Strong Q3 underwriting results expected, but fundamentals weigh: KBW

Analysts at Keefe, Bruyette & Woods expect the majority of insurance and reinsurance firms will report strong third-quarter results in the coming few weeks, but warns that market fundamentals haven’t changed and pressure is still apparent on pricing.

Market and economic factors which continue to affect the insurance and reinsurance sector and are expected to manifest in re/insurer results, in the KBW analysts opinion, include:

• The steady deceleration of primary commercial line rate increases (as we covered here just the other day).
• Significant and broadening reinsurance rate decreases often combined with looser terms and conditions.
• Modest interest rate increases especially on 2 and 5 year U.S. treasuries.
• Falling crop commodity prices which could impact crop insurers’ results.
• The modest but now fading inflation uptick.
• Modest, but steady, economic growth.

Other contributing factors of relevance to Artemis readers include:

• The flow of property catastrophe rate decreases into earned premiums destined to result in a hit to re/insurers core loss ratios.
• The growing need for consolidation within and beyond the Bermuda re/insurance industry, but with a low near-term likelihood of deals being announced.

The lack of major catastrophe loss events both in the U.S. and globally, with another quiet Atlantic hurricane season, is the obvious factor which will allow re/insurers to report strong results once again. Some regional storm activity will be attritional, notes KBW, but with favourable weather and catastrophe experience we can expect underwriting performance to be strong.

Individual insurance companies are likely to face some notable catastrophe losses but the aggregate losses across the period should come in well below normalised levels, the KBW analysts expect.

Pricing remains the hot topic for the reinsurance industry, with KBW expecting continued rate declines at the forthcoming January reinsurance market renewals.

KBW analysts expect reinsurance rates across the market will fall by 1% to 2%, but on U.S. property catastrophe reinsurance lines of business a steeper decline is once again forecast, with 5% to 10% the expected number for rates to drop.

Some loss affected lines may see positive price development, such as aviation and war risk, but KBW notes that there is too much capacity both in the market and on the sidelines for these lines to see the 50% to 100% increases that some participants hope for.

KBW says that the trend towards looser terms and conditions, such as the hours clause extension, improved reinstatement terms and inclusion of other risks such as cyber or terror in programmes, is a trend that will continue to be seen. The analysts note that these terms and condition changes are inherently riskier to underwriters than price decreases, as they require additional assumptions about the size and timing of claims.

On the asset side of the business, KBW expect persistent low-interest rates will continue to pressure insurers and reinsurers returns on their portfolios. The coincidence of a low-interest rate environment combined with declining reinsurance pricing is discouraging, the analysts explain.

The analysts are cautious on the impact of economic growth, as they say that despite growth resulting in ‘more stuff to insure’ it could result in higher inflation and as a result higher loss cost inflation which could be a negative drag on re/insurers.

Core reinsurance loss ratios are expected to continue to deteriorate, despite the expectation that strong results will be reported for the third-quarter. This means that the devil will be in the detail of expense ratios, loss trends and combined ratios, even while premium income, earned and growth may all look very positive.

KBW notes that after double-digit rate declines earlier this year, most of the catastrophe reinsurance premiums earned during the third-quarter are at lower rate levels and with much lower profit margins, than preceding quarters. While a 10% rate reduction could affect premiums by only a small amount, if losses and expenses are independent of rate levels that could manifest itself as a 5% to 10% shrinking of core underwriting profits.

Consolidation continues to be needed in the sector, KBW says. At the moment though, KBW says that it would advise most potential acquirers’ investors against mergers or acquisitions right now, preferring to advise them to wait. However M&A will emerge, they say, with it being a matter of time until rate pressure or loss cost inflation becomes too much for some players to bear.

In fact they see market conditions as a self-fulfilling prophecy for M&A. As both insurance and reinsurance pricing becomes more negative and buyers continue to focus on scale, consolidation is almost guaranteed in these conditions. So unless something changes we should begin to hear more M&A stories in quarters to come.

So the outlook remains difficult, despite the expectation that Q3 2014 results will be strong. Expect more strong statements from reinsurance company executives on their ability to navigate the market, pull-back from lines of business that don’t meet their technical pricing, how the large reinsurers can avoid the worst areas of the market and how there is no need to worry.

We should also expect further discussion of alternative, or third-party, reinsurance capital’s impact on the market. However, at this stage with the traditional players so well-capitalised and driving down pricing on their own, without the help of insurance-linked securities (ILS) investors, this is becoming noise and needs to be looked beyond.

We’ve been hearing these statements for well over a year now. The expectation is that, at some point in the not too distant future, expense ratios and loss costs will start to outweigh any positive reserve development and suddenly the weight of market fundamentals and pricing trends could begin to look even heavier.