Return pressure the new reality for reinsurance: A.M. Best

by Artemis on April 14, 2016

Persistent challenges in the investment markets has created a need among reinsurers to rely more on their underwriting results, however, a continuation of price declines and reinsurance market structural change suggests a new reality of less impressive returns, according to A.M. Best.

Reinsurance industry rates remained under significant pressure at both the key January 1st and recent April renewals season, with some regions and business lines experiencing declines of more than -10%.

And with further declines expected at the upcoming June/July renewals, A.M. Best has warned that during the coming months reinsurers might need to accept a new reality of reduced profitability.

“The reinsurance market remains under pressure from renewal rate declines, broader contract terms and conditions, and the dual limiting threats to operating profitability of low investment yields and continued pressure from alternative reinsurance capital in the reinsurance sector.

“The new reality for the reinsurance market at present encompasses less impressive returns because of persisting instability in investment markets and the necessity for underwriting to become a larger and more consistent contributor to operating profits,” said financial services ratings agency A.M. Best, in a special report titled, ‘Reinsurers Enjoy Good Fortune, But Is It Sustainable.’

Industry reports from mid-year renewals in 2015 suggested some rate stabilisation in the global reinsurance marketplace, however, rates continued to decline across the majority of business lines throughout last year and the trend has persisted into 2016.

A lack of significant loss events in recent times has seen reinsurers utilise reserves to offset diminishing underwriting profits, a trend that could come back to bite some firms when losses begin to return to more normal levels.

A.M. Best underlined that the profitability reported by reinsurers in recent quarters at times of market turmoil could prove unsustainable, owing to the “likelihood that net favourable prior year loss reserve development will soon wane,” another potential contributing factor to diminished reinsurance rates moving forward.

Artemis has discussed several times before how persistent and aggressive reserve releasing during the current benign cat environment in order to mask true underwriting profitability could prove dangerous for some, especially should the market experience a significant loss event.

Exacerbating the benign loss environment is the increased competition from a wealth of traditional and alternative reinsurance capital providers, fighting for a seemingly shrinking share of the market in an effort to remain relevant in testing times.

Despite a reported slowdown in the entry of alternative reinsurance capital in more recent times, A.M. Best, like numerous other industry observers expects third-party reinsurance capital “to continue to enter the market as large pension funds and hedge funds search for ways to diversify their portfolios while chasing higher returns.”

Combine this with limited potential to make a profit on the investment side of the business, resulting in a heightened need for underwriting profits at a time of diminished rates, and it’s not too surprising A.M. Best warns reinsurance companies of a possible “new reality.”

“Absent a major, industry-changing catastrophe event, competitive market conditions are likely to persist over at least the near-term,” says A.M. Best, although some in the space have suggested that even this might not be sufficient to significantly turn the softening landscape.

Despite a growing need for underwriting profitability among reinsurers, the ratings agency remains doubtful that underwriting will contribute more to profits and operating returns anytime soon, “as underwriting fundamentals continue to weaken and catastrophe losses are inevitable at some point.”

“The expectation remains that reinsurance pricing, overall, will continue to be under pressure in 2016 given ongoing pressures from alternative capital and the lack of any price-changing event over the past few years,” said A.M. Best.

As noted by A.M. Best, alternative reinsurance capital continues to enter the space even at times of reduced returns; in part owing to the diversification benefits it provides capital markets investors that participate in the space.

And while its presence continues to impact rates in the global reinsurance market, it could also be utilised by reinsurers as an efficient form of capital, increasing cost-efficiencies at a time it’s needed most, a trend that is reportedly gaining traction.

“Reinsurers are utilizing the increasing capital market capacity to better limit down-side risk by reducing the percentage of their balance sheet capital exposed to net probable maximum loss exposures in peak zones,” said A.M. Best.

The warning from A.M. Best again brings discipline to the front of reinsurance industry discussions. But it’s also important that firms from both the reinsurance and ILS world continue to innovate and look for opportunities in new regions and risks.

After all, deploying capacity into new regions and perils will help to alleviate some of the supply/demand imbalance in the global reinsurance space, which is most pronounced in the property catastrophe segment where competition is intense.

As usual, the question remains as to whether the ILS business model can sustain the lower underwriting returns, due to its lower cost-of-capital and often more efficient operational structure? Even ILS fund managers and investors require a minimum return though, which suggests that eventually the floor on pricing will be found more widely.

Ultimately this would go some way in helping to reduce some of the competitive pressures in the space, and potentially lead to more positive rate movements.

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