Capital and competition converging on U.S. P&C insurers: S&P

The factors which have been responsible for triggering the price declines across property catastrophe and other reinsurance lines are now beginning to converge on U.S. property and casualty insurers with the effect likely to be reduced profitability.

U.S. P&C insurers are highly capitalised, have experienced a year of lower losses and high profitability in 2013 and are coming under increasing competition from their own kind as well as from reinsurers looking to broaden their underwriting into primary lines.

As a result, U.S. P&C insurers are expected to come under increasing pressure on profits, as the high levels of capital, softening reinsurance market, benign catastrophe losses and knock-on effects of an ample supply of third-party reinsurance capital begin to exert influence on primary insurance pricing.

Ratings agency Standard & Poor’s said in a new report that the U.S. P&C insurance sector is unlikely to be able to repeat the profitable underwriting seen in 2013, the second highest seen since 2007 with an industry combined ratio of 96.7%. Rate increases, lower catastrophes and robust reserve releases helped P&C insurers to this impressive year but S&P does not believe these factors will continue to help insurers.

S&P has a long-standing view that the reserve cushion for these insurers is diminishing, on top of which the underwriting profitability is expected to drop. S&P expects lower profitability and a combined ratio of between 98% and 100% for 2014, with lower rate increases likely across most lines of business and pricing not expected to surpass loss-cost trends anymore.

On top of this S&P says that weather volatility could have an impact and reduced reserve releases could increase pressure on insurers underwriting profitability. S&P is also not expecting any increase in investment income in the short-term, even while interest rates slowly increase, so this will not provide a sufficient offset to any dip in underwriting profitability.

Despite the lower profitability S&P continues to forecast a stable outlook for the majority of U.S. P&C insurers over the next twelve months, with capital levels, conservative investment strategies and enterprise risk management set to help them maintain their ratings.

S&P says that the recent trend towards hardening rates in P&C insurance has been short-lived. The record high levels of capital in the sector and the high profitability experienced mean that rates are not hardening as has been seen in the past. This is very similar to the experience in U.S. property catastrophe reinsurance after the 2011 catastrophe year, when rates rose, but only briefly before a gradual softening triggered by capital levels, low-levels of catastrophes and ILS market growth kicked in.

Losses continue to be below long-term averages for P&C insurers, S&P notes, which should help them to maintain a level of profit even if not at the rates seen in 2013. S&P expects some pricing momentum will continue, but not as rapidly as seen in 2013. In fact S&P expects low single digit rate increases which would only be at a par with loss cost trends suggesting more of an even market.

In primary property lines S&P expects the combination of low catastrophe losses in 2013, softening reinsurance market pricing and ample third-party reinsurance capital to contribute to a low single digit to flat primary property insurance pricing environment.

As a result S&P expects even more pronounced property pricing reductions in large accounts, where reinsurance trends can often be felt most strongly. Further pressure on property insurance rates will come from reinsurers who increase their focus on primary specialty and commercial underwriting to offset softening property reinsurance rates. This will increase competition for primary insurers and soften pricing more broadly if trends continue in the same vein.

It’s interesting that P&C insurers are facing some of the same headwinds that reinsurers began facing in 2012. High levels of industry capital and low levels of catastrophe losses are pressuring prices and preventing the insurance price hardening from continuing as has been experienced in the past.

At the same time reinsurance industry trends, again high capital, low losses but with the additional influence of third-party capital, are pressuring P&C insurance too. The trend towards reinsurers expanding their primary insurance underwriting is another influencing effect on insurer profitability that has to be considered as well.

All of the these factors are going to continue to converge on insurers while the market remains free from large, capital draining losses. The longer that continues the greater the pressures will be and we could see some areas of the P&C insurance market, particularly property, looking flat to down very soon, we would expect, if nothing changes.

It should be noted that it is the convergence of multiple factors which is affecting the rate environment in reinsurance and now threatening profitability for insurers. It is not, as some media would have you believe, the result of alternative capital and instruments such as catastrophe bonds alone which has bludgeoned reinsurers into reducing pricing.

The reality is far more nuanced and complex. Alternative capital, ILS and catastrophe bonds remain a small part of the very large global reinsurance sector. It is the high levels of traditional capital, low levels of losses, resulting high competition plus the competitive reaction of reinsurers to relax on terms and conditions which has helped push pricing down market wide.

The difference in this soft market, compared to others, is that alternative capital and the investors behind ILS and cat bonds have become much more familiar and comfortable with assuming reinsurance risks over the last few years. It’s also worth noting that the ILS capital has now become much more competent at recognising its true cost-of-capital, allowing it to bring pricing down from the levels seen a few years ago, as managers and investors learn where their sweet spot is.

This is testament to the increasing sophistication of ILS managers, the growing maturity of the market, the increasing acceptance by cedents and continued diligence displayed in deal-making and basically a market which has now passed its infancy and is finding its feet.

It is not, as again some mainstream media would have it, a market driven by investors simply hunting for yield, so desperate for returns they will invest in any peril brought to market. Equally discussions of a bubble in cat bonds, which have appeared in mainstream financial press over the last few weeks, are hard to take seriously when the cat bond markets growth rate is at around $3 billion per year (in terms of risk capital outstanding) and size continued to hover around the $20 billion mark.

It takes more than a still niche, although growing, ILS and alternative reinsurance capital market to cause such disruption alone. The convergence of the multiple factors of capital, low losses, competition and the addition of new capital which come together to create the disruption which is now beginning to be replicated in the primary U.S. P&C insurance space.

ILS and alternative capital is an influencing factor in the current reinsurance market environment and the reinsurance market environment is now having a knock-on effect on primary insurance it seems. However, without the high levels of capital, low levels of losses and high competition among primary insurers this effect would be muted on its own.

When markets get disrupted it is often the innovative, new and misunderstood which get held up as an example and often blamed for the disruption. While we’d love to say that ILS alone is disrupting the entire insurance and reinsurance space, that simply isn’t true at this time.

It takes two to tango and the combination of high levels of capital and competition, relaxed terms and conditions and benign loss experience of the traditional re/insurance market combined with the recently discovered lower-cost of ILS capital have converged to create waves (and headlines) which are likely to continue for the foreseeable future.

S&P maintains a stable outlook on U.S. P&C insurers, but how long that will last for remains to be seen. If there is no change in reinsurance industry trends, even if pricing finds a floor and simply flattens, insurers will be facing an ever more soft market themselves particularly in the property space.