Concern over re/insurance terms relaxation in London market: A.M. Best

Rating agency A.M. Best says that it is concerned that relaxation of insurance and reinsurance contract terms and conditions in the London market could adversely affect results in coming years and that it is monitoring how companies deal with increased exposures.

It’s perhaps the strongest worded warning from a rating agency citing specific concerns over terms and conditions relaxation and broadening so far.

The expansion of terms, which effectively provides broader coverage to cedents, results in an increase of the underlying exposures assumed by underwriters. Hence it becomes more prevalent in a challenged and softened market, as we see now.

In a report on the London insurance and reinsurance market, published this morning by A.M. Best, the rating agency cites the difficult trading conditions facing London market re/insurers and the Lloyd’s of London re/insurance market.

Re/insurers in London are dealing with difficult trading conditions, thanks to changed buying patterns, growing competition from insurance-linked securities (ILS), catastrophe bonds and alternative reinsurance capital, as well as ongoing global economic uncertainty.

With insurance and reinsurance premium rates under pressure, particularly in once profitable lines such as catastrophe risks but now also spreading more widely across the market, any return to more normal levels of catastrophe losses could quickly take insurer and reinsurer combined ratios over 100%, the report says.

“Premium rates are under pressure and a return to a more normal level of catastrophe losses could push this year’s technical results into the red,” explained Catherine Thomas, director, analytics. “With interest rates set to remain at historically low levels, investment income will provide limited earnings support.”

The continued and growing interest of third-party and institutional investors in accessing the returns of insurance and reinsurance business more directly through ILS funds and investment vehicles, is applying greater pressure which is now impacting such markets as Lloyd’s.

In the report this morning A.M. Best states again that the more ILS capital grows the more permanent it can be considered, as the types of investors backing it are increasingly long-term, large pension funds, for whom a small allocation to ILS is considered a diversification.

As a result, A.M. Best says that it “does not anticipate a material withdrawal of this source of capacity following either large catastrophe losses or an increase in returns for other asset classes.”

At the same time there are an increasing number of broker facilities, which turn the typical London market syndication of risk model upside down, to a degree, and are further disrupting the market.

On broker facilities the rating agency warns; “Underwriters should exercise caution when participating in pre-brokered facilities, mindful of the diminished ability to influence risk selection and pricing, as well as the associated costs.”

Best notes that underwriting panels are shrinking and some of the smaller following London insurance or reinsurance markets, such as smaller Lloyd’s syndicates, are falling off the bottom of line slips. We’ve noted this before, as there are now ILS managers that appear higher up these slips than many Lloyd’s syndicates, as they can deploy larger line sizes.

That is applying greater pressure through the London market, as re/insurers struggle to find something to add to their offerings to better, or lock-out ILS capital and other new competitors. The expansion of terms and conditions is one way that traditional insurance or reinsurance players have been fighting back.

Traditional London market re/insurers have been using terms and conditions to protect market share, according to A.M. Best, by offering terms that it is hard for ILS or third-party capital to replicate. The use of multi-year deals, reinstatements or broader coverage are all increasing exposures assumed.

The rating agency stated; “A.M. Best is concerned that a relaxation in terms and conditions will adversely affect results in the London market over the next few years and is closely monitoring how individual companies manage any subsequent increase in exposure.”

Taking on a greater amount of risk through expanded terms, while the prices are depressed due to the softened market, is a key risk to insurers and reinsurers that if not well-managed could result in issues further down the road.

Any uptick in catastrophe loss experience, particularly if a loss is magnified due to some expansion of terms, perhaps something like the hours clause, and the re/insurance market could see some players dealing with an outsized share of the market loss.

That could show up any underwriters that have been offering broader terms, but without adjusting the way they diversify to compensate, resulting in concentrations of risk or greater exposure to certain loss scenarios or an aggregation of loss events.

A.M. Best explains; “Strong underwriting discipline, as well as prudent management of capital and aggregate exposures, will determine which companies are able to absorb any catastrophe losses and maintain capital strength.”

Similarly, A.M. Best warns companies that are seeking to expand into new lines of business and emerging risks such as cyber that with loss history often lacking, it is important to monitor any potential for aggregation of exposures and to have loss limits in place.

London market re/insurers are increasingly looking to manage third-party capital, partner with an ILS specialist, or look at ways to bring institutional investor money into their underwriting in order to boost line size capacity.

The use of special purpose syndicates (SPS) at Lloyd’s is one way this is being achieved, using the vehicles as a kind of reinsurance sidecar, typically entering into quota share agreements with them. In addition some now have ILS fund management units of their own, enabling them to manage third-party capital, benefit from fee income as well as increase capacity.

At the same time the Lloyd’s insurance and reinsurance market is increasingly a target of ILS fund managers and institutional investors, with a number of ILS players already active in the market. That number is expected to increase, as Lloyd’s acceptance of ILS capital grows over time.

The Lloyd’s market saw a combined ratio of 87% in 2014, slightly up on the year before. However A.M. Best notes that this has been helped significantly by lower than average catastrophe losses and prior year reserve releases.

Catastrophe and large losses added just 3.4% to the loss ratio in 2014, which is well below the ten-year average of 11.3%. At the same time reserve releases reduced the loss ratio by 8%, a figure which is not expected to grow and may dwindle over coming years.

So it’s easy to see that a return to normal losses, combined with a slow down in reserve release amounts, would get the Lloyd’s market closer to breakeven, in terms of combined ratio. Add to that the potential for any loss aggregation, or outsized losses, due to expansion of terms and conditions and it’s easy to see why A.M. Best is concerned.

At the same time, some companies in the London market have been taking advantage of attractive reinsurance market conditions and the rise of ILS to reduce their catastrophe aggregate exposure.

A.M. Best notes that alternative capital can be a partner as well as a competitor, adding that there has been an increased use of industry loss warranties (ILW’s) and catastrophe bonds, as London re/insurers seek balance sheet protection at attractive rates.

However, perhaps demonstrating that the London market remains behind the U.S. in terms of adoption of ILS capital, A.M. Best notes that London companies continue to approach new sources of capacity with caution, citing wariness of dispute risk and the potential for continuity issues.

In the U.S. it seems that primary insurance firms have got beyond these concerns, helping ILS capital, largely through collateralized reinsurance and cat bonds to play a role in many reinsurance programmes. London is still a little behind, A.M. Best’s comments would seem to imply.

“Successfully navigating a difficult and evolving operating environment is the biggest challenge currently faced by London market insurers,” A.M. Best concludes.

Traditional insurance and reinsurance business models are under threat, the rating agency says, as consolidation, alternative insurance capital structures and changed buying patterns result in increased competition.

“Strong underwriting discipline, as well as prudent management of capital and aggregate exposures, will determine which companies are able to absorb any catastrophe losses and maintain capital strength,” the rating agency continued.

“How individual insurers fare will depend on how each adapts to the changing market environment,” A.M. Best says, which underscores the focus on discipline. Any re/insurers that have let discipline slip, in the expansion of terms and underwriting practices, are likely the most at risk.

A.M. Best notes that going forwards there is expected to be a “greater divergence in the competitive position of market participants.” Companies that are better able to be flexible while leveraging specialist expertise are the ones the rating agency believes will hold the stronger position.

A.M. Best’s concern over relaxation of terms and conditions will apply to more than just London of course, it has just focused on that in this report. The same concerns will be held across other re/insurance markets where the same expansion of T&C’s has been happening as traditional markets seek to compete with ILS and new capital entrants.