Innovation and adaptation are two key traits of global reinsurance firms that will succeed in remaining relevant as they navigate what will eventually result in a reconfiguration of the reinsurance industry, according to Standard & Poor’s.
The challenging soft reinsurance market environment, of excess traditional capital, growing alternative capital and ILS, lower prices and margins, structural change and what we believe will be a deeper reinsurance convergence, will require reinsurers to find ways to prove their worth to clients and reinvent their business models, S&P says in its latest report released today.
The report, the latest in a string published by S&P in the run up to the Monte Carlo reinsurance Rendezvous, highlights the importance of remaining relevant in the current environment of rapidly changing market dynamics. Challenged from all sides, traditional and non-traditional, reinsurance firms must turn to client service, innovation and be willing to adapt if they are to remain relevant.
Staying relevant, to clients, brokers, partners and even to their own shareholders, has become a bit of a buzzword for essentially remaining viable. Relevance is what makes a reinsurer stand-out enough to be included on renewals as a lead, enough to even get on the slip sometimes and S&P warns that if reinsurers do not adapt and find ways to innovate their chances of remaining relevant, perhaps even surviving as a viable entity in its own right, are going to be much slimmer.
Competition from both traditional and non-traditional sources in reinsurers’ core markets is making them adjust or adapt in order to retain relevance. S&P does not mince its words, saying that the traditional reinsurance model is not just under threat from alternative capital, insurance-linked securities (ILS) and capital markets investors, but also that; “The traditional reinsurance business model is under threat from external sources, such as corporations and technology companies that could become substitute providers of risk protection.”
S&P is absolutely right. Technology firms are looking at many of the same issues that reinsurers focus on and as we all know firms like Google are skilled at moving into new markets, removing friction and breaking down barriers between products and the necessary capital or financing. It has already done this in industries like travel and has looked at insurance sectors such as motor, so there is every reason to believe that in the future they will look to any reinsurance risks that can be commoditised, broken down, understood and algorithmically matched with capital. Reinsurers beware.
Such disruptive change is likely a way off though and S&P’s report really deals with the near term horizon of the next year or two, during which it believes reinsurers need to be innovative and adaptable. The risks are clear, S&P explains; “If reinsurers fail to make use of their key strengths and expertise to establish their relevance to new and existing clients, the traditional reinsurers could find themselves marginalized.”
Over half of the global reinsurers that it rates are susceptible to the lower pricing and reduced margins caused by the softened reinsurance market environment, says S&P. In such an environment opportunism is not the answer, a longer-term view of product development is required if reinsurers are to be successful.
This means reinsurers need to become adept at spotting emerging trends, product design as well as development, innovation and also incubation of product ideas. Long-term success comes from long-term planning, a mantra in many industries, is something the reinsurance industry may need to accept if it is to spot and capitalise on opportunities to create value for its shareholders.
As well as product development, reinsurers need to be looking to expand into new markets and to solve issues affecting global growth. Of course to do that product design and development is going to be key, as is technology and analytics (increasingly) which does favour those reinsurers with scale currently.
From a ratings point of view, S&P says that, were it not for the strong balance sheets of the reinsurance industry, it would likely have taken rating actions already on some of the reinsurers most exposed to the market pressures.
Showing that reinsurers need to be aware of the longer-term horizon and potential for more fundamental change in the industry in years to come, S&P says that even those reinsurers well-positioned to stand up to softening prices now are likely to find the pressures to come much harder to handle over the longer term.
An inability to adapt to these threats, posed by a changing industry, will weaken reinsurers credit quality and could lead to rating downgrades, S&P explains. Increasingly, the market is moving in such a way that more reinsurers are exposed to negative pressures and S&P notes the ability of recent trends of competition, pricing and the potential for heightened earnings volatility could erode reinsurers business risk profiles.
Any reinsurers that fail to withstand the increasing pressures, or that fail to navigate the soft market environment through being adaptable and innovative, could be susceptible to ratings revisions, notes S&P. In fact, S&P’s forecast for average combined ratios across its rated reinsurers for 2015 suggest that some will be on the verge of becoming unprofitable, it forecasts a range of 98% to 104% with resultant return on equity of just 7% to 9%.
The need to keep shareholders happy is going to become increasingly important if results do turn that bad for reinsurers, as positive reserve releases dry up and the softened market persists. Could this see an increased opportunity for alternative capital to partner with reinsurers, given its lower cost-of-capital and return hurdle? Perhaps.
