European Reinsurance
Beneficiary of global deleveraging?

A combination of falling supply and higher demand will, in our view, drive reinsurance prices up by
an average of 5% during the 2009 renewals seasons. Demand for reinsurance is increasing as
primary insurers, with their capital stressed, deleverage their balance sheet risk. We expect the
reinsurance supply to fall 12% by year-end 2008 because of higher claims, asset erosion and the
stream of net capital outflows from the industry.
Incumbent players should be in a significantly better competitive position than in previous
contractions due to the absence of private-equity/hedge-fund invested sidecars and a lack of new
entrants as the ‘flight to quality’ raises the barriers to entry. We regard reinsurance as relatively
defensive and a rare growth story in European insurance during these exceptional times.
Munich Re (target price EUR125.4) and Scor (initiation of coverage, target price EUR16.1), both rated
Overweight (V), are our preferred stocks. We see those players as the key beneficiaries of the upturn
of the P&C reinsurance cycle due to their relatively strong balance sheets, with few concerns about
their asset quality.
We downgrade Swiss Re (target price CHF53.2) from Overweight to Neutral (V); although
adequately capitalised, its well-flagged exposure to adverse macro-economic conditions could deter
investors from re-rating the shares in the short term. We initiate coverage of Paris Re (target price
EUR13.1) at Neutral (V) and Hannover Re (target price EUR16.9) at Underweight (V).

Beneficiary of global deleveraging?
We believe the credit crunch and the ongoing deleveraging should promote a return to basics in the
reinsurance industry: the number of players is falling, global reinsurance capacity is declining, the
development of the alternative risk transfer market is on hold and demand for reinsurance is rising. This is
in sharp contrast to the situation in the global reinsurance industry between 2002 and 2007, when prices
suffered from significant capacity growth due to new entrants and favourable capital markets. The nearterm
outlook for Property and Casualty (P&C) reinsurance is positive, in our view, although longer term
we favour life reinsurance.
P&C reinsurance cyclical upturn in sight
We believe that P&C reinsurers will benefit from a gradual improvement of the industry’s fundamentals,
in stark contrast to the primary life and asset gatherers, which are facing unprecedented challenges.
Although reinsurers have not escaped the ravages of the current crisis, we believe their relative balance
sheet strength and resilience have materially increased their bargaining power (maybe temporarily) going
into the European treaty renewals season at the start of next year.
Reinsurance capacity is set to fall by at least 12% by year-end 2008e
We forecast a 12% fall in global reinsurance capacity by year-end 2008e due to higher claims (hurricanes
Gustav and Ike could cost up to USD30bn), the collapse of bonds and equity values, lower profitability
and capital outflows. This would mark the end of the growth of industry surpluses that has continued
almost unabated since 2001, and would return reinsurance capacities to 2006 levels.
Historically, when capacity reduces and pricing prospects improve, new capital enters the market. This
time around we expect things to be different; we do not expect be the sector to be awash with new capital
as private equity/hedge fund-sponsored sidecars are unlikely to be renewed and ‘flight to quality’ has
raised new barriers to entry. Ultimately we believe the incumbents will be in a much better competitive
position.

Reinsurance demand is increasing
Two key forces are at play:
 Capital adequacy under pressure. Weakened balance sheets are forcing primary insurers to re-assess
the level of on-balance-sheet risks they run (underwriting and financial guarantees). In our most
recent note, Capital raising? Dividend cuts? (Part 2), 23 October 2008, we estimated that the sector
may require up to EUR10bn to meet ‘A’ S&P requirements, although note that several insurers have
higher official ratings. Reinsurance offers insurers an alternative solution to raising capital through
debt or equity.
 Historically high retention to be cut after costly 2008. Primary insurers that have been running
historically high retention rates (now 90% in Europe and the US as the chart above illustrates) have
borne the brunt of the sharp rise in claims costs this year due to the rise in frequency and severity of
claims. In future we expect primary insurers to re-assess their risk appetite and buy more reinsurance
(reduce retention) in light of this year’s shocks.
Imbalance to drive prices up by at least 5%
We expect a 5% aggregate increase in reinsurance prices next year in contrast to a 7% decline so far in
2008. Favourable discussions regarding pricing between the reinsurers and their clients at Monte Carlo
and Baden-Baden, coupled with marked deterioration in financial markets, have forced us to diverge from
the original market consensus expectations of a further price decline of -3% to -4% next year. The size of

