Reinsuring insurers is a great business when there are no major catastrophes. It gets even better when fairly recent shocks result in rational pricing.
Reinsurers such as XL Capital (NYSE: XL), RenaissanceRe (NYSE: RNR), and Arch Capital Group (Nasdaq: ACGL) have basked in the post-Katrina days of rational reinsurance pricing and few catastrophes. Aside from the windstorm Kyrill, the first quarter of 2007 was benign, and Montpelier Re (NYSE: MRH) posted strong results, with earned premiums up almost 9%, investment income up 15%, and net income up 84%.
Much of the improvement in net income was thanks to the combined ratio decreasing by 10 points, which was mostly because of a 13.2-point drop in the expense ratio, which in turn was mostly because of a shift in the mix in Montpelier's business. For the quarter, excess of loss (XOL) insurance accounted for 88% of earned premiums, and proportional treaty accounted for the remaining 12%. Last year, this mix was 56% and 34%. For excess of loss contracts, Montpelier takes on all losses past a certain point. For proportional, Montpelier proportionally shares in all losses, earned premiums, and commission expenses.
Thus, the higher mix of XOL insurance cut Montpelier's acquisition costs in half to 13%. This also changes the risk profile. Management categorized the first quarter as a "below-average catastrophe quarter." Because Montpelier doesn't take a loss on XOL contracts until a certain level of losses has been reached, the company basically rakes in the dough when there isn't a big catastrophe, but it could also take a big hit if another Katrina type of event happened.
There were also some pockets of weakness. In the retrocession market, where reinsurers look for reinsurance, rates were down significantly, especially on industry loss warranty protection, which guards against very large loss events. Management speculated that this was because of new entrants such as hedge funds and other financiers.
Overall, it was a nice quarter, partly because there were few catastrophes, and partly because management made the right bets on writing more excess of loss contracts.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He owns shares in Montpelier Re. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
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