Reinsurer earnings deterioration obscured, pressure continues: Moody’s

The deterioration of earnings in the reinsurance sector is being “obscured” by the twin forces of positive reserve releases and the benign catastrophe loss environment, effectively enabling reinsurers results to look more positive than they are, according to ratings agency Moody’s.

In its latest reinsurance update Moody’s explains that the pressures witnessed in the reinsurance market in 2015 are set to continue into 2016, with excess capital and reduced demand likely to signal continued softening of rates.

“An abundance of reinsurance capacity and decrease in demand from primary insurers has created sustained pressure on reinsurance pricing and erosion of terms and conditions”, explained Simon Harris, Moody’s Managing Director.

As a result Moody’s outlook for the global reinsurance industry remains negative, reflecting this continuation of the trends of excess capacity and shrinking demand.

With interest from insurance-linked securities (ILS) investors and other sources of alternative capital seeking to access the relatively uncorrelated returns of insurance and reinsurance risk investments remaining strong, while traditional reinsurers face little in the way of losses, the build up of capacity shows no sign of slowing.

The subject of masked performance, due to the effects of positive reserve releases and the lack of major losses, of the combined ratio and earnings is one that came up repeatedly in 2015. Moody’s raises this again, saying that the extent of earnings deterioration has been obscured.

This suggests that reinsurers aren’t doing as well as their results would suggest, a fact that has not gone unnoticed throughout this year as some shareholders have sought to push boards to be more proactive in finding new revenues.

As a result Moody’s says that reinsurers ability to make their cost-of-capital is under threat, meaning that returns may be getting down to the level where underwriting becomes increasingly unprofitable.

At the same time reinsurers are trying to innovate or entering into mergers and acquisitions, in response to the pressures, but Moody’s notes that this comes with its own risks, as poor execution can result in meaningful threats to the business.

Alternative capital, meanwhile, is increasingly becoming embedded in the industry and is spreading beyond just property catastrophe reinsurance business.

This presents a continued threat to reinsurers that have not learned how to increase their own efficiency, reduce their cost-of-capital, or started to bring third-party capital within their own business structures.

Moody’s notes that alternative capital is both a “threat and an opportunity” for reinsurers. This has been said for many years now, but still and despite the ongoing pressure some reinsurers are failing to embrace the capital markets, thus not benefiting from the opportunity and turning this purely into a growing threat.

At some point in the not too distant future, we believe, it is going to be too late for reinsurers to suddenly try to embrace ILS and alternative capital as anything other than a cedent. The choice available for investors seeking professional management of their capital is growing all the time and additional reinsurer owned ILS asset management units may struggle to gain traction in the future.

Moody’s notes that alternative capital now makes up 12% of global reinsurance capacity, according to figures from Aon Benfield. While this is only slightly up from a year earlier and growth has clearly slowed, in response to the lower available returns, the trend for further growth looks assured as ILS managers increasingly find new ways to break down the risk transfer value-chain and get closer to the risks they underwrite.

At the same time catastrophe bond pricing is now broadly correlated with traditional reinsurance, according to Moody’s. If further strides can be made in reducing the frictional costs associated with issuance of cat bonds, the pricing could become so attractive that cedents increasingly seek to add a cat bond to their reinsurance programs.

Looking ahead, Moody’s expects reserve redundancies will dwindle, and lower releases will erode reinsurer returns. By masking pricing trends and loss development, reserves have been artfully used to enhance earnings reports, however Moody’s warns that the “subsidization of recent vintage business could lead to reserve deficiencies and an amplified effect on future profitability.”

It also begs the question of how reinsurers will be impacted by the next big catastrophe loss event, particularly a U.S. event where terms and conditions have stretched the furthest, and aggregate, multi-peril and multi-year covers are becoming the norm.

Some reinsurers could find the hit to earnings much larger than their modelling might have suggested to them, which could erode a significant amount of their profitability and capital base. Of course at that point there will be a push for rate rises, after which we would expect the capital markets to turn on the taps and alternative capital to flow meaningfully into the space. The threat to some traditional reinsurers under such a scenario could be severe.

The reinsurers most at risk of failing to meet their cost-of-capital are those most reliant on reserve releases, Moody’s says. However, the more conservative are likely to see their reserves continue to flow, aiding their ability to navigate the market pressures.

So no end in sight to the challenging and competitive reinsurance market conditions, according to Moody’s.

The longer the situation persists, the greater the pressure on earnings will be. Just how long the masking can continue to obscure the very real effects of the state of the market on earnings is unclear, but for some of the more marginalised reinsurers the moment of truth may not be that far away.