Unconvinced by reinsurance pricing floor, declines likely at 1/1: Fitch

Fitch Ratings said this morning that it is not convinced that the much discussed reinsurance pricing floor has been reached, even in property catastrophe exposures and peak lines, with further single-digit declines expected at the 1/1 January 2016 renewals.

“We do not view the reduced pace of price reductions reported for some bellwether lines in June and July 2015 renewals as a convincing signal that a price floor in the market has been reached,” Martyn Street, Senior Director at Fitch reported.

The global reinsurance market remains in a difficult position, with an adverse operating macro environment, according to Street who was speaking at a media briefing this morning at which Fitch released its latest report on the global reinsurance market.

Fitch maintains a negative outlook on the global reinsurance sector, while its rating outlook on individual reinsurers remains stable for now. Fitch views the large, globally diversified tier 1 reinsurers as standing the best chance of navigating the challenging environment, but warns that further difficulty could be ahead.

While unconvinced that a pricing floor has been established, even in the most competitive regions such as Florida property catastrophe risk, Fitch does believe that the signs of a floor demonstrate that underwriting in the reinsurance market has retained a degree of discipline to date.

Fitch views the evolution of the reinsurance market as a permanent change, with the potential to affect the traditional cycle and have wide-reaching ramifications for traditional companies and their shareholders.

With alternative capital and insurance-linked securities (ILS) growth applying increasing pressure, it is pushing reinsurers to look to expansion, mergers & acquisitions or entering new lines of business, effectively spreading the high levels of competition and applying pressure more broadly.

On alternative capital itself, Street said; “Alternative capital capacity will continue to impact the market. We continue to see private equity, hedge funds and pension plans going into the space, attracted by higher yields, as yields generally remain under pressure.”

“Our view is that this is a permanent feature, so this isn’t something that is going to reverse,” Street continued. “I think there is a growing acceptance across the market that this is a permanent change and something that needs to be addressed and adapted to.”

As a result Fitch is monitoring the traditional reinsurance players closely for any signs of a worsening of prospects or a reduction in discipline, which could emerge as the pressure ramps up and conditions remain difficult.

One of the areas Fitch monitors is the combined ratio, across the reinsurers it tracks. The combined ratios are already averaging above 100%, if you factor in a normalised catastrophe loss year, Street explained.

At the same time reserve releases, which have been prudent and sustained well through recent years, are likely to decline.

“We expect reserve releases to decline slightly through 2015,” Street said. The key reasons for this are that as soft pricing filters through across the balance-sheet, the amount that reinsurers are able to releases will reduce.

Street continued; “We’re also seeing that reserve releases this year and last year have been supported by the run-off of major losses in 2012 and earlier years. Because we’ve seen the most recent years being relatively quiet, the ability to release reserves from events that have not occurred is not there, so we expect reserve releases to be lower because of that.”

Combined ratios and reserve releases, on top of pricing factors, expenses and profitability, all serve to create the return on equity (ROE) that shareholders expect reinsurers to produce. ROE’s have been on a downward trend in recent years.

Fitch sees a 10% average sector ROE as a key indicator for its ratings, with the net income ROE “a key trigger for us when we come to the rating outlook, which is currently stable,” Street said.

“If net income ROE falls to below 10% that could lead us to change our view, we could see a lot more negative rating actions off the back of that,” Street explained.

“Why 10%?,” Street asked. “Because we feel that that is around the level that reinsurers meet the cost of return on their capital. So below that it becomes more prudent for them to either withdraw their capacity and return capital, or to manage their books more closely.”

The average of the reinsurance sector Fitch rates is nearing the 10% mark and the rating agency has an expectation that it will remain close to the trigger in 2016, or perhaps even pass it. This could result in some individual companies underperforming and becoming subject to negative rating actions, Fitch explained.

“We could see a lot more pressure within the space if market conditions continue,” Street explained. “We have to look individually at company performance to understand how companies are performing and managing through the current cycle.”

