrade" or "termination" clauses provide extra protection for ceding insurers, most agree that widespread use of the provisions would create problems for reinsurers, imposing additional costs and reducing investment flexibility.

"From the reinsurers' perspective, I don't see how it could be anything other than a negative," said Robert DeRose, senior financial analyst with A.M. Best Co. in Oldwick, N.J.

The renewal market, meanwhile, remains tight for most buyers, with slower rates of increase in property reinsurance pricing and continued hardening of casualty pricing, especially for such difficult lines as commercial umbrella, professional liability and medical malpractice, reinsurance market sources report.

Focus on security

AIG has taken the lead in pushing reinsurers for additional security.

At the insurer's annual shareholder meeting in May, Chairman and Chief Executive Officer Maurice R. Greenberg noted that huge insurance and investment losses have led to numerous reinsurer rating downgrades.

"Every reinsurer we do business with has to meet certain standards," Mr. Greenberg said. "As they were downgraded, we have taken them off our credit list. They can only stay on our list if they post collateral-and we don't care if they are domestic or foreign-adequate to meet the exposures we may have to them."

If AIG's list of approved reinsurers shrinks, "so be it," Mr. Greenberg said. "If we keep more business for ourselves, we will do that....We will not reinsure with somebody that might not be around to pay a claim."

To stay on AIG's approved list for certain casualty business, some reinsurers have been asked to collateralize all outstanding recoverables, including incurred-but-not-reported losses, reinsurance market sources say. The insurer's demands have varied, though, from reinsurer to reinsurer, sources add.

An AIG spokesman cited Mr. Greenberg's comments at the annual meeting but did not respond to requests for further details.

A number of ceding insurers-particularly large stock companies-have followed AIG's lead, seeking collateral for outstanding recoverables or demanding downgrade clauses in contracts up for renewal, reinsurers report.

There are more downgrade clauses, said John N. Gilbert, president and chief executive officer of New York-based reinsurance intermediary Holborn Corp., a reinsurance intermediary. "They have become quite popular," he said. "I don't want to say they're necessarily standard, but they are in greater use, though some companies and markets view it as potentially creating problems for both parties. There is some resistance to them."

David Priebe, managing director at reinsurance intermediary New York-based Guy Carpenter & Co., said that "it's a growing issue" as to whether reinsurers will support a clause that requires them to post collateral. "From what we're seeing, there are certain reinsurers willing to embrace the concept."

However, "the majority of reinsurers haven't yet agreed to follow that provision. Most of our clients have taken a rather disciplined approach in terms of their market selection and have adopted a variety of techniques to ensure the quality and the performance of their reinsurance contracts, and so I think that's still under discussion and changing," said Mr. Priebe.

In some cases, particularly where a reinsurer is showing financial weakness, the actions make sense, some reinsurers concede. Banks demand added security from riskier borrowers, so, "Why should reinsurance be any different?" said John Berger, president and chief executive officer of Chubb Re in Bernardsville, N.J.

Even reinsurers with A+ Best ratings are being asked for collateral and downgrade clauses, though.

"What it's saying is that they have no confidence in the rating agencies," said James Pilla, CEO of Toa Reinsurance Co. of America in Morristown, N.J., referring specifically to AIG.

Downgrade clauses may not provide the intended extra security if they become too widespread, some reinsurers suggest. If a reinsurer that has the clauses in most of its contracts is downgraded, the sudden obligation to post a large amount of collateral may prove too much for it to handle, some say.

"Downgrade clauses sound good," Mr. Berger said, "but if everybody has one, it doesn't help them that much."

The security demands unquestionably create new headaches for reinsurers, analysts and reinsurance sources agree.

Reinsurers' costs will be driven up by the need to post LOCs, Mr. DeRose noted. Alternatively, if a reinsurer puts funds in trust as security, its investment returns will suffer, because it would likely invest the money in more conservative, lower-yielding instruments.

Downgrade clauses that allow ceding insurers to commute their contracts also could mean significant lost business for affected reinsurers, he added.

"It's an additional cost, it ties up capital and reduces flexibility," observed Mike Hayes, CEO of Alea North America Reinsurance Division in Wilton, Conn.

The extent to which the security provisions will catch on remains uncertain, though some expect them to become more common.

"You're going to see more and more of them," Mr. Berger predicted, adding that the trend will favor the strongest reinsurers. "The smaller, less well-rated companies will really suffer."

Some observers claim the provisions are not new, though. Patrick J. Denzer, president and chief operating officer of reinsurance intermediary John B. Collins Associates in Minneapolis, said his firm's contracts have had standard termination wording in the event of a downgrade, the loss of a certain percentage of surplus, or runoff. "We allow our clients to terminate their position retroactive to inception" of the contract, he said.

