Cat bonds hit floor 18 months ago, reinsurance still searching for it

One measure for catastrophe bond pricing shows that cat bond investors reached the bottom of their risk appetite around 18 months ago, since which catastrophe risk adjusted spreads have been rising, but at the same time, the global reinsurance market continues to search for its floor.

One of the key takeaways from the Monte Carlo Rendez-vous this year was that reinsurance executives believe the floor is approaching, but almost everyone else (brokers, analysts and media alike) expect further price declines at the upcoming key January renewal season.

But the impression is increasingly that rate declines are slowing and expectations for January are that reinsurance rates could decline in low to mid-single figures, with analysts from J.P. Morgan suggesting -3% to -5% as a likely range for renewals.

Meanwhile Guy Carpenter said at Baden-Baden this week that the broker expects a steeper decline, with double-digit negatives possible at the January renewals. This perhaps hints at the fact that while cat bond investors have pulled on the reins, the traditional reinsurance market and collateralized reinsurance investors have yet to do so.

The analysts note that there is a widely held opinion in the market that “margins in P&C reinsurance are approaching a level where the industry may no longer be covering its cost of capital.”

This means that underwriting discipline is now being tested, as there will still be pressure to further reduce pricing in many lines of business. However the analysts also suggest that brokers acknowledge that pricing is approaching technical levels, which perhaps suggests they won’t push much further.

But the evidence all points to catastrophe bond pricing having “troughed” or bottomed-out around 18 months ago, J.P. Morgan cites RMS data on catastrophe risk adjusted spreads as evidence for this. So if the insurance-linked securities (ILS) investors found the lower limits of their risk appetite that long ago, why are reinsurers still searching for it?

The answer perhaps comes down to competition. ILS investors can just say no and bookrunners have to either go with the markets price indications or pull the deal completely. In traditional reinsurance, with so much excess capital available, it has perhaps been less easy to say no as quickly.

At the start of this year there had been a considerable backlash from traditional reinsurance players claiming that ILS capital was pushing down pricing. However, look at the evidence. A number of large ILS players returned capital at the start of the year. Pricing on new cat bond issues bottomed some time ago. ILS gains and growth of the market slowed considerably this year as well. It all points to the majority of the ILS market having been quite disciplined, in terms of deploying capital and demanding a minimum return for it.

But reinsurers continue to search for a pricing floor, suggesting that risk appetites have not yet been reached.

There are many contradictory messages coming from the reinsurance industry today. Major reinsurers have been pulling back from catastrophe risk exposed lines, but at the same time underwriting increasing volumes of premiums in other areas. Terms and conditions have been expanding the point where senior executives have been warning about discipline waning, but at the same time large reinsurers have been growing their books.

At the same time some reinsurance companies continue to blame alternative capital, ILS and those pesky pension funds or hedge funds, as responsible for driving down pricing. But the evidence is that ILS has slowed its growth dramatically, suggesting that ongoing price pressure and especially the spreading of pressure to longer-tailed lines is being caused by traditional rather than alternative capital.

These contradictions suggest that some companies are not telling it straight, of course. It’s important to maintain a facade of discipline, even if under the hood the underwriting has become more risky. It’s impossible to believe that everyone in the market is disciplined, on either traditional or alternative side.

But the fact that cat bonds found a pricing floor suggests that reinsurance will too, the question is when? The other question is how much does collateralized reinsurance underwriting from ILS funds add to the pressure, making the floor remain out of reach?

J.P. Morgan’s analysts say that the evidence that ILS investors have return hurdles below which they will not drop, “suggests that the dynamic of ILS taking share from traditional reinsurance may be becoming more balanced, which overall should result in improving pricing conditions we believe.”

Overall the emergence of a pricing floor would be a sign that the “dynamic between alternative capital and reinsurance may be moving toward an equilibrium, which we see as positive for the sector,” the analysts suggest.

Of course if reinsurers continue to maintain their cost of capital even when underwriting at these lower levels of return, and if ILS and alternative capital continues to wait for the opportunity to come into the reinsurance market en masse, while breaking down the value chain by accessing risks nearer to the primary source, then there is no reason to believe pricing will tick up very much even after a floor is found.

Herein lies the conundrum. Capital needs to be deployed, risks need to be underwritten, discipline needs to be maintained. How do you achieve that when the returns are squeezed and show no signs of improving?

This is when innovation becomes important; an ability to gain an edge over competitors through product design, development and distribution, with enough capital and operational efficiency in order to make a satisfactory profit and return.

That suggests to us that, even after a pricing floor is found (which it must be eventually), the pressure in the market on incumbents to adapt and new entrants to disrupt, is destined to continue.