the price increases will be market-specific – with US property catastrophe and offshore energy likely
show the highest increases.
It is important to flag that the reinsurers’ cost of equity will markedly increase as they turn to raising
capital through issuing equity, since the equity and credit markets can no longer be relied on to provide
the funds needed to plug holes left by large claims. Reinsurers will do their best to pass this increase on to
their clients in the form of higher prices. We expect favourable news on reinsurance pricing over the
course of the year, with European treaties renewals running from January to April and US/Asian renewals
from June to July.
Long-term attractions of Life & Health reinsurance
Over the past 17 years, growth in Life & Health (L&H) reinsurance (10.2% CAGR) has outstripped Property
& Casualty reinsurance (5.7% CAGR), and Life & Health now accounts for 45% of total premiums and c30%
of pre-tax profits. We expect Life reinsurance to continue to achieve superior growth over the medium term,
due to new cover needs and longevity demand, although near term this sub-sector is facing difficult headwinds,
particularly in the US and the UK. Longer term, we like Life reinsurance for its ability to generate a noncyclical
earnings stream that provides a natural hedge to the cyclicality of Property & Casualty, albeit with a
lower ROE. Life reinsurance is a concentrated industry: the top six reinsurers control 75% of the market owing
to significant knowledge and scale barriers to entry.
Reinsurance deserves a defensive premium
We regard the reinsurance industry as a relatively defensive sub-sector of our European insurance coverage
universe for five key reasons:
  
  . According to our HSBC Capital Adequacy Model, European reinsurers rank well
on an absolute basis and relative to their European primary insurance peers. We believe this is
attributable to the reinsurance model, in which balance sheet strength is at the centre of the
reinsurers’ value proposition. The reinsurance industry is historically more sensitive to rating agency
decisions but also more aware and cautious in capitalising its business. From 2001, reinsurers have
operated under tougher rating agency constraints following capital requirement changes in the wake
of 9/11 and the fall in equity markets. This signalled the end of the AAA rating in the reinsurance
industry (the only remaining one is on Berkshire Hathaway, but this reinsurer operates a different
business model from the others).


 . Operating cash flows are higher in the sub-segment, due to reinsurers’
bias towards non-life activities, which are highly profitable in the current environment and have little
top-line growth to finance. Our reinsurance universe trades on a 17.2% 2009e cash flow yield. We
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%

3%
7%
15%
12%
3%
-5%
1%
-4%
-7%
5%
3%
30%
10%
25%
37%
40%
35%
36%
3%
32%
25%
33%
-15%
-5%
5%
15%
25%
35%
45%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e 2010e
Price increase Cumulative price increase
Required profitability
Source: HSBC estimates

thus believe there is a below-average risk of dividend cuts and of capital increases, except for purely
strategic reasons;
  . Reinsurers have high cash balances on their balance sheets in order to be able to
meet claim payments. Reinsurers’ cash balance in H1 2008 equated to 84% of their current market
capitalisation versus an average 61% for the insurance sector.
 
   

 (ALM) strength. In our view, there are no risks of deformation of the
ALM matching as reinsurers have full control of their balance-sheet liabilities, which, moreover, have
little correlation with the financial environment. In P&C reinsurance, large claims have no direct
correlation with the financial environment and little correlation with the economic environment. Even
large nat cat (natural catastrophe) events do not translate into immediate large cash movements as
claims are paid out over 18 months at best. In L&H reinsurance, here also mortality and morbidity
trends are not correlated with the macro environment and are not subject to policyholders’ behaviour
changes.
 
 . Our analysis suggests that reinsurers have a lower asset gearing to
shareholders’ funds (equity) and to corporate bonds than the wider insurance sector: reinsurers’
equity gearing is half that of the rest of the insurance industry (15% versus 51%, respectively) and
corporate bonds’ gearing is less than one-fifth of that of the industry (64% versus 341%).
Valuation
The reinsurance industry has been de-rated over the past 10 years (not just during the last 12 months) in
absolute terms and relative to the wider insurance sector. Reinsurers are now trading at 0.8x book versus
1.9x book in 2002 (versus sector 1.0x book currently and 1.73x book in 2002). Some of this de-rating is
justified by reinsurers’ inability to generate capital over the previous cycle, relatively low ROEs versus
primary companies, higher earnings volatility and a more recent disconnect between all insurers’ share
prices and fundamental valuations (due to heightened solvency/macro fears, although these are not a big
issue for reinsurers in our view). Although it remains difficult to call the beginning of a long-term rerating
process of the reinsurance industry, which will depend on its ability to demonstrate superior and
sustained profitability with less volatile ROE, we believe that historically low valuations should provide
investors with a certain degree of comfort.
At current levels, we believe the European reinsurance industry offers compelling value on most
conventional valuation metrics – P/EV, PE and dividend yields – in both absolute and historical terms.
Although valuation has ceased to be a stand-alone catalyst we believe the reinsurance sub-segment’s
improving fundamentals and increasingly attractive defensive qualities (well capitalised, low asset risk,
high cash flow generation) could attract incremental buyers.

目录

Valuation, momentum and
risks 3
P&C reinsurance: cyclical
upturn in sight 9
L&H reinsurance: key to
diversification 24
Dissecting reinsurers’ balance
sheets 33
Valuation methodology 49
Munich Re 53
Swiss Re 67
Hannover Re 80
Scor 91
Paris Re 106
Disclosure appendix 116
Disclaimer 120
2000 2001 2002 2003 2004 2005 2006 2007
Av erage EU Av erage US Av erage Asia
Source: HSBC estimates