Pricing remains a key issue in the reinsurance market, with conditions soft in catastrophe risks, softening in casualty and other lines. The pressure this applies to reinsurers can result in reactive strategies being adopted, some of which are unproven as yet.

But the rumours of a pricing floor and price stabilisation have provided some solace to reinsurance company CEO’s of late, we expect it to be a key topic of conversation in Monte Carlo at the 2015 Rendez-vous, but Fitch is unconvinced.

“We’re not convinced that we’ve reached the floor,” Street said. “We’re at a point where discipline remains in the market and we’re seeing companies managing their fortunes individually.”

Street mentioned that smaller to mid-size companies are the most exposed to the pressures, causing the desire to seek scale to become larger and more diversified.

“Some of them have gone the route of M&A, the larger players have the ability to manage it in different ways,” Street continued.

But Fitch is watching the trends closely and believes that if pricing continues to fall it could trigger a less disciplined market approach for some players, which could result in rating changes.

Street explained; “This is something that we watch quite closely, at the agency, as we feel that pricing movements are an important lever for reinsurers to manage their earnings.

“If we see disorder in the market in the next 12 months, then that could quite quickly result in a number of negative actions on some companies.”

Rate decreases at the mid-year renewals were around the single digit range, across whole reinsurance company portfolios, which the market took some comfort in seeing and has been reported as the emergence of a pricing floor and a sign of discipline.

But, Fitch “remains unconvinced that that’s the case. We believes that if conditions remain as they are we are likely to see further falls as we move into 2016.”

Street continued; “Our concern is that there appears to be discipline in the market at present, but we could get to a point where as reinsurers look to maintain their positions and market shares they step back from being as disciplined as they have been and we could see price falls increase again.

“It’s something that we’re watching closely and particularly the January 2016 renewal, we will see how that takes shape.”

Fitch is also keeping a close eye on the way pricing pressure is spreading, into casualty and other lines, as this suggests broader pressure ahead for reinsurers that have a diversified portfolio.

Pricing seems to have moved past the point of cyclical movements, with the level of price changes shallower than previously. The concern is that with alternative capital coming into the space en mass, pricing movements may not be the same as before.

Street discussed the traditional reinsurance cycle and questioned whether it will ever be the same again.

“Are we seeing a permanent erosion of profit and margin?” Street questioned, adding that the mono-line reinsurers who fail to or find it difficult to adapt are most at risk.

Summing up, Street said that the reinsurance sector outlook has been held at negative since January 2014 and that there is no sign of this changing any time soon. Further price falls are to be expected in 2016, with the steepness of any declines difficult to forecast, but potentially volatile still.

Additionally the macro environment is not getting any easier for reinsurers, with investment returns still low and no sign that they will bounce back significantly in the near future. The soft market conditions are also continuing to drive more M&A activity through 2016, but increased M&A is not expected to improve the sector outlook alone.

The January reinsurance renewals will be a key opportunity to gauge the health of the market and reinsurers themselves. Fitch is not confident that prices will stabilise and expects that we will see more price declines.

Across company portfolios, Fitch expects to see single-digit rate declines in January 2016, “Similar low single-digit rate falls are expected,” Street said.

He went on to say that double-digit rate declines across whole company portfolios would be concerning and could herald a closer look at a company rating.

So while reinsurance market stabilisation is being reported by many, Fitch expects the downward trend will continue, albeit more slowly. With further rate declines ahead at the January 2016 reinsurance renewals, Fitch will be keeping a close eye on reinsurer performance.

Of course, what this does mean is that either reinsurers will relax discipline to underwrite similar amounts of business, or that they could relinquish some lower-priced lines of business to those with more efficient capital, or a lower-cost of underwriting.

Could this be positive for the ILS market and result in more risk being ceded to the capital markets through catastrophe bonds and other ILS structures? It’s possible if the ILS market is the only source of capital that can safely sustain the lower rates the reinsurance market is heading towards.