Reinsurers increase peak zone cat risk exposure despite softening: Moody’s

by Artemis on April 5, 2016

Despite continued softening and resulting rate declines at the January 1st renewals, reinsurers’ probable maximum loss (PML) disclosures reveal that many actually increased their allocation to peak zone catastrophe risks, according to Moody’s Investors Service.

January 1st modelled PML exposures reveal that the majority of firms increased, or maintained a generally flat level of exposure to peak zone catastrophe risks during the period as a percentage of equity capital, with U.S. wind and U.S. earthquake being the most prevalent.

This is at a time of limited profitability and organic growth potential in the global insurance and reinsurance industry, owing to the continued softening reinsurance landscape that’s exacerbated by the benign loss environment and ample capacity from both traditional and alternative sources.

“The increase in PML as a percentage of equity capital reverse a general downward trend in catastrophe risk over the past several years, a period in which firms had reduced exposure and the associated volatility as pricing deteriorated,” said Moody’s.

However, as pricing has continued to decline further across the majority of reinsurance business lines, firms appear to have increased their exposures to peak zone catastrophe risks in order to secure additional premiums from low probability event risk.

Moody’s explains that the increase in PMLs are most pronounced for U.S. hurricane and earthquake risks at the 1-in-250 year return level, which, suggests reinsurers are either “still able to find pockets of attractively priced business on a risk-adjusted basis, and/or are willing to take on more low probability event risk to bring in additional premium,” said Moody’s.

Data from Moody’s shows that reinsurance giant Swiss Re increased its 1-in-250 year event PML by the most for U.S. wind, by 4.7%, at January 1st 2016, when compared to a year earlier and as a percentage of equity capital.

Validus Holdings and XL Group also increased their allocation to 1-in-250 year event PML U.S. wind exposures by more than 4%, giving an idea of just how much more low probability, high severity risk was taken on at 1/1 in light of the softening landscape.

Given that property catastrophe reinsurance pricing was down by up to 7.5% for loss free accounts in the U.S., and by up to 15% in Europe, “it is surprising that PML-reporting firms in the sector generally increased their catastrophe risk exposure profiles at 1 January 2016,” said Moody’s.

“We think this year’s change in capital allocation is indicative of the pressures reinsurers face in maintaining profitability against the strong downward pull exerted by underwriting margin compression and low interest rates,” continued Moody’s.

Not all reinsurers followed the general trend of flat or increased peak zone catastrophe exposure allocation at 1/1, with some pulling back on certain lines, as they were able to take advantage of efficient retrocessional reinsurance capacity to mitigate exposures.

An increased utilisation of retrocessional reinsurance capacity might also feature later in the year, especially for those firms that significantly increased their PML exposures at 1/1, as market players can reduce their U.S. wind exposure through additional retro capacity at mid-year renewals, so before the U.S. hurricane season starts.

That could be an opportunity for the more efficient capital of the ILS market to take on more risk from these traditional reinsurers, to help them to balance their peak zone exposures and shave the tops off their PML’s.

In fact, the way the reinsurance market is behaving suggests that we will see an uptick in demand for instruments such as ILW’s in the coming months, as both traditional reinsurers and some ILS players look to manage their exposures as the U.S. wind season approaches.

That being said, and perhaps part of the reason reinsurers felt able to increase their PMLs to peak U.S. catastrophe risks, a land-falling hurricane has failed to occur in the states for more than a decade, but it’s important that the market remembers this is only a matter of time and doesn’t fall into a false sense of security.

“Looking ahead, the upcoming June/July renewals in Florida will provide another test of both the risk appetite and resolve of reinsurers’ underwriting discipline in the face of weak property catastrophe reinsurance fundamentals,” said Moody’s.

Essentially, Moody’s analysis and commentary shows that many reinsurers decided to take on more peak zone catastrophe risk at 1/1 2016, despite rates continuing to decline across the sector.

While this adds additional premium for the firms that grew their exposure, it also suggests that when the next big loss event occurs some could find themselves in a very difficult position owing to a lack of underwriting discipline and resulting over-exposure.

Profits are hard to come by in the reinsurance market at present, and wider financial market volatility continues to dampen potential returns on the investment side of the books.

As a result it’s not overly surprising that some reinsurers increased their PML exposures at January 1st renewals in an attempt to increase revenues and maintain a desirable flow of business.

However, when the next large industry loss event happens, and if for example there is a lack of available retrocessional capacity, companies that increased PMLs to peak catastrophe risks could be open to an array of problems, and find themselves in a more difficult position than necessary.

As highlighted by Moody’s, all of this points to a continued and increased need for underwriting discipline and sophistication, knowing when to write, and when not to write business, something that can be more difficult to assess in a softening market as ultimately, the need for profit remains.

It also suggests an increasing need to assess retrocessional capacity and to establish exactly which risks a reinsurer wants to retain and which it needs to cede onwards. Again this provides an opportunity to the capital markets and the ILS fund managers, and could result in attractive opportunities as any reinsurers look to reduce PML exposures.

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