A perfect storm of factors has combined to cause serious soft market conditions for the global reinsurance markets. The sector has become a victim of its own success as recent profitable years, coming on the back of historically low catastrophe losses, have prompted a deluge of new capital looking to take advantage while investment returns in other asset classes continue to struggle.
Reinsurers are currently faced with low premium rates that threaten to go lower still at the crucial January 1 renewals. In addition to the record volumes of capital and low catastrophe claims, the soft market has been caused by intense market competition and sluggish cedant demand and low investment returns. This trend is being exacerbated by the formation of a number of reinsurers by hedge funds as well as the exponential growth of insurance-linked securities.
The traditional start to negotiations for the January renewals is September’s Reinsurance Rendezvous in Monte Carlo. And reinsurers at this year’s event surprised many seasoned observers due to their resignation that little could be done to prevent market conditions softening further – at least in the short term.
Tom Bolt, Director of Performance Management at Lloyd’s of London, says this is a remarkable period for a reinsurance industry that is beset by a number of challenges.
He says: “First, this is the first soft cycle we’ve had with virtually no material investment income. Second, the concentration ratio of brokers in the market is higher than in the last soft cycle by some margin.
“Also, excess capital is always a feature of the soft cycle, but what we have this year is close to an epic excess. At the same time, the regulatory burden on the industry is heavier than it’s ever been. And all this is happening while economic recovery is still fragile.”
Bolt says that market conditions are unlikely to improve for insurers in the near term because it is hard to envisage what will change the overall investment return picture and what will reduce the level of capital interested in entering the insurance business.
Ratings agency Fitch Ratings has had a fundamental outlook for the reinsurance sector of ‘negative’ since the beginning of the year.
In its ‘Global Reinsurance Guide 2015’, Fitch says the price adequacy is expected to decline next year although rates of return are expected to remain above reinsurers’ cost of capital. Earnings pressure is forecast to increase across the sector as softening pricing in property business migrates to other lines, such as casualty, as reinsurers look to redeploy capital in more profitable areas.
At present individual reinsurers remain well capitalised. And Fitch says it would take a seismic shock to the industry in the shape of $70bn catastrophic loss event or an abrupt jump in interest rates to threaten the industry’s robust balance sheets. Such an event would leave some reinsurers on the brink and may prompt other, newer entrants to the industry, to withdraw capital and look for safer returns elsewhere.
Fitch says: “Such a scenario would leave balance sheets temporarily more exposed to adverse events and is particularly concerning if reinsurers do not have sufficient liquidity to pay claims and need to sell investments at a loss and/or raise new capital at a higher cost.”
The agency notes that ironically it is the favourable underwriting results posted by the industry since the record catastrophe loss year in 2011 which has fostered the current challenging reinsurance environment.
Fitch says: “Reinsurers’ profitable results are attracting more capital to the sector, which has created excess reinsurance underwriting capacity, leading to price competition and falling reinsurance rates.
“However, recent performance reveals that pricing and competition need to deteriorate significantly more before profit erosion becomes untenable, as reinsurers in aggregate posted combined ratios below 90% and returns on equity (ROE) of around 12% in the last few years.”
The persistence of low investment yields increases the risk of the reinsurance sector being exposed to adverse investor behaviour, driven by a search for higher yields.
The influx of capital has been most notable as external investors, including pension and hedge funds, search for yield by investing in alternative reinsurance.
These non-traditional forms include catastrophe bonds (cat bonds), collateralised quota-share reinsurance vehicles (sidecars), industry loss warranties (ILWs), hedge fund-supported reinsurers and asset managers investing in insurance-linked securities (ILS).
Fitch says: “Alternative forms of risk transfer are here to stay, having gained acceptance by both cedants and most traditional reinsurance providers as a structural change to the reinsurance sector, principally in property catastrophe risk.
“Fitch Ratings views the growth and acceptance of alternative reinsurance as a strain on the credit quality of reinsurers, particularly for smaller, standalone property catastrophe reinsurers.
“The benefit to traditional reinsurers from added fee income and risk management tools is more than offset by the increased competition from capital market capacity that, in conjunction with the strong overall capitalisation of the reinsurance industry, are resulting in a deteriorating profitability profile for the sector.”
However, the travails of reinsurers could well prove a boon for primary insurers. Competition between the traditional reinsurance market and the considerably larger overall capital market has been a benefit to primary insurers that are taking advantage of having diversified sources of reinsurance.
Fitch says: “The abundant reinsurance market capacity has resulted in lower reinsurance pricing (particularly on excess of loss business), and the broadening of policy terms and conditions.
“Furthermore, the non-traditional reinsurance market has helped insurers manage their exposure, transfer risk and reduce capital volatility. In addition, primary insurers benefit from the reduced volatility of reinsurance rates after a catastrophe, as alternative reinsurance coverage frequently remains available during a period of more scarce underwriting capacity and serves to dampen potential rate increases.”
Reinsurance savings are also pressuring reductions in primary rates as cheaper reinsurance costs increases the competiveness of the primary market.
For the man in the street this would mean that premiums on home or car insurance decrease as insurers battle for market share. It may also mean that insurance cover on personal lines is expanded with add-ons like legal protection being included in policies as a standard rather than optional extras.
Then agency adds: “Fitch expects insurers to continue to find it economically efficient to transfer to the capital markets a portion of their more standardised property and property catastrophe tail risk business. This action moves higher risk business off-balance sheet, thus freeing up capital in rated entities that can be used to support less volatile business or for other capital management activities.”
For reinsurers, the current rating environment means that a focus on the bottom line is more important than ever. Companies like Swiss Re, one of the world’s largest reinsurers, say it expects the decrease in natural catastrophe prices to slow down while other lines will exhibit mixed trends.
In the meantime reinsurers will focus on strengthening customer relationships and developing cutting-edge in-house Research & Development in areas like catastrophe modelling.
Michel Liès, Swiss Re Group CEO, says: “In my 35 years of experience in the business, I’ve seen many turns of the reinsurance cycle and have learned that pricing is only one dimension of it. In order to succeed, you need to develop your business model based on a deep understanding of market fundamentals, participants’ behaviours and the evolution of your clients’ needs.
“Rigorous cycle management, portfolio steering and underwriting discipline remain the obvious tools for profitable success. There are opportunities for our industry — especially in high growth markets. We remain firmly focused on the bottom line and are making sure that we support our clients to successfully capture the profitable opportunities they are pursuing.”