Excess-of-loss reinsurance underwriters most affected by rates: S&P

by Artemis on August 8, 2013

The current reinsurance market pricing environment, with declining rates seen on many property catastrophe lines particularly in peak zones, is likely to affect those reinsurers which are more involved in underwriting excess-of-loss, or non-proportional reinsurance contracts, said Standard & Poor’s.

The rating agency suggests that it is excess-of-loss and non-proportional reinsurance covers which are most likely to see rate decreases. Conversely, primary insurers continue to find rates increasing and are also taking advantage of decreases in the cost of reinsuring themselves, a win-win situation for many of them but not for reinsurers.

The increasing amounts of capital and capacity in the reinsurance market, both from third-party capital vehicles and traditional players with high levels of capitalisation, alongside large primary insurers increasingly retaining more risk, is exacerbating the rate declines. But Standard & Poor’s says that these market conditions are likely to affect different types of reinsurance in different ways, and they highlight nonproportional, excess-of-loss covers as the most impacted.

Standard & Poor’s explains in a report on the topic; “Proportional reinsurance contracts generally assume a direct proportion of a cedant’s losses for the same proportion of premiums, whereas XOL policies compensate for losses that exceed of a cedant’s specified loss retention. This allows proportional reinsurance to benefit from primary insurance rate increases, while XOL pricing remains subjected to rate decreases.”

S&P do not expect a wholesale shift towards proportional reinsurance underwriting, however, and say that managing this part of a particularly difficult reinsurance cycle is key for reinsurers credit quality, particularly for those reinsurers for whom excess-of-loss reinsurance makes up a large amount of business.

Despite the fact that primary insurance rate improvements have flowed through to proportional reinsurance covers, S&P says that it does not expect significant growth in this area as there is limited demand from cedants.

Abundant supply of reinsurance capital and capacity affects the whole reinsurance market but for excess-of-loss reinsurers a deterioration of profit margin is expected as excess-of-loss rates are expected to decline most rapidly. Excess-of-loss reinsurance tends to be more susceptible to fluctuations in reinsurance supply and demand and thus the current market environment, exacerbated by third-party and insurance-linked securities capital, is bringing this issue to the fore.

Reinsurers are going to come under pressure to mitigate this price decline if it continues for the foreseeable future. S&P says that factors such as competitive positioning in the market, capital strength, efficient use and management of third-party capital funding, enterprise risk management, and a reinsurers management’s ability to negotiate underwriting cycles, are all potential ways to mitigate the impact.

Diversification is also going to be key, being able to mix property and casualty lines, dip into insurance business, and even life reinsurance, are all potential ways to mitigate the impact of the current price declines in excess-of-loss reinsurance. However a lot of emphasis is going to be placed on strategy going forwards for reinsurers it seems.

It is the property catastrophe reinsurance lines where third-party capital is participating to the fullest where this issue is going to be felt the most. That means Florida, and some other U.S. catastrophe zones, where influxes of investor capital in ILS and fund managed vehicles have pushed down rates the most.

S&P notes that this does also raise the potential of an opportunity to hedge ones own risks, for reinsurers, as retrocessional coverage also becomes cheaper. This would allow reinsurers to take on higher paying risks and retrocede portions of catastrophe risk more cheaply thanks the capital that the ILS and third-party investors are contributing.

Standard & Poor’s stresses that it is adaptation that will be key. The ability of large reinsurers to mitigate this issue by moving sideways into other lines of business, taking advantage of hedging opportunities, innovating to create new opportunities and sources of revenue, while at the same time managing risk and capital (both shareholder and third-party) effectively can offset the issues in excess-of-loss pricing to some degree.

“Under current conditions, the ability to adapt may be more critical for reinsurers with substantial XOL writings than for those with significant primary insurance and proportional reinsurance,” commented Standard & Poor’s credit analyst Jason Porter.

While the trend remains and the market remains free of large catastrophe losses it looks like excess-of-loss reinsurance underwriters will be forced to pull back in some areas and find new avenues to profit from. This could lead to new opportunities and new innovations in the market, so perhaps shouldn’t be looked on as all bad. The winners will likely be those that can adapt to the current market conditions, while remaining ready to redeploy limit, at better pricing, once the cycle changes again.

The full report is available to Standard & Poor’s Ratings Direct subscribers or for purchase to non-subscribers.

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