Reinsurance price declines to continue, profitability to suffer: S&P

Reinsurance pricing is expected to continue to soften at the upcoming January 2016 renewal season, with S&P forecasting further declines of around -5% across the market leading to an expectation that most reinsurers will find profitability waning.

Global reinsurance companies are expected to continue to face “elevated competitive pressures and industry risk” according to rating agency Standard & Poor’s latest update to its sector outlook.

Continued supply and demand dynamics are impacting pricing, with capital in the reinsurance sector at all-time highs and alternative capital from third-party investors expected to keep pressuring rates as well, the rating agency said.

At the same time the demand-side remains weaker, with buyers adjusting how they purchase reinsurance protection, resulting in lower demand and making organic growth difficult for reinsurers to come by.

As a result of the expected continuation of the pressures that have been seen over the last few years, S&P says that it expects that many reinsurers will “find it difficult to maintain strong profitability over the next 24 months.”

Today S&P joined fellow rating agency Fitch in forecasting further rate declines at the January reinsurance renewal, which it believes will result in declines across the market of around -5%. This is a lower pace of decline than seen a year earlier, but further declines will erode additional profitability for the reinsurance sector, leaving S&P to maintain a negative view on credit conditions in the marketplace.

With adjusted combined ratios for the global reinsurers that S&P tracks hovering around an expected 95%+ for 2015, a few additional points off pricing will hurt some companies, making it harder to maintain the levels of profitability that their shareholders have come to expect.

S&P says that it sees “no relief in sight” for reinsurers, as the risks to their businesses continue to increase rather than go away. This has left the large global reinsurers to search their playbooks for a strategy to counteract the difficult market conditions, which S&P believe has helped to a degree so far.

S&P said that “the defensive actions they (reinsurers) have already taken have helped to prove the industry’s resilience,” which leaves the rating agency to predict that although it expects reinsurers “competitive positions, earnings, and capital bases to remain under pressure over the next 12 months” it does not expect this to result in many rating actions.

The strong capital base of the sector is helping, as too is the shift in business mix to less-pressured lines, strong risk management, the focus on primary risks at some of the big players, the increasing use of reinsurance and retrocession, as well as the consolidation wave which increases scale and diversification for those involved.

These defensive measures have helped reinsurers to maintain capital levels, although perhaps the biggest two drivers of this have been the low-level of major catastrophe losses, combined with the prudent releases of prior year reserves.

The decline in pricing has been slower than S&P expected, the rating agency said, but it remains watchful for reinsurers who seek to take on more risk in order to maintain profitability in the face of lower rates.

The reinsurance industry is “demonstrating its resilience” leading S&P to call the industry risk level ‘intermediate’ at present. If S&P was to change that assessment to a more negative outlook it believes that less than half the rated reinsurers would be downgraded as a result, which perhaps reflects the defensive strength that the industry has managed to maintain.

Reinsurers continue to indicate that pricing is sufficient for them to maintain a return and meet targets, but despite this S&P says that its “earnings expectations remain low compared with the sector’s historically strong performance.”

While earnings are not expected to be stellar, S&P does say that it expects that the majority of reinsurers will be able to maintain their capital levels in the current pricing environment. Here discipline will come into play and those that maintain it will stand a better chance of hitting targets.

S&P believes that reinsurance market tiering is continuing to develop, with “barriers to entry for reinsurance changing and a divide forming.”

While alternative capital and ILS has broken down some barriers, the new trend towards larger companies through M&A is creating a divide once again. It’s the smaller players and the specialist Lloyd’s syndicates that may be the ones to suffer here, as they struggle to put out large enough lines to remain truly relevant to cedants and counterparties.

“Given the increasing sophistication of reinsurers’ clients, reinsurers must prove that they have the size, expertise, and reach to remain relevant,” S&P explained.

At the moment S&P views “operational barriers to entry” as moderate, but says that it is keeping an eye on this as the dynamic evolves rapidly.

“The best offense is a strong defense,” S&P insists, highlighting the strategies that have helped to insulate global reinsurers from market forces to a degree.

The question is how long this insulation can protect the mid-sized players. The very largest reinsurers seem assured of continued profitability, but as you come down the scale ladder the future looks very much less certain for many companies.

However, S&P warns that the defensive plays that are seen currently, while buying time, are not going to completely insulate companies from pressures if the market conditions remain negative with no improvement on the horizon.

“Earnings deterioration appears to be unavoidable,” S&P says, while the pricing declines continue and investment yields remain tough to achieve. At the same time the benefits from reserve releases look likely to become harder to maintain, as the loss heavy year reserves begin to dwindle.

“The results in the first half of 2015 support our view, as many companies are reporting weaker underlying results (adjusted for catastrophes and releases) than experienced in 2014,” S&P’s latest publication explains.

S&P forecasts a “combined (loss and expense) ratio of 95%-100% in 2015 and 97%-102% in 2016, assuming 10 percentage points (ppts) for catastrophe losses and 6 ppts of benefit from reserve release, and ROE of 8%-10% over the same period.”

It won’t take much in the way of a slightly elevated catastrophe loss experience, or reduced reserve releases to impact those figures and turn performance negative for individual companies. Hence the discipline and underwriting standards adhered to in recent years are potentially going to come to the fore, particularly once losses do rebound to more typical levels.

At that point the relaxation of terms and conditions could become more evident, as that could result in some companies experiencing outsized losses compared to the industry from an event, resulting in a rapid deterioration of results.

“The industry should be able to withstand these weakened earnings for the next two years, but we do not think these levels are sustainable over the longer term,” S&P warns.

That suggests that if the softening doesn’t stop, or at least we see no rebound in prices, profitability will be on a constant decline over the next few years unless companies can find a new growth avenue.

The result should be continued pressure to enter into M&A, diversify into new lines, move into primary insurance and also to leverage cheaper reinsurance capital to offset some of the risks assumed.

“A deeper review of reinsurers’ recent performance supports our expectation of continued deterioration. By stripping out reserve releases and catastrophe losses, we can observe the clear erosion of reinsurers’ underlying earnings,” S&P explains. “Pricing continues to decline, although more slowly than we originally expected, we anticipate that underlying loss ratios will continue to increase.”

S&P views the credit conditions as continuing to be negative for the reinsurance sector, with the catastrophe exposed companies the most at risk of declining profitability. While these companies have proven resilient to date, they are set to find it harder to compete over the coming two years, S&P warns.

Further consolidation is expected, as a result of the ongoing expectation for price declines and pressure, as reinsurers continue to look for a strategy to help them to avoid the worst of the pressure.

S&P’s outlook is as gloomy as most other observers. An expectation for pressure to continue to hurt reinsurers and for the smaller to mid-sized companies to feel the most pain in the years to come.

Defensive plays may be helping for now, but as prices decline again in January companies may begin to run low on options. Defense may be the best offense for now, but in 2016 we may need to see companies being a little bolder and looking for new and innovative opportunities for growth, if they are to escape the mounting pressures.

S&P global reinsurance outlook infographic (click for larger version)

Also read:

– Reinsurance has an identity crisis, increasingly like ILS – S&P.

– Reinsurers’ management of catastrophe exposures diverges: S&P.

– Berkshire Hathaway copycats will pressure reinsurance pricing: S&P.

– Reinsurance M&A no panacea, but momentum to continue: S&P.

– Reinsurer net investment yields down 30% in four years: S&P.

– Alternative reinsurance capital pressures ASEAN insurers: S&P.

– S&P warns on reinsurers protecting profits through reserve releases.

– ILS market growth should not be at the expense of discipline, S&P warns.

– M&A won’t stop the tide of reinsurance price declines: S&P.