Reinsurance margins heading ‘below acceptable returns’: KBW

Modest rate decreases are expected across almost all reinsurance and commercial insurance lines over the next few years, unless something happens to turn the market, “eventually compressing underwriting margins below acceptable returns” according to analysts at KBW.

Margins are already thin in reinsurance and heading that way in commercial insurance lines of business, but Keefe, Bruyette & Woods analysts led by Meyer Shields expect they may get thinner.

“The second derivative of commercial and reinsurance pricing is negative in virtually all commercial and reinsurance lines of business,” the analysts explain in a recent report timed to coincide with the 2015 Monte Carlo Reinsurance Rendez-vous.

Property catastrophe reinsurance is a surprising exception, but that is due to the fact that rates are now bottoming out, due to weakened expected margins after two or more years of rate declines. As the rates are bottoming in this sector the capital inflows have slowed, which is helping to level off pricing in some regions and perils.

But across the rest of the reinsurance world continued rate decreases and resulting margin erosion is expected to continue, while conditions in the market remain the same and major losses remain absent.

Similarly, commercial insurance lines, under pressure due to diverting capital from reinsurers and also the entry of some alternative capital into some areas of this market, has resulted in a market state of “commercial rate increases are either decelerating or evolving into small rate decreases.”

Encouragingly, after speaking with many reinsurer and insurer management teams over recent months, KBW’s analysts report that the majority believe “competition is still rational, with companies’ behavior tempered by better premium and loss data and analytics on one hand, and still-low interest rates on the other.”

KBW notes that this is “probably true”, but with prices still on the wane it’s hard to believe that every re/insurer is being rational in its underwriting at recent renewals. In fact, with the expansion of terms it is almost certain that companies are taking on more risk than ever, at pricing perhaps nearing the lowest points ever. Is everyone being rational? Only time will tell.

But more worrying for reinsurance and commercial insurance management teams is what this will mean in years to come, if indeed there is no real upward change in pricing, or if the cycle now does not respond as companies have historically been used to.

“Pricing cycles have their own momentum, and we expect modest rate decreases for the next few years, eventually compressing underwriting margins below acceptable returns,” KBW offers.

And in fact, KBW is not convinced that a major loss event is the most likely catalyst of market turn at all.

“We think that loss cost inflation inflection is a much likelier catalyst of an eventual market turn than, say, a major weather-related loss, reflecting the vast amounts of traditional and alternative capital available to underwrite catastrophe risks and the fact that advanced modeling means that few investors would actually be surprised by a hurricane or earthquake,” they explain.

If underwriting margins are no longer making acceptable returns, with re/insurers perhaps struggling to make their cost-of-capital, where do the extra few percentage points of performance come from to help them to survive?

The asset side of the business? Perhaps, if they all increasingly embrace alternative investments, or at the least add some risk and duration to the portfolios. Otherwise there is no sign that interest rates are going to rebound sufficiently to help re/insurers for at least a number of years.

Reserve releases? Again perhaps, if the companies in question have reserved prudently and not released to quickly in recent years. With no major catastrophe loss events for a few years now, the reserves have not been rebuilding at rates seen pre-2012, which could suggest that those not reserving and releasing prudently may see the benefit of prior years decrease, rather than support waning margins.

Where else? New initiatives, innovation, technology adoption, entry into new lines of business, reinsurers moving into primary lines and primary insurers moving into reinsurance. Of course this will help those that are bravest and most innovative, but in many cases largely just ramp up competition and apply even greater pressures.

Efficiency? Reducing costs, almost guaranteed to be a focus in years to come. Scaling back on lines of business that aren’t returning margin, again likely to happen. Stepping out of catastrophe risks to allow lower-cost capital to take that market? Perhaps drastic, but in years to come if conditions don’t change, you never know.

Adding fee income from other sources? Managing third-party capital from capital market investors through ILS vehicles and funds of course comes to mind. We do expect to see this continue to gather pace, particularly as reinsurers look to find ways to remove their own capital from lines that don’t meet their return requirements, but perhaps do still meet the return targets of efficient capital providers.

Lowering capital costs? Again, introducing third-party capital into the business can help to do this. Insurers are increasingly looking at how they can control more of their own margins, by extracting every ounce of premium from the business they underwrite as possible. Third-party capital self-reinsurance vehicles can help them to achieve this. Similarly, reinsurers operating sidecars can help to reduce their own capital costs, and again help them to optimise which type of capital underwrites which lines of business.

Of course, we at Artemis are slightly biased and do feel that alternative capital presents an opportunity for insurers and reinsurers to not only access efficient capital for reinsurance and retro, but also to enhance their own returns and margins, benefit from the efficiency themselves and also gain from fees.

The tightrope walk between welcoming alternative capital and ILS into a traditional re/insurance business and ensuring that it’s not eroding returns that could have been made on equity capital is one that many companies are going to walk in years to come.

It’s a balancing act, but one which re/insurers may have to get used to, as with margins waning there may be no choice but to make your capital more efficient.

Read all of our Monte Carlo Rendez-vous 2015 coverage here.