"We've probably been a little more forceful in how we advise our clients to apply those clauses, but we've been doing that probably two or three years, I'd say. I think it's getting a little more press, lately, for obvious reasons," said Mr. Denzer.

Guy Carpenter's Mr. Priebe said the intermediary has "historically had provisions in our reinsurance contracts in many cases which gave the client the opportunity to either commute or cancel a reinsurer's position in the event of a change in their financial status, be it a rating downgrade or reduction in capital below a certain threshold, so that's something that's always been there."

David Cameron, senior vp at reinsurance intermediary Benfield Blanch in Minneapolis, said, "That's been a push for a while for Benfield, both in termination as well as funding clauses, for a couple of years now," although "there's probably been some contracts that had them added this past renewal season."

Others say they have not seen increased evidence of downgrade clauses.

"I'm not seeing a massive rush to that," said Steven Bolland, senior vp at reinsurance intermediary Gill & Roeser in New York. "Obviously, reinsurers don't want it. If you have a large program with a number of reinsurers in it, it would get very clumsy. I haven't seen that as being a big issue."

"We haven't run into that," but that may reflect the reinsurers with which Dallas-based EWI Re deals, said Patrick J. Stangle, its president and chief executive officer.

However, he added, security "is probably one of the most prominent issues in the reinsurance industry," he said. "Ceding companies are being much more selective as to whom they're dealing with. I think that's the key. You have to seriously look at the reinsurers you're dealing with, and I think more ceding companies are being a lot more selective," said Mr. Stangle.

Others agreed the number of reinsurers with which insurers will do business has decreased.

Richard DiClemente, president of New York-based THB Intermediaries Inc., said certain insurers "have begun to restrict the number of reinsurers they're dealing with. Reinsurers that drop below A are being summarily removed from lists, and there's much more concern...about security, and the result of that is a smaller approved list of reinsurers for the major buyers.

"It's also much more difficult to get new markets approved, since a lot of carriers are now taking a larger net positions on account and keeping more risk in house, so there's been some reduction" in reinsurance purchasing because of that as well, said Mr. DiClemente.

Gill & Roeser's Mr. Bolland noted that although there are fewer reinsurers to begin with because of consolidation, "there are a few of the smaller, weaker reinsurers who are going to get squeezed, particularly on the casualty side, where people recognize that you pay the premium today and the payout could be over 15, 20 years or more, and, therefore, compromising on security when you go out 20 years is a big gamble."

Guy Carpenter's Mr. Priebe said there has been a five-year trend toward shortening approved lists of reinsurers on the liability side. Over the past six to 12 months, several reinsurers "have now fallen off those so-called approved lists" in a reflection of the "financial challenges" many have gone through over the past two years, he said.

Mr. Denzer said, "I think that there is a continued flight to quality, that more and more companies are cognizant of the quality of their security and willing to pay maybe a little bit higher price for security."

Apart from the debate over reinsurer security, the midyear renewal season has offered few surprises.

Noncatastrophe property treaty business is seeing modest single-digit price increases, while the "catastrophe market seems to be leveling off around the world," in part because of the influx of new capital devoted to cat risks, said Rick Smith, president and CEO of global property and casualty reinsurance at Overland Park, Kan.-based Employers Reinsurance Corp.

Facultative property placements may be somewhat tougher: American Re-Insurance Corp. is getting an average increase of about 20% on its business, where loss experience tends to be more volatile than in the general run of property treaty, according to Kevin Davidson, president of the reinsurer's direct facultative unit.

The casualty market remains tighter than property, with reinsurers enjoying double-digit price increases even for run-of-the-mill general liability business as they become much choosier about the risks they take on.

Employers Re, for example, has stopped writing pharmaceutical risks and is "extremely selective" in writing national account umbrella, directors and officers liability and professional liability business, Mr. Smith said.

"In general terms, the casualty market has, from a reinsurance perspective, improved year over year from" last July 1, said Peter Zaffino, managing director at Guy Carpenter. "While reinsurers are still monitoring aggregates very closely, there seems to be a little more aggregate available this 7/1" compared with last year.

"General terms and conditions, meaning ceding commissions, are not as stringent as they were last year," said Mr. Zaffino. Having said, that, however, certain segments-including directors and officers liability, errors and omissions, large accounts, lawyers and coverage for large financial institutions- are "still getting hard-market rates and in some cases still experiencing some rate increases," said Mr. Zaffino.