A.M. Best turns negative on reinsurance sector, joins other rating agencies

Rating agency A.M. Best has finally turned negative in its outlook for the global reinsurance sector, citing weakening operating fundamentals and significant ongoing market challenges which will hinder the potential for positive rating outlooks and upgrades.

Now all four of the major rating agencies have a negative outlook on reinsurance as a sector. The first to adopt a negative stance was Standard & Poor’s in January, followed by Fitch Ratings and then Moody’s in June changed its sector outlook to negative. Now A.M. Best has joined the others in placing a negative cloud over the reinsurance sector, as it forecasts a challenging market environment ahead for reinsurers everywhere.

The “significant ongoing market challenges” are set to “hinder the potential for positive rating outlooks and upgrades” and over time this may “result in negative rating pressure”, said A.M. Best in a report just published.

Best first said that there may be negative pressure ahead for reinsurers in April, but it has taken the passage of the mid-year renewals, when reinsurance pricing and terms remained under pressure, for it to take the stand to lower its sector outlook.

A.M. Best’s move has been expected, nobody would have assumed that it would have maintained a stable rating on a sector so challenged by excess-capital, competition and the entry of insurance-linked securities (ILS) and alternative capital vehicles. The effect of a negative rating outlook is not in itself significant for reinsurers, but it does signal that if the fundamentals get any worse there could be ratings actions ahead for individual companies most impacted by the market challenges.

A.M. Best said; “It has become even more apparent that as compression continues bearing down on investment yields and underwriting margins, this strain on profitability will ultimately place a drag on financial strength.”

At this stage, A.M. Best said that its view is longer term than its typical 12 to 18 month outlook, perhaps reflecting the serious impacts the market challenges may have but also the unprecedented nature of the current soft market environment, with new players now in the picture.

“While A.M. Best does not anticipate a significant number of negative outlooks or downgrades over the very near term, the market headwinds at this point present significant longer term challenges for the industry,” the rating agency explained.

In coming to its negative rating outlook for reinsurance, A.M. Best said that it purposefully tried to look beyond the issues of excess-capital, rate declines, unsustainable loss reserve release activity, low investment yields and the continued impact of convergence capital on traditional reinsurers.

The rating agency also considered issues such as traditional reinsurers increased use of alternative capacity to help optimise results, net probable maximum loss (PML) for peak zones as a percentage of capital, how reinsurers approach cycle management and the strategy between primary and reinsurance platforms, as well as reinsurers changing investment strategies into asset classes and more aggressive investment return targets and the reinsurers moves to produce more fee income.

However, despite all these considerations A.M. Best found it hard to ignore the simple fact that returns are down, margins are down, terms and conditions are broader, meaning that profitability suffers and reinsurers take on more risk for lower rewards.

At the moment reinsurer balance sheets are well-capitalised but over time this could become eroded, said A.M. Best, as earnings become more volatile and favourable reserve releases drop off. The other impactful item of note is that alternative capital is expected to erode reinsurers ability to earn back losses after catastrophe events, something we at Artemis have been highlighting as a likely development for more than two years now.

A.M. Best explains; “All of these issues reflect increased concern that underwriting discipline, which until recently had been a hallmark for the reinsurance sector, is beginning to diminish as companies look to protect market share at the expense of profitability.”

Looking at where reinsurance rate adequacy is, A.M. Best says it will take continued benign conditions just for reinsurers to produce even ow double-digit returns. Levels of return like this would have been considered average just a few years ago.

The prospects for improving those returns are not looking too good either, with further rate pressure likely in January, an increasing push into specialty and casualty likely to depress rates there, growing focus of hedge funds and private equity on the mid to longer tailed business and of course catastrophe bonds and ILS ready to take on the peak catastrophe type exposures. This doesn’t leave anywhere to hide for a reinsurer right now.

As a result, A.M. Best says; “In our view, companies with diverse business portfolios, advanced distribution capabilities and broad geographic scope are better positioned to withstand the pressures in this type of operating environment, and have greater ability to target profitable opportunities as they arise. It also places increased emphasis on dynamic capital management in order for companies to manage the underwriting cycle and remain relevant to equity investors.”

It’s no surprise to see a negative rating outlook for the reinsurance sector from A.M. Best. In fact the only real surprise is that this move didn’t come much earlier this year.

It seems that as the reinsurance sector outlook is assessed as negative, what is in fact being assessed is the traditional reinsurer business model with no changes. Reinsurance firms which have not made any attempt to shift or augment strategy to navigate the difficult market environment may be the first to come under adverse ratings pressure once the focus moves from sector level down to individual performance.

With market conditions unlikely to change in the coming months, large catastrophe or market changing events aside, we could see the reinsurance sector outlook sit under a cloud of negativity for some months or years to come as the market continues to adapt to the new capital environment.