Growing influence of ILS exacerbates pressure on reinsurers: A.M. Best

The growing influence of ILS and the capital markets in reinsurance is exacerbating pressure on rates, terms and conditions, while the expanding remit of alternative capital is eroding prices across a broader swathe of the market, according to A.M. Best’s Chief Rating Officer.

“The reinsurance sector in the U.S. has maintained a negative outlook for a couple of years now and that’s really driven by pressure on pricing, first and foremost. That pressure is exacerbated by the growing influence of ILS and capital markets activity,” Stefan Holzberger explained in a recent interview with A.M. Best TV.

The influence of ILS capacity and the capital markets, through collateralised reinsurance, is expanding into new lines of business, which in turn helps to push traditional reinsurers to compete across a broader range of market segments, further exacerbating the pressure.

Holzberger continued; “Sidecars, collateralised reinsurers are putting pressure on the traditional market, in terms of rates, terms and conditions. That pretty much started with peak-zone property catastrophe, U.S. wind and earthquake, but because of that heightened competition we’ve seen pricing erosion translate into non-cat property as well as the casualty lines of reinsurance.”

However reinsurers and the most affected segment of the primary market, commercial insurers, remain largely profitable thanks to the low catastrophe loss environment, which has helped them to bulk up capital buffers (another factor exacerbating pressure on pricing and terms).

But profits do not always translate into adequate returns and the reinsurance market environment is one of diminishing returns, despite the low headline loss figures.

“It’s been three very strong years from an underwriting perspective,” Holzberger commented. “From a return standpoint it’s not quite as strong of a story, because you’ve got fairly depressed investment income and an amount of unrealised capital losses, that hurt overall ROE. So ROE is probably not at the level that you would hope it to be, considering the industry is able to generate an underwriting profit.”

Going forwards, Holzberger cited “challenges to maintaining that level of profitability on the underwriting side.”

“We’re seeing pricing deterioration come through in the reinsurance segment and certain casualty classes for commercial lines as well. So those are going to be headwinds in the effort to sustain that technical profitability,” Holzberger forecast.

Profitability is expected in 2016, even at more normalised levels of catastrophe loss, Holzberger said, but one of the factors that could impact that, particularly for commercial insurance players is the prospects of casualty reserve strengthening being required, as well as further expected price declines.

“We’re seeing pricing deterioration come through in the reinsurance segment and certain casualty classes for commercial lines as well,” Holzberger continued, adding that there has been “some adverse reserve development seen” in commercial lines.

Commenting on the potential for reserve inadequacies, Holzberger said; “We’ve also seen isolated cases of adverse reserve strengthening. Now if that goes from those one-off company specific issues to perhaps an issue across a line of business, that will also be a challenge.”

As ever, underwriting discipline is seen as the key to successfully navigating the challenging reinsurance and commercial insurance market environment, by rating agency A.M. Best.

“We’re squarely in the soft cycle of the market,” Holzberger explained. “Rates, terms and conditions are under significant pressure. We see a market where risk adjusted capitalisation is close to, if not at, an all time high. And companies want to put that excess capital to work and in such a competitive environment it’s very difficult to find ways to grow the top line profitably.”

For the moment the rating agency is happy that discipline is being maintained, but Holzberger notes that this is one of the areas where A.M. Best will be keeping a close eye on how the market develops over the coming renewals.

“It is an issue, it is a concern,” he continued, “As of today we would say that we are seeing a level of discipline in the market. Rates are remaining adequate at an actuarially justified threshold, but we’ll see how that plays out in 2016 and beyond, in terms of whether those rates hit a floor or whether they continue that downward trend.”

The ILS market and collateralised reinsurance capacity from investors and ILS funds continues to grow, in terms of available capacity and expand in terms of business lines underwritten. As this continues and as ILS players look to get closer to the risk by directly providing reinsurance capital to back primary insurance business, the exacerbating effect on rates is not expected to let up.

The most encouraging factor for traditional reinsurers should be the fact that ILS investors and fund managers clearly understand where their limits are, on pricing, as evidenced by transaction pricing on cat bonds and the experience at the January renewals.

Perhaps most concerning for traditional reinsurers is the prospect that ILS players wield their lower cost-of-capital even more meaningfully after the next big loss events, making it much harder (or impossible) for the traditional market to recoup the payback it is used to and how, as a result, the pricing cycle reacts.