Dear friend,

It was over a year ago that I appropriated a phrase I had read in a Benfield report describing the state of the market in terms of a crème brûlée dessert. The general idea was that the market was hard in loss-affected US coastal and Caribbean areas, but was pretty soft underneath.

Well, that was then and this is now.

Fifteen months later and the latest piece of literature to come out of Benfield demonstrates a culinary metamorphosis worthy of the finest celebrity chef. It seems our crème brûlée caterpillar has pupated and emerged as a fully-formed crème caramel.

Now a crème caramel might contain a similar vanilla and dairy theme to a crème brûlée, and it will certainly be topped with a hint of caramelised syrup reminiscent of its culinary cousin, but its consistency is another matter entirely. Crème caramel is soft right through, from top to bottom.

So, crème caramel it is — where do we go from here?

Traditionally our industry does one of three things — it either goes on a mergers and acquisitions splurge, a headlong land-grab for market share, or it gives money back to shareholders in the form of special dividends or share buybacks. Collectively it does a combination of all three.

The problem is that the first two have a chequered history. Take the first: taking out your opponents by buying them is potentially a good thing, especially if you don’t overlap so much that you end up losing many of your most enterprising staff to the competition in the process.

These moves always look like a good idea at the time (usually in a soft market) but rarely make any sense in the cold harsh light of a hard market. The problem is that the buyer usually has to overpay for his quarry — witness the top-dollar valuation put on Converium by Scor (and this was without a rival bid emerging) or the heady price generated by the unseemly bidding war for medium-sized Lloyd’s player, Talbot Underwriting for recent examples.

Logically these richly-valued deals often fail to work financially for many years, and can perhaps only be justified if they are strategically ‘transformational’ enough to justify the capital destroyed by the tie-up.

No-one can deny that the Ace could not have got where it is today without the strategic Cigna, Cat Ltd, Tempest Re and three Lloyd’s buys. Similarly the XL of today is unimaginable without the Brockbank/Mid-Ocean, Le Mans and Winterthur International deals. Partner Re or QBE’s successes are built on the foundations of a similar acquisition trail.

But you only have to look into Munich Re’s 2006 annual report — ten full years after its acquisition of American Re, Berkshire Hathaway’s 1998 swoop for of General Re or GE’s purchase of ERC Frankona for details of how things can go badly wrong.

So what about alternative number two? Putting your opponents out of business by being consistently cheaper than they are and taking away their best accounts is often deployed but rarely admitted to. But rather like option number one, this one can only work in practice if you are big enough to withstand the subsequent pain of repeated years of significant underwriting losses. And when the upturn comes, you have the frustration of see nimble start-ups sharking in on all the best business and taking all the gain with none of your pain. So this one is strictly for the deluded or suicidally optimistic.

This leaves the already well-established prudent reinsurer, with only one option — give money back to shareholders, batten down the hatches and be prepared to put whole departments in mothballs if need be.

The trouble is that even this strategy is not as easy to follow as it sounds. It is very difficult to keep staff motivated if there is no business to write. Underwriters are natural optimists, after all, they have to be. They don’t generally put down lines on business expecting to lose money. If you instruct a natural optimist to scale down a $50m book down to $5m in two years, you’re liable to lose that person to a more aggressive rival offering the prospect of a growing book. Okay, you’ll live to fight another day, but the stockmarket may not like what they hear when you outline your cautious approach and award your more aggressive rivals with a premium growth rating.

Your more aggressive rivals might use that higher rating to buy you out and you’re out of the game again.

So it turns out his game of pass the hot capital potato, is more like a round of scissors, paper, stone. The rock of M&A can sometimes be wrapped by the paper of aggressive pricing but it can sure blunt those who return capital a little too aggressively and voluntarily retire from the game. You get the picture.

Being a reinsurance CEO in a rapidly softening market is the hardest job going — don’t let anyone tell you otherwise.