Despite the fact that a reinsurance market price recovery of sorts is anticipated in 2018, on the back of the major catastrophic losses, rating agency Fitch says that it expects reinsurers will remain pressured, with their earnings in 2018 likely only barely above cost-of-capital.
Fitch says its sector outlook for reinsurance remains negative and while its ratings outlook is stable that could change if loss expectations from 2017 catastrophes worsen for any of the cohort of global reinsurers it tracks.
The 2017 catastrophe losses have driven the average combined ratio across the group of reinsurers to 110% for 2017, but Fitch does expect that earnings from the investment and operations outside of non-life reinsurance will help the group to report positive earnings for the year.
Fitch forecasts that the group of reinsurance firms it tracks will achieve net income return on equity (ROE) of 2.1% in 2017, down from 8.5% in 2016.
With all the discussion of higher reinsurance pricing and a post-loss shift in the market cycle you might have thought the forecasts for 2018 would be for ROE’s to increase for reinsurers, but actually the opposite is true.
Fitch says that, under a normal catastrophe load, it anticipates that reinsurers will achieve a 7.1% ROE for 2018. That’s “barely expected to be above cost-of-capital,” the rating agency notes.
Fitch estimates that cost-of-capital comes in at between 6% and 7% for the reinsurers and says that as underwriting and investment returns are likely to remain stressed in 2018 this may only barely be achieved.
That’s based on a forecast combined ratio for 2018 of 96% across the group of reinsurance firms, with an average catastrophe loading of 8 points for the year.
Fitch does note that, “The underlying combined ratio should improve slightly in 2018 as reinsurance market pricing appears to have reached a bottom in 2017 and is expected to turn positive in 2018,” but still this is not expected to improve the picture dramatically.
Given any price rises achieved may be relatively short-lived, as the weight of capital in the reinsurance sector is expected to increase as loss reserves and collateral trapping issues get resolved over the coming months, this is not a particularly rosy outlook for the traditional reinsurers.
It implies that profitability is going to remain depressed and that any increase in losses above the average levels could push the sector towards unprofitability across the year.
That’s precisely the situation reinsurers found themselves in at the beginning of 2017 and so it appears market forces have not changed significantly.
While the underlying may improve, with the help of price rises achieved at the renewals, the best way to capitalise on them and turn them into higher profits is going to be reductions in the expense ratio, intermediation costs and other factors that eat into underwriting profits.
Hence the focus on digitalisation, expense efficiencies and directly accessing risk are likely to increase even more among the major reinsurers. At the same time the ILS players are likely to continue to push for higher margins in their underwriting as well, using similar approaches.
Once again this all points to a highly competitive marketplace, where efficiency of capital is going to remain a defining factor between failure and success for some players in the future.
Fitch’s analysts say, “Capitalisation should remain strong, and we expect shareholders equity growth of 1% for 2018.”
The question is, how long will shareholders back a sector that is growing so slowly? Any pressure from investors is sure to accelerate the desire to innovate and evolve, which could speed up change in this market over the coming years.
It’s vital to make a better return above the cost-of-capital, or the proposition of backing some traditional reinsurers could become less compelling. That suggests some radical changes in strategy may be required, as well as expense cuts in order to offer investors a more compelling proposition. It could also lead to further reinsurer experiments in using third-party capitalised balance-sheets, as a more efficient home for certain types of risks.
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