The capitalisation of reinsurance companies won’t be the main driver of ratings in the current soft and challenging market conditions, rather it will be performance as reinsurers struggle with low investment returns, softening rates and diminishing reserve releases, according to A.M. Best Chief Rating Officer Stefan Holzberger.
Speaking today at rating agency A.M. Best’s 2016 Insurance Market Briefing – Europe, Holzberger gave an overview of reinsurance market conditions and stressed that capitalisation is not going to be the issue to cause rating downgrades, given the excessive levels of capital traditional reinsurance companies are holding.
More of an issue is the actual performance of companies and this is more likely to be a deciding factor in any rating downgrades that A.M. Best might make. The rating agency maintains a negative rating outlook on the sector, but has stable outlooks for company ratings currently.
“There are a lot more headwinds for this sector than tailwinds,” Holzberger said. “When we look at where the sector is rated, in the A, A+ range, so quite highly rated at this stage of the marketplace, capitalisation is not going to be the driver we don’t think, in the aggregate, of negative rating pressure or downgrades.”
Reinsurance firms are facing considerably lower reinsurance pricing compared to a few years ago, ongoing competitive pressure from insurance-linked securities (ILS) funds and other sources of alternative capital, growing pressure from new entrants and technology related startups, reduced demand from major ceding insurers and low investment yields.
They are actively offsetting this reduced return environment through the use of reserve releases and also have benefited from the lower incidence of major catastrophe losses in recent years, however this means the returns generated by reinsurers, typically advertised in the range of 9% or 10% actually work out normalised at closer to 4% or 5%, according to Holzberger.
Holzberger suggested that this means the margins for error are shrinking, in terms of performance, as returns are now down significantly with no sign that they will rebound.
“Performance really matters and with those headwinds it’s going to be very difficult from a performance standpoint to meet the expectations that we would have, let alone to say investors would have, in terms of the ratings where they currently reside,” he continued.
Explaining what is happening, with respect to reinsurance company returns, Holzberger said that meeting cost-of-capital is no longer guaranteed.
“I think on the surface we would probably accept a high single digit RoE, but in the context of this sector you have to look at the normalised RoE,” Holzberger said.
Natural catastrophe and man-made losses have been well below reinsurers budgets and reserve releases have been helping returns out, he explained.
“If you normalise that you’re going from a 9 or 10 percent RoE to a 4 or 5, that is not reaching the cost-of-capital. It’s not meeting our expectations at the rating level, or investor expectations.
“What you really have to bear in mind is that this is an average across the sector, which means that there are companies above and there are companies below. When we talk about rating pressure really what we’re honed in on is those companies that are at the bottom end of the mean and are struggling to meet their cost-of-capital or to achieve a reasonable return,” he continued.
With the margin disappearing out of the reinsurance business, reserve releases boosting returns and enabling companies to report something acceptable in the upper single digits, but at the same time capital in the sector remaining so high it is underutilised, it seems that while capitalisation is not an issue, any drop in performance could be the cause of a reduction in capital leading to rating amendments.
Reserves are set to shrink and releases to decline, Holzberger said during his presentation and this means the declining return on equity trend will continue. But capacity is underutilised, with just 72% put to work meaning the industry could actually risk-up by 28% if it could find profitable opportunities to put the capital to work.
But what does this all mean for ILS funds and other alternative capital players? Efficiency of capital and capacity will remain the differentiator and enable the sector to keep growing, at a time when reinsurers clearly cannot put their total capacity to work and hence we see the large returns of capital to shareholders.
With ILS capital still growing and traditional reinsurance capital actually having contracted slightly, the evidence would suggest that ILS players are better able to grow in the current lower priced environment, but also highlights the flexibility that not having to hold excess capital allows them, as capacity is always near to 100% utilised.
Other trends highlighted by A.M. Best analysts at the Briefing event yesterday suggest that reinsurers are increasingly offering working-layer coverage, where pricing can be more attractive, looking to expand into new risks such as cyber and shifting into longer-tailed lines of reinsurance or primary lines of insurance.
These shifts are actually helping ILS and alternative capital players to strengthen their position in the key property catastrophe markets currently. However they also raise questions around the levels of discipline being applied to underwriting by reinsurers that are expanding their reach in an effort to put excess capacity to work.
Again that comes down to performance. It’s fine to expand as long as done with experienced underwriting teams, writing to risk tolerances and with an eye on returns and making cost-of-capital. But if this expansion is not focused on making returns and there is any hint of discipline slipping reinsurers could put themselves at risk.
In a world where normalised returns on equity are now so low, expansion, shifting of focus and even new ventures must be well-controlled in order to maintain performance, even if that performance is a little lack lustre.
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