Despite falling returns equity investors unlikely to exit reinsurance: S&P

The majority of reinsurance equity investors are likely to remain in the sector despite persistent rate declines as returns continue to be more favourable than other industry sectors, according to Standard & Poor’s (S&P).

Rates have declined in the global reinsurance industry for some time, and despite a moderation of reductions in some business lines during more recent renewals, it’s expected that the soft pricing environment is going to persist.

Clearly, for shareholders of global reinsurers lower returns is by no means ideal, but S&P feels that the increased appetite for yield and diversification among equity investors and its favourable return on capital when compared with other sectors, suggests limited investor capital withdrawal.

“Our base-case assumption is that most reinsurance equity investors will reluctantly accept declining returns on their reinsurance holdings, rather than exit the sector. Given the current low interest rates, investors remain hungry, even desperate, for yield,” said S&P, in a recent report examining the dwindling profitability of the reinsurance industry released around the 2016 Monte Carlo Reinsurance Rendez-vous.

The ratings agency continued to note that while rates are declining in the sector, the group of reinsurers it rates recorded a return on capital of 8.5% at the end of 2015, which “compares relatively favourably with other industry sectors,” suggesting that equity investors have “limited options elsewhere that offer more favourable (or even comparable) rates,” explains S&P.

For example, at year-end 2015 the average return on capital for major banks was 3.4%, the global industrials sector’s was 6.5%, and returns on five-year risk-free assets stood at 1.76%, says S&P.

So it’s clear that while rates are falling across the reinsurance sector the current, global, financial and economic turmoil is impacting a range of sectors and in comparison, equity investors are likely to achieve better returns in reinsurance.

It’s important to note, and of particular interest to us here at Artemis, that insurance-linked securities (ILS) also continues to record stable, albeit reduced returns in the current market environment.

The uncorrelated nature of ILS investments to the broader financial world, and its strong diversification benefits, suggests that this is also an asset class that can provide better returns than some of the more traditional and other alternative asset classes.

“Investors may also decide to stay within the reinsurance sector because when a large catastrophe event causes significant rate hardening, there will be a sudden pick-up in demand for reinsurance shares. Investors will want to take advantage of those more favourable rate conditions,” said S&P.

S&P raises a valid point, but in today’s softening cycle that is exacerbated by the benign loss experience and persistent inflow of disruptive alternative reinsurance capital, it’s also widely expected that any price-surge post-event will be much flatter than witnessed previously.

In order for the softening reinsurance landscape to start to turn, industry experts and analysts have said that truly significant, mega-event is required if sufficient capital is to be removed from the space.

But again, with a wealth of alternative and traditional capital reportedly sat on the sidelines waiting to enter after the next large loss, just how big of an event is actually required remains to be seen.

“As returns on reinsurance securities decline, investors will likely reassess their reinsurance investments. One consequence, should investors withdraw their capital, would be that reinsurance rates could harden as the excess supply of reinsurance capital is reduced,” said S&P.

“Reinsurance still offers returns that exceed those of most competing asset classes. This should limit the likelihood of a mass exodus of investors from the space,” concludes S&P.

One factor to consider though, is the types of equity investors in reinsurance and whether that mix could change. Increasingly, long-term investors such as pension funds are buying into insurance and reinsurance businesses, as evidenced with the Canada Pension Plan stake in Ascot recently.

Could we see more long-term, institutional capital and less of the speculative types of capital equity markets more typically flourish on? Perhaps and that may not be a bad thing for re/insurance, as long-term investors mean more permanent capital, something the industry requires.

Read all of Artemis’ Monte Carlo Rendez-vous coverage here.