The stand-alone reinsurance business model may be unsustainable in the future and M&A may not be the fix, as pressure from ILS and alternative capital continues to undercut the traditional reinsurer model, according to analysts from Goldman Sachs.
The latest report from Goldman Sachs equity research analysts, led by Michael Nannizzi, suggests that the profitability of the stand-alone reinsurance model is fading and that reinsurer results are likely to “grind lower”, due to reduced demand, more competition and excess capital in the sector.
While the entry of alternative capital into the reinsurance market is not a new concept, the impact it is having on the traditional reinsurance business model is under appreciated, the analysts note.
While pricing has been declining on traditional reinsurance lines, particularly in property catastrophe risks, there remains a wide spread between the pricing on instruments such as cat bonds and traditional reinsurance options.
However valuations of reinsurers have not perhaps factored all this negativity in yet, as benign loss experience boosts capital and masks the effect of reduced pricing, higher competition and greater retention by cedents.
“Valuations have not fully reflected what could become a multi-year cycle of margin compression,” Goldman Sachs analysts warn and they feel that the pressure could eventually get to a level where by certain business models in reinsurance become untenable.
The analysts explain; “If market conditions do not change we believe the stand-alone Bermudian reinsurance model may struggle to exist longer-term, as market forces have caused returns to fall below adequate levels for pure-play reinsurers.”
This concern has been evident for some time, with pricing declining to below the level where a traditional reinsurer can still make a profit above its cost of operations and capital. Some more focused reinsurance players may already be at that point where profitability on the business underwritten no longer supports them.
Goldman’s analysts believe that reinsurers are increasingly losing their ability to dictate terms and pricing, instead being led by lower-cost capital. This also erodes their ability to maintain discipline on terms and conditions, especially as some traditional players need to deploy capacity and expansion of terms can help to secure signings.
The analysts believe there has been a permanent shift in the reinsurance market, which now sees some capacity providers evaluating the risk and return of insurance business relative to other asset classes, instead of relative to other insurance risks.
While this shift is now thought to be permanent, perhaps a function of insurance and reinsurance risks becoming an accepted asset class in their own right, the effect of it has so far been masked by the low catastrophe loss experience of recent years, the analysts explain.
Demand for reinsurance cover has changed in recent years, as cedents retain more risk, bundle purchases, centralise buying and increasingly look to establish their own facilities that allow them to extract more profit from the risks they underwrite.
Unless there is some change in demand, the analysts expect supply of capital to drive the pricing in reinsurance. “With capital markets able to efficiently enter and exit the market, the opportunity for reinsurers to extract excess returns has substantially diminished and is unlikely to re-emerge, in our view,” Goldman Sach’s analysts continue.
On the subject of mergers and acquisitions (M&A), the analysts note that while this has helped support valuations it does not solve the underlying problems. Unless “tangible value creation” can be clearly demonstrated, these deals are unlikely to generate increases in value for the firms involved.
While acquisitions can provide cost synergies, allowing cuts to reduce the expense base while aiming to maintain the premium income, these benefits are considered likely only temporary, unless the market conditions improve, in the analysts view.
All of this pressure has not yet resulted in significant share price under performance, the analysts explain. While the permanent shift in the reinsurance business is evident within the market, reinsurer shares have been insulated thanks to three factors that the analysts identify.
Firstly the unusually light weather and catastrophe loss experience. This has helped to offset the pressure of lower pricing, so the reduction in catastrophe reinsurance rates is not yet fully shown in results at this time.
“Light losses have more than offset margin pressure and thus have supported above-trend book value growth and capital deployment over the past two years, two factors that we believe investors value,” the analysts explained.
Secondly, investors have remained attracted to P&C reinsurer stocks, despite the clear pressure on the sector. The uncorrelated nature of reinsurance risks has also made reinsurers attractive, according to the analysts; “In much the same way that alternative capital providers have espoused reinsurance risks, equity investors seeking low-beta stocks have favored P&C names, including reinsurers.”
Thirdly, the recent M&A activity has been a “catalyst for reinsurer stocks recently”, as the activity implies that consolidation may increase the valuation of those participating in transactions. For M&A to be accretive to valuation it needs to meet investor expectation without generating any risk, the analysts note. If M&A is pursued as a defensive response to the challenging reinsurance market environment the ability to generate value may be limited, the report explains.
The report from Goldman Sach’s equity analysts goes on to explain that the impact of alternative capital has more room to pressure prices. While there is evidence of a floor being established in catastrophe bond pricing, the spread between traditional reinsurers underwriting yield and the capital markets remains wide enough to signify that reinsurance prices will keep falling.
“We think that underwriters are still writing business at a substantial spread to the capital markets which could signal further pricing and margin pressure,” the analysts state.
So, further pressure on pricing to come through the year in property catastrophe reinsurance renewals, which will also spill over to other lines of business which are coming under pressure due to ramped up competition and the early effects of the capital markets seeking to enter new business lines.
However the low levels of losses seen in the last couple of years is masking the effect for reinsurers, enabling them to largely keep their shareholders happy at this time. In a more average loss environment the impacts of declining prices would likely be much more apparent in reinsurers results.
Demand continues to shrink and on top of that initiatives such as ABR Re and also the growing focus on fronting for third-party capital, as well as other innovations, are likely to reduce risks ceded to the traditional reinsurance markets, while allowing third-party capital to get closer to the risk.
The “sun may have set” on the traditional reinsurance business model, Goldman Sach’s analysts caution.
What will be interesting is how the emergence of new business models, new partnerships and joint-ventures, between reinsurance firms, asset managers and third-party capital, may provide new opportunities for investors to benefit from the returns of insurance and reinsurance business.
While the profitability of the old equity investing model in reinsurance companies may face dwindling value in years to come, the emergence of new and innovative businesses in the sector may attract some of these investors instead.
A general trend of retaining more profit from reinsurance business underwritten, while disintermediating incumbents and drawing capital closer to the ultimate risk, seems to be the emerging trend in the market right now.
As that trend continues it looks set to position insurance-linked securities (ILS) and alternative capital right at the heart of the reinsurance market. As even the traditional players launch new ventures drawing on capital markets convergence and ILS techniques, it may serve only to increase the rate of innovation and draw more capital into the market.
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