Risk free rate hike could see further decline of reinsurer RoE’s: J.P. Morgan

by Artemis on September 29, 2016

Following meetings with re/insurance industry observers and experts in Monte Carlo recently, analysts at J.P. Morgan have warned that any hike in risk free rates, while unlikely, could lead to further deterioration of reinsurers’ RoEs.

Speaking with an insurance and reinsurance rating agency at the 2016 meeting of the reinsurance industry in Monte Carlo recently, J.P. Morgan discussed the possibility of an increase in risk free rates, and what this might mean for the reinsurance sector and its participants.

The marketplace remains heavily capitalised and the larger players in the space have maintained balance sheets with high solvency capital and strong reserves, suggesting that any scenario that could lead to potential ratings downgrades are rare, says J.P. Morgan.

One of the possibilities explored and discussed by the firm at Monte Carlo relates to a sharp rise in risk free rates, which, although unlikely, could result in some potential difficulties for the sector.

“We believe the main potential risk is that a hike in risk free rates would likely increase the cost of capital of the reinsurance sector (the risk free rate is a main component in the cost of equity calculation), and in the short term value creation, the difference to reported ROEs, could potentially drop or even turn negative,” explains J.P. Morgan, in a recent European Equity Research report.

The reinsurance market remains under pressure from a variety of headwinds, which, as reported previously by Artemis, has resulted in consistent price declines and the deterioration of RoEs across the sector.

At the start of the month reinsurance broker Willis Re noted that the average reported RoE for the sector was 8.3%. However, when normalised for a more typical catastrophe load and absent the benefits of any reserve releases, the broker underlined that the realistic RoE fell to 4.5%, pushing reinsurers closer to unprofitability.

Should risk free rates witness a sharp increase, then, the cost-of-capital for the reinsurance industry has the potential to increase, which in turn could see further deterioration of RoEs in the space.

But remember that this is without accounting for a more normalised catastrophe loss experience and the benefits of releasing reserves in order to boost returns, suggesting that any hike to risk free rates could actually see underlying RoEs fall even further.

Despite becoming the new norm in more recent times, an RoE of below 9% is generally considered low for the reinsurance industry, so should losses normalise, reserves diminish, and risk free rates increase, some in the sector could rapidly find themselves in unprofitable territory.

“But we also discussed a potential positive offset: alternative capital, which prices its capital return target directly from the risk free rate, would likely immediately raise its cat bond and insurance linked solution pricing, this would likely lead to a hike in reinsurance pricing, and this would help restore the sector’s profitability,” continued J.P. Morgan.

We tend not to agree with the above note from J.P. Morgan, as catastrophe bonds and other forms of insurance-linked securities (ILS) effectively utilise a floating price above the risk free rate of the collateral return.

In turn, this means that investors in the space would actually receive a higher premium for their investment should there be a sharp rise in the risk free rate, suggesting that ILS investment managers could actually have greater leeway to dictate pricing, and could keep it at lows, at a time when traditional reinsurers wish it would rise, rather than increase it.

But regardless of the potential influence of alternative reinsurance capital and ILS solutions and investors, a rise in risk free rates is another factor that has the potential to drive up cost-of-capital levels, and drive down reinsurer RoEs in an already challenging environment.

J.P. Morgan does stress that a sharp rise in risk free rates is unlikely, but the fact remains that reinsurance companies are coming under increasing pressure to produce adequate returns for shareholders, in a softening market cycle that shows little sign of turning in the near-term.

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