Despite the well (or perhaps over) capitalised, highly competitive catastrophe reinsurance market, resulting in continued softening of prices and poor industry fundamentals, Bermudian reinsurers appear to have coped well with this difficult environment.
However, there may be a very good reason that Bermuda’s reinsurance firm share prices have not suffered, as perhaps might have been expected under the competitive and price pressured, softening rate environment, according to analysts from Keefe, Bruyette & Woods.
KBW believes that strong capital management, largely in the form of share buybacks, has helped to support recent share performance for these Bermudian reinsurance firms but notes that if this support fades reinsurance company valuations may become more vulnerable.
The market environment has become so competitive because traditional reinsurance firms are well-capitalised, due to low levels of catastrophe losses over the last two years and profitable underwriting. On top of this the influx of alternative reinsurance capital has increased the pressure, both in terms of rate reductions partly driven by the lower-cost insurance linked securities (ILS) and collateralized reinsurance options as well as by the increase in competition, with more capital competing for often less business, due to rising retentions, in the marketplace.
These factors have created a difficult market environment for reinsurers and with Bermudian players right in the firing line of these trends it had been expected that some might begin to suffer in terms of share price performance.
KBW’s analysts believe that the active capital management performed by reinsurers in Bermuda may have helped them to avoid the impacts of market conditions so far. With options for deploying excess capital limited, the analysts expect this trend of share buybacks to continue for the foreseeable future.
However, KBW’s analysts warn that the strong capital management and high-levels of share buybacks could leave Bermuda reinsurance firms vulnerable if a sizable event occurs.
Firstly, the increased level of excess capital in the reinsurance industry could mean that the rate environment does not react as expected after a large catastrophe loss event. As capitalisation continues to rise it becomes less and less likely that reinsurance pricing will respond favourably after a major industry loss event.
KBW continues, saying that it feels that overcapacity has damaged reinsurers abilities to raise pricing after a catastrophe event, meaning that recouping losses will be hard. As a result, if this scenario played out, KBW’s analysts feel that reinsurers valuations could be negatively impacted after a major loss event.
The second potential vulnerability may occur after an event that erodes reinsurers excess capital to some degree. If this happens, KBW says it would expect a reduced level of share buybacks until a capital cushion is rebuilt. If this support is removed, KBW warns that reinsurer share prices could suffer.
The analysts note that there is no way to say how much impact share repurchases are having on reinsurer share prices, but it will not be immaterial and reinsurer valuations will be more vulnerable with that support removed. For some reinsurers regular buybacks may have had an effect of propping up share prices to a degree.
This becomes particularly interesting if you combine the discussion of capital management with the discussion of the relaxation of reinsurance contract terms and conditions. KBW’s analysts said only last week that attempts by some reinsurers to ward off pricing pressure by loosening reinsurance terms, conditions and coverages are a dangerous and under-appreciated side effect of the pricing pressure in the market.
Consider the following scenario. A major industry loss event occurs; excess capital is eroded, share repurchases grind to a halt, catastrophe reinsurance pricing does not rebound as expected plus broader reinsurance price cycles seem muted, add to this the fact that some reinsurers are found out for having overly relaxed terms and conditions leaving them more exposed than their assumptions allowed for. What then the outlook for impacted reinsurers?
This is the danger of the soft market environment. Fundamentals can look threatening but at the same time company performance can be buoyed by cleverly managed capital and low levels of loss, which can have the effect of making the threats posed to the market look benign.
It’s only when the most impactful of events occur that the exposure to market conditions will be fully-realised and some reinsurers might find the scenario laid out above much closer to reality than they would like, should a really major industry loss occur.
Of course this is not to say that all reinsurers face this threat. Many are intelligently managing capital and refusing to relax terms too far, maintaining their underwriting discipline. It is those who are not who will be under increasing pressure should industry losses sharply rise.
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