With few places to hide from soft market, reinsurers need to adapt: S&P

by Artemis on July 17, 2014

With rates falling almost universally across the reinsurance market global reinsurers are left with few places to hide. But in this low rate environment the ability to adapt has become increasingly vital, according to a report from Standard & Poor’s.

Reinsurers globally are facing increasing headwinds from a number of directions, S&P explains. Firstly, these companies have amassed a huge amount of capital, near record levels, faster than they can deploy it into new reinsurance business. The resulting excess capacity combined with even more capacity coming from alternative reinsurance capital sources and insurance-linked securities (ILS) is driving down premium rates across the board.

The most significant drops in pricing have been seen in U.S. property catastrophe reinsurance but the effects of all this capital are being felt broadly across reinsurance lines now. This could hurt reinsurers competitive positions, says S&P, and could result in or encourage looser underwriting discipline and risk controls.

Reduced profit margins and potentially riskier underwriting behaviour could result in more volatile earnings, something the analysts will be looking out for at the end of coming quarters. Any sign of a decline in earnings at a reinsurer may just be the first of a number of less positive quarters, as the impact of lower pricing has now been evident in the market for more than a year.

If the price softening remains a feature right through to January reinsurance renewals and beyond, some reinsurers may begin to look like they are struggling if earnings volatility just won’t go away. S&P notes that any earnings volatility could represent a heightened risk profile at a reinsurer as in the soft market environment reinsurers face pressure to reduce controls and risk management as the ability to compete gets eroded.

Staying profitable while also being competitive will require discipline and could be a difficult balancing act, warns S&P, hence the ability to adapt becomes more important and we would add to that the ability and willingness to be flexible as well.

Companies that cannot meet these challenges may be at risk of downgrades as their business or financial risk rises, warns S&P.

S&P has already warned that the reinsurance sector is at risk of a downgrade and has a negative outlook on it. This isn’t changing yet but this new report goes into a lot more detail about what puts reinsurance firms at risk of downgrade, in the softening market, and what they need to do to avoid that.

The ability of ILS investors and alternative sources of reinsurance capital from third-parties to assume concentrations of catastrophe risk, as they typically have little exposure to it before accessing the ILS asset class, exacerbates the issue as these investors need not demand additional returns for assuming these risks.

Unlike traditional reinsurers who have historically demanded premium for assuming high concentrations of peak risks and who have carefully controlled their terms to ensure they do not become over-exposed in these peak regions, such as Florida.

With few places to hide reinsurers need to be willing to adapt and be flexible with where they place their capital. With rate declines broadening in reinsurance there are few options to reallocate capacity in that market. As a result reinsurers are looking to new areas of insurance, new deals with primary companies, buying back shares or deploying capital back to investors and also, of course, to managing alternative reinsurance capital themselves.

Reinsurers can find some reprieve from the soft market environment by shifting into profitable insurance lines, writing more quota-share reinsurance, buying more retrocession protection or by creating their own alternative capital and ILS platforms, S&P explained. Reinsurers can also look to emerging markets and new products but this comes with additional risks.

Of course creating an alternative capital unit and looking to manage lower-cost capital sources from third-party investors may not be the panacea it appears. Not every reinsurer will be able to attempt this transition to a capital-source agnostic reinsurance company as successfully as some of those who have been doing it for a while and we may find that, for some, the effort to manage outside capital is as painful as remaining with just their own balance-sheet. This will be one of the interesting things to note over the next year or two, who has been successful in managing third-party capital and who has struggled or found it not to be of benefit to the overall company.

S&P warns on the loosening of terms and conditions on reinsurance contracts, saying that risk-adjusted rates don’t adequately capture these changes in the rating agencies view. Risk-adjusted pricing does not adequately reflect all of the ways that terms are loosened, which could put reinsurers at risk should losses start to creep up, while at the same time profit margins are down and therefore the combined ratio worsens.

S&P explains its concerns well, that looser terms and conditions are often hard to decipher and the true impact may only be known over time when the reinsurers track record begins to degrade.

S&P explains:

Such loosening of terms and conditions, while currently limited, may be particularly dangerous because it can be hard to quantify and monitor—and because it may not have an immediate impact on profits, it’s a tempting way for underwriters to stay competitive. This trend could degrade underwriters’ discipline and risk management and allow them to evade scrutiny by regulators, investors, and possibly their own management. We view the potential for competitive pressures to push reinsurers to relax their risk management significantly as most worrisome because it would heighten the financial risk of those businesses and erode their credit quality.

“Companies that fail to maintain their profitability and competitive positions or compromise their risk management through this trough in the market cycle could be at risk of downgrades,” commented Standard & Poor’s credit analyst Jason Porter.

S&P notes that the market environment should not actually be surprising for reinsurers, who should be used to cyclical pricing caused by capital, demand and catastrophes impact. However S&P says that it does not see any signs that operating conditions will improve over the next two years, enough time for the ramifications of reinsurers recent actions and the competition from new players and ILS capital to really manifest in earnings.

As pressure builds reinsurers will need to work hard to maintain profitability and competitive edge, says S&P, but without causing any detrimental effects to their risk profiles. Selecting and implementing a strategy which is resilient to the current market environment will be testing for reinsurance firms and should they fail to do this they could be at risk of downgrades in the future.

Times are hard for reinsurers and may get even harder over the next year or two, however those willing and able to adapt, be flexible, to innovate and to rethink their strategies will find the soft-reinsurance market a lot easier to navigate. Those who aren’t willing or able to do this may find themselves increasingly under pressure and increasingly under the rating agencies scrutiny.

The full report from S&P, titled “A Slippery Slope: Pricing Slides As Reinsurers Strive For Competitive Footing”, can be downloaded by subscribers to its Global Credit Portal.

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