Pairing capacity from the capital markets with alternative business models could see wider coverage available for more lines of business in future. It could also help to grow catastrophe reinsurance penetration in regions and for types of peril which are not covered comprehensively right now. This would be an opportunity for reinsurers, to share their expertise and scale with capital markets investors to enable them to access new business.
However, S&P notes that largely the capital markets remain focused on well-established lines of reinsurance business, which keeps the competition it presents high and reduces opportunities for reinsurers to leverage their expertise in managing it. It also, we would say, enforces the need for a lower-cost of capital and a lean operation, something the ILS managers have to their benefit still today.
As pricing declines and reinsurance buyers rationalise their spend, insurers are also reducing the number of counterparties they want to do business with. This further reinforces the need to be relevant, in fact it means reinsurers also need to stand out, in terms of offering or service and may mean that price becomes less important as we reach the bottom of the pricing cycle in months to come.
The reduction in returns that reinsurers face, at a time when investment returns are also not exactly stellar, will result in a slow deterioration of metrics such as combined ratio and their actual risk exposure levels. Taking on more risk for lower returns will show in results eventually, unless reinsurers are very lucky and S&P warns of a gradual slide in capital adequacy, greater earnings and capital volatility to balance sheets in years to come.
S&P expects reinsurers will look to fend off market conditions and competition, but warns that quick-fixes are likely to be insufficient with such a wholesale structural change in the market. There are windows of opportunity, growing reinsurance penetration and need, moving risk from government schemes into the private market, etcetera, but competition for these opportunities may increasingly be more fierce anyway.
Small and mid-sized reinsurers, unless particularly specialised and with skills unavailable elsewhere, are as expected the most at risk of feeling the pain from the current reinsurance market environment. Consolidation may come, but it is not an answer to the capacity conundrum, warns S&P. Mergers between smaller players could just result in overlap, rather than diversification, resulting in more excess capital and less value creation.
S&P does not consider it inconceivable that corporations could look to bypass the insurance industry in future, perhaps ceding risks directly to the capital markets. Nor is it inconceivable that huge companies from outside the sector may come in and disrupt the status quo (the Google’s of this world).
To meet such challenges the reinsurance sector is going to have to become proficient at not only demonstrating relevance and value, but also learning how to put that value to work in product development and also in its marketing.
S&P’s report highlights areas of potential opportunity, such as big data use, emerging market or sovereign disaster risk transfer, mobile sales channels, cyber risk, microinsurance or providing more fee based services such as to capital markets investors. However, none of these alone will be a panacea unless reinsurers learn to innovate and adapt.
S&P’s report states:
The reinsurance market is currently difficult for all players. We expect pricing and profitability will continue to deteriorate for the next 12 to 18 months, and we don’t anticipate any increase in investment returns that could provide a respite.
Roughly half of the global reinsurers that we rate are more vulnerable to the current competitive pressures because of their scale and business mix. Some of these companies will find it difficult to defend their competitive positions in the market and may struggle to generate earnings that can meet their cost of capital without taking excessive risks.
Successful players in the current market, which we expect to be able to weather the current conditions, have the capital strength to withstand increasing risk exposures, can exercise disciplined underwriting to maintain profitability, and can retain or expand their presence with key clients by offering capacity, expertise, and a range of products that can support cedents’ changed buying patterns. These companies are well-placed to withstand this soft cycle.
What reinsurers are facing is a “reconfiguration of the industry”, said Dennis Sugrue of S&P at a briefing about the report this morning. The industry will look different when the dust has settled, the report concludes.
How will the reinsurance industry look different? The report says to expect fewer, larger reinsurers. These few large players will leverage capacity from the capital markets, alongside their own capacity, to continue to provide the level of syndication and diversification of risk capital that the insurance market requires.
Reinsurers will have to reinvent themselves, says S&P, in terms of business models in order to remain relevant as the economy changes and the industry reconfigures itself, or is forced to reconfigure itself. Proactively looking for the upside is key rather than just managing the downside and reacting to short-term opportunities.
The last line of the report sums this up well:
The entire sector can’t be a following market, and those that choose to follow are likely to find that someone else will lead.
You can access this report from S&P via its website here (login may be required). S&P will be releasing the full compendium of recent reinsurance reports in its Global Reinsurance Highlights publication timed to coincide with the Monte Carlo Reinsurance Rendezvous.
You can read our write-ups of recent S&P reinsurance reports at the links below (most recent first):
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