NEW YORK (CNNMoney.com) -
With Thursday marking the official end of the powerful 2005 hurricane season, Wall Street is looking for the next big thing to come out of the insurance sector.
On the surface, the reinsurance industry is poised to fit the bill.
With meteorologists forecasting that this year's hurricane season is a harbinger of more wicked weather over the next two decades, analysts estimate that reinsurers who insure property-casualty companies could raise rates as much as 25 to 40 percent.
And investors are banking on this, on the belief that higher rates could translate into solid profit growth down the road. The Dow Jones U.S. Reinsurance Index, has jumped 15 percent since mid-October while both the Dow Jones industrial average and the broader Standard & Poor's 500 are up less than 8 percent.
Lured by the prospects of higher rates, there's been a wave of capital flooding into the reinsurance market as eager financiers hope to take advantage of the expected boom in reinsurance profits. But the rush to raise new capital may end up costing reinsurers the rate increases they'd hoped to achieve.
It's a simple supply and demand issue.
Robert DeRose, assistant vice president of reinsurance ratings at A.M. Best, said the reinsurance industry is expected to have lost $60 billion from last summer's hurricanes.
Faced with more deadly hurricanes to come, primary insurers are expected to stock up on reinsurance to mitigate future losses. And the suppliers of that reinsurance, reeling from a dramatic hit to their own capital base, can justify charging significantly higher rates.
But the rush of new capital into new firms jumping into the reinsurance business could bolster competition and put pressure on the industry's ability to charge higher rates.
A flood of capital
Since Hurricane Katrina -- the costliest storm on record with estimates of as much as $60 billion damages -- there's been a flurry of activity in reinsurance, particularly in Bermuda. Rob Haines, analyst at Credit Sights, said in a research note that more than $8.2 billion in new reinsurance capital will be raised in Bermuda alone by year-end.
"Before the hurricanes hit, everyone was saying that reinsurance and primary rates were softening," said Donald Light, senior analyst at Celent LLC. "But after the hurricanes, more capital than expected started coming in and there were suddenly new startup (reinsurers). There's the feeling in the industry that the bus is going to leave so everyone better jump on it."
So far nearly a dozen startups have registered in Bermuda. Some of the most prominent players include New Castle Re, capitalized with $500 million from Chicago-based hedge fund Citadel Investment Group, and Harbor Point Re, funded by a partnership between Chubb and private equity fund Trident III LP.
Some London-based insurers such as Hiscox and Amlin are also pumping new capital into their Bermuda reinsurance entities.
Former Marsh & McLennan CEO Jeffrey Greenberg, who stepped down shortly after New York Attorney General Eliot Spitzer charged the company with bid-rigging, has also thrown his hat into the ring. His private equity firm Aquiline Capital Partners LLC is providing the backing for a new startup in Bermuda called Validus Holdings.
Tempered rate hikes
The rush is being driven by anticipation of higher rates, Credit Sights analyst Rob Haines wrote in a research note. But "while it's clear that reinsurance rates are going higher near term," he added, "we believe the increase in capacity will ultimately temper the sector's ability to raise rates."
He added that reinsurance rates will inevitably spike in hurricane-prone coastal areas and certain lines of business such as energy and marine insurance, but that the hikes, and how long they last, may disappoint some investors.
Bob Hartwig, chief economist at the Insurance Information Institute, said he expects the influx of new capital to "remove some of the froth from these markets and have some muting impact on prices."
But even if rate hikes are depressed slightly, analysts still expect rates to climb significantly.
There's also no guarantee that all the new players will be able to start writing business for the latest renewal period, starting in January.
"It's getting late in the season already and it's still not clear how many of these vehicles will get off the ground in time," John Vollaro, CFO of Bermuda reinsurer Arch Capital Group, said at an industry conference Thursday morning. "I'm not sure if anyone knows that they will be well capitalized in time for renewal season."
As a result, analysts said, reinsurers that are ready to renew business can still have a solid case to request larger rate increases in the short term. And that should translate into gains for investors.
Should investors buy?
But how long those gains will last is still up in the air. Celent's Light said reinsurance rates will climb in the short run but that rate increases may not stick through next year.
And Credit Sights' Haines warned investors that the outlook for the reinsurance sector remains negative.
"We expect profitability at most U.S. reinsurers to remain at unacceptable levels for the foreseeable future," he said. "Although rate increases may provide a temporary reprieve, we believe the underlying performance of the sector is unlikely to improve significantly any time soon."
Insurance CFOs expect to pass along higher reinsurance costs to policyholders. For more on that story, click here.
Allstate's CEO sees big rate hikes to come. Click here for that story.