Capital market threat could be reinsurance game-changer: A.M. Best

The latest report on the global reinsurance sector from rating agency A.M. Best suggests that the market may be at an apex point, with the only way being down as the impact of recent trends including the capital markets threatens to be game-changing.

A.M. Best gives the reinsurance sector a stable rating outlook, but warns that this will be reviewed after the mid-year reinsurance renewals after which the outlook may change to negative if there is no change to the current build-up of pressures on reinsurers.

Of the threats that the reinsurance industry faces, A.M. Best notes that the external threat posed by the capital markets, flowing capital into the sector through insurance-linked securities (ILS) and collateralized reinsurance structures with potentially vast amounts of capital to come, is of concern and could be the real game-changer.

The report from A.M. Best, titled ‘Could 2013 Be the Apex of the Next Few Years?’, reviews and condenses many of the trends written about recently here on Artemis into a single piece. It discusses the build-up of pressure on reinsurance pricing and on reinsurers, with threats from both internal and external competition and capital and suggests that the tipping point, or apex, for reinsurers may have been reached.

Best says that 2013 was a miraculous year for reinsurers, as they overcame adversity to turn in a very respectable profit. Low-levels of catastrophe losses was the main driver of this profit aided by favorable prior year loss reserve development. Despite this Best says it would be foolish to lose sight of what lies ahead for reinsurers, which it describes as potentially much more treacherous.

The report goes into the build-up of capital, both traditional capital from reinsurers with low loss experience and high profits as well as the increasing non-traditional capital from capital markets investors, pensions funds, hedge funds and private equity investors entering the space.

Best notes that the influence of this capital is spilling outside of the property catastrophe lines of business, as reinsurers look for rate environments that are more conducive to capacity deployment. Primary insurance is included in this now, as an area that some reinsurers have sought to deploy more capital, and the rate environment there is becoming increasingly tepid.

The investment environment is also not conducive to maintaining profits for reinsurers, with low-interest rates meaning that the typical reinsurer investment strategy is not able to recover any lost margin on underwriting. Best notes the emergence of more focus on the asset side, with riskier strategies and more active investment policies at reinsurance start-ups, something that we may see established reinsurers looking to dip their toes in if profits cannot be found elsewhere.

A.M. Best says that the best hope for reinsurers is that softening rates and relaxed terms and conditions remain within rational bounds. Taking on unprofitable business or too much risk could end in disaster under the current market conditions for some reinsurers if strict enterprise risk management practices are not adhered to.

Best comments on capital management that returning capital through share buybacks and dividends may be a better choice than deploying capital into unattractive reinsurance business, as Artemis has discussed a few times lately. Reinsurers inability to find new attractive opportunities for capacity deployment is a real challenge that only innovation and product development in new regions and emerging economies is going to help to solve.

If soft market conditions persist Best notes that mergers and acquisitions may become more attractive to incumbent reinsurers looking to deploy capital or to relinquish their responsibilities as individual players in the market and seek solace under a larger corporate umbrella.

The worst scenario is to overly relax underwriting criteria and to end up overexposed to complex and difficult events, something that relaxation of terms and a strong desire to deploy capacity is known to have caused before. With the market at an inflection point, Best notes the importance of diligence and a rational approach to underwriting at this time.

The mid-year renewals will mark an important point where the next chapter will begin to unfold, said Best. Artemis has been saying for some time that it is likely the Q3 results in 2014 where we may begin to see some effects of recent trends on reinsurers profits and expense ratio reports.

A.M. Best is suggesting that if the mid-year renewals show further declining of reinsurance rates and with no clear change on the horizon it may move its outlook for the reinsurance sector to negative. Best notes that at that time it will be interesting to see whether new capacity inflows continue to come into the market, as these may accelerate the deterioration.

Best questions the staying power of alternative capital:

It seems ironic that as underwriting opportunities have waned, the reinsurance sector has attracted additional capital to a market already saturated with it. Is this smart money or is it naive?

The reinsurance segment has performed well over the long term relative to the total industry. However, this was through a hard-market dynamic. The key phrase here is long term. Near-term results can be very lumpy. The greatest opportunities usually follow significant catastrophes when capacity is in relatively short supply. Now, it’s questionable whether capacity will ever be in short supply. After the $100 billion industry losses in 2011, there were some pockets of short-lived opportunity, but the magnitude of those losses did not move the market as might have been expected; it merely slowed the softening, and capital poured in.

As the common disclaimer states, historical performance is not a guarantee of future results. In the reinsurance business, many years of profit can be lost in the blink of an eye if accumulation controls are not prudent and underwriting and pricing parameters not sufficiently comprehensive. Investors beware! It is not as easy as it may look. Buffett wisely points out the old adage, “the other guy is doing it, so we must as well.” This psychology may be the real force behind the rush of alternative capacity.

This remains the big question for many, will alternative capital prove sticky in the face of losses or if the market continues to soften will its appetite wane? Artemis is still of the opinion that alternative capital is savvy, some (perhaps most) will prove sticky after a loss, some may decide to pull-back if rates decline too far, but post-event with any hardening there is an even more significant pool of capital waiting for opportunities within reinsurance.

Alternative capital providers that Artemis speaks with are aware of their limits as far as pricing and risk appetite goes and already some believe that cat bond rates may have reached a floor for certain perils and expected loss levels.

Best then explains some of its current concerns about the reinsurance sector which lead it to believe the future may look more negative.

“There are early indications that underwriting restraint may be waning as competition from alternative capital intensifies. The supply/demand equation of too much capital chasing the same opportunities has not only put pressure on reinsurance pricing, but also placed focus on reinsurance terms and conditions. The recently concluded April renewals revealed a worse than expected outcome for reinsurers as the abundance of worldwide capacity weighed on negotiations,” the report says.

Despite the competition in the reinsurance market capital continues to seek opportunities in reinsurance business and this is forcing the pricing pressure outside of property cat and into other lines of business. Primary insurers increasing retentions exacerbates this trend, said Best.

The potentially game-changing threat comes from the capital markets though, explained Best; “While the risk-sharing struggle between primary and reinsurance companies is significant, it is much different from the inflow of capital entering through insurance-linked securities (ILS) and into collateralized structures and even rated balance sheets. This external threat (with vast amounts of money) is of concern and could be the game-changer. These players’ ability to operate at a lower cost of capital is placing pressure on the traditional reinsurance model to become more capital efficient or increase investment returns by taking more asset risk.”

Best then suggests that a large loss could see unrated reinsurance players suffering a larger loss as a percentage of capital than rated players, which could change the status quo. It also notes that convergence capital remains in its early stages and that commitment, reinsurance acumen and appetite for risk must be considered.

Best agrees with other rating agencies who have said that the large and globally diverse reinsurers with an ability to also manage third-party capital remain the best positioned to weather the current trends.

You can access A.M. Best’s report via its website.

Here are a selection of recent articles from Artemis which discuss these reinsurance market trends:

– Watford Re, and start-ups, a blank canvas for reinsurance innovation.

– Reinsurance renewal prices fall by as much as 20% across sector.

– Alternative reinsurance capital to grow to $100 billion: BarCap.

– Will Lloyd’s look to embrace third-party reinsurance capital?

– Munich Re on competition and alternative reinsurance capital.

– Munich Re: Reinsurance market competitive as capital spills over.

– Zenkyoren sets the tone for April reinsurance renewal pricing.

– April’s reinsurance renewals to show alternative capitals influence.

– Traditional reinsurers challenged to compete on cost-of-capital .

– Willis warns reinsurers to stay relevant in a market in flux.

– Capital creates competition in casualty reinsurance, where next?