Cost-of-capital to be a struggle in reinsurance: S&P

by Artemis on December 7, 2016

Reinsurers are going to find it increasingly difficult to meet cost-of-capital requirements as the ongoing softening market cycle mounts pressure on firms’ profitability. With the current market environment expected to persist into 2017, some reinsurers will likely see profit levels fall below their cost-of-capital, according to Standard & Poor’s (S&P).

International financial services ratings agency, S&P, adds to the insurance and reinsurance sector analysts and observers that have highlighted the continued deterioration of profitability in the global reinsurance sector, emphasising the challenging times market participants are experiencing.

The softening reinsurance market cycle is approaching its fifth year, but while rates have persistently fallen across the majority of business lines and competition has intensified, the benign catastrophe loss experience and reserve releasing practices of reinsurance companies has seen the sector remain profitable.

S&P highlights this point in its recent Investor Discussion publication, citing that benign losses and favourable prior-year reserve releases have “flattered reinsurers returns.”

“In our view, given a more normalised loss experience, the reinsurance sector’s overall profitability would not have exceeded its cost of capital in 2015 or in the year to date,” said S&P.

By the end of 2016 and through 2017 the ratings agency expects the reinsurance industry’s cost-of-capital to fall to roughly 6%, compared with the 6.6% reported at the end of 2015.

At the same time, S&P predicts that the sector’s return-on-capital will deteriorate to approximately 5.5% – 7.5% as at year-end 2016 and year-end 2017, which suggests that some reinsurers will likely fail to meet cost-of-capital levels and experience unprofitability on the underwriting side of the business.

“Even assuming continued favourable prior-year reserve releases and benign natural catastrophe losses, we anticipate that reinsurers will barely cover their cost of capital over the next two years.

“More normalised loss and prior-year releases (as already demonstrated by some reinsurers during the first half of 2016) will result in the sector’s profitability dipping below its cost of capital,” said S&P.

Falling returns, a lack of large losses, prior-year reserve releases, an abundance of capital and diminished investment profitability, among other headwinds, has seen the return metrics of global reinsurers come under increasing pressure.

However, as noted by S&P and also noted by other industry analysts in recent times, the larger, or stronger reinsurers are expected to be able to withstand profitability falling below their cost-of-capital for a short while, owing to the substantial volume of reinsurance industry capacity, from both traditional and alternative sources.

“Moreover, given the paucity of asset classes and sectors offering comparable (or better) yields for investors, we do not expect reinsurance investors to rush for the exit door en masse, even as reinsurers’ profitability comes under increasing strain,” said S&P.

As the softening reinsurance market cycle has persisted and intensified, the ability of reinsurers to meet their cost-of-capital targets, and the impact this will have on their willingness and ability to keep writing business, has been discussed by a number of industry analysts.

While some have warned that re/insurers will continue writing business, even below cost-of-capital, the general view from the market appears to be that profit margins will continue to thin, and that a return to more normalised losses and reserve practices will see the reinsurance industry turn unprofitable, and perhaps faster than some anticipate.

The abundance of traditional and alternative reinsurance capital continues to influence the insurance and reinsurance industry structure, and S&P explains that the excess capacity in the space could be a driver of further merger and acquisition (M&A) activity during the next 12 months.

Artemis reported towards the start of 2016 that some reinsurance lines were no longer meeting cost-of-capital, and with many of the same headwinds persisting and even intensifying, it’s not surprising that S&P has warned that some in the sector might not be too far away from failing to meet their cost-of-capital, especially if losses pick-up and reserves continue to wane.

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