Reinsurer returns on equity more realistic at 5.9%: Willis Re

The return on equity figures that reinsurance firm’s have been reporting recently have been artificially boosted by low levels of catastrophe losses as well as positive prior year reserve releases, according to a new report from broker Willis Re.

Underlying returns on equity (RoE) are in reality much lower than the 11.5% aggregate, from companies providing a catastrophe loss disclosure, that Willis Re has recorded from reinsurers included in its newly launched Willis Reinsurance Index.

The aggregate reported is a healthy figure, but Willis Re has calculated that a more realistic representation of reinsurer performance may be to assume a more typical catastrophe loss year and to exclude prior year reserve releases.

When these adjustments are applied, the 11.5% return on equity aggregate drops to just 5.9%, a level that would clearly be inadequate for many shareholders if reinsurers were to report such a figure.

Willis Re’s new report highlights data and analysis from the new Willis Reinsurance Index. Using the Index the report places global reinsurance capital at $425 billion, an unprecedented level of capital which is adding to the strain on reinsurer RoE’s.

“The growth in global capital dedicated to reinsurance continues to exacerbate the challenge of oversupply, placing further pressure on already weak rating conditions for the remainder of 2015,” Willis Re explains.

Willis Re recorded a 5% increase in global reinsurance shareholder equity in 2014, taking the total to the $425 billion, which includes non-traditional sources such as insurance-linked securities (ILS) fund capital as well.

This growing capital base has been compounded by a third consecutive year of low global catastrophe losses, which Willis Re’s report estimates were down around 25% in 2014, compared to 2013, at just $35 billion.

“Market pressures are now manifesting themselves in diminishing underlying Return on Equity (RoE), which continue to be supported by prior year developments as well as the below average catastrophe losses,” the report explains.

John Cavanagh, Global CEO of Willis Re, commented on the reports release; “The market is being squeezed from all directions with underwriting and investment conditions compounded by the oversupply of capital.”

While excess capital has exacerbated the softening of reinsurance rates, which has led to the significant decline in RoE’s, the inability of the sector to put capital to work is now becoming a real problem for some.

Capital management, through returning excess capital to investors or shareholders, or acquisitions, or other means, can only go on for so long. At some point shareholders will have to begin to question why reinsurers are having to return capital when new start-ups continue to be formed (after raising more capital) and ILS players continue to grow and find ways to utilise their collateral.

Are reinsurers trying hard enough? Is there a lack of innovation in certain sections of the industry which means reinsurers have nothing more productive to do with excess capital than return it?

Of course it’s not that simple. Many reinsurers are trying to expand, diversify and innovate, but it’s not a quick process and it takes time for new initiatives to become mature enough to soak up the excess capital in the sector.

“For the time being, reinsurer RoEs continue to be flattered by low catastrophe losses and strong support from prior year reserve releases, but the continuing shift of the reinsurance market reflects the required balance sheet scale and breadth of product offering required for reinsurers to remain relevant in this highly competitive market,” Cavanagh explained.

Artemis has been reporting for some time that RoE’s are being masked by reserve releases, low losses and excess capital and it’s useful to have a figure to now compare. The 5.9% average underlying RoE is akin to an average investor return from a diversified, balanced and lower risk ILS strategy in the current market.

As reserve releases taper, with no new major events to be reserved for, the RoE’s will slide whether underlying or not. As expenses remain at historic levels, we see no significant sign of reinsurers looking to control these in recent results, and if catastrophe losses jump back to average levels, the RoE’s could deteriorate rapidly.

At that point reinsurers may come under pressure to hike rates, in an attempt to boost returns and generate some of that all important payback. However the amount rates can be hiked and how much payback can be recouped is now going to depend on how aggressive alternative and ILS capital wants to be.

Reinsurers risk getting into a situation where they need rate hikes to maintain returns but direct capital markets investors refuse to support them and are able to undercut their pricing, winning over larger shares of core markets.

That would exacerbate the problem, bringing more third-party capital into the space, which would flatten any rate hikes and perhaps see softening begin again rapidly. The pressure on RoE’s therefore may not let up at all and in fact market conditions could become more challenging after the next losses, rather than any easier.

Supposition of course, as is so much forward-looking commentary on reinsurance in a market that is changing so rapidly. However it is clear that with underlying returns shrinking reinsurers are in as tough a spot as ever, with no sign of it easing dramatically except perhaps after some truly remarkable and outsized losses.

Willis Re’s report shows that underlying RoE’s were an estimated 6.7% in 2013 and then fell to 5.9% in 2014. With rates having softened further throughout 2014 at every renewal and continuing to do so at 2015 renewals, what could we expect in terms of a number for 2015?

With prior year reserve releases thought to be slowing for many reinsurers, losses remaining low, capital continuing to flow in, on top of price declines, we’d expect the number to be even lower if nothing changes dramatically.

Add to that the effect of reinsurers increasingly working with alternative capital and ILS investors to share some risks, in order to source lower-cost capital in return for management fees, that could be eroding the RoE earned from underwriting that might once have sat on the balance-sheet.

Willis Re’s report explains a little more on this topic, saying; “The convergence of reinsurance and capital markets continued to heighten the need for diversified product offerings. Many reinsurers continued to expand their underwriting on behalf of third party capital provided by ILS funds, providing an additional revenue stream without exposing their own capital base. But in doing so, reinsurers are facilitating capital in the market and pushing price down.”

So there is a case for thinking that reinsurers may, to a degree, be exacerbating the issues they face. However it’s a case of having to try for many, better to be attempting to navigate your way out of a challenging position than to sit back and watch returns be eroded.

Looking ahead the market will face continued challenges Willis Re believes, with no sign of any change in conditions ahead. “The Willis Reinsurance Index underscores the challenging outlook for the reinsurance industry,” Cavanagh said.

Also read:

– Soft market, third-party capital top reinsurance survey concerns: Xuber.

– Expense efficiency becoming vital as re/insurance ROE targets drop.

– Soft reinsurance market to show who takes ROE seriously: Munich Re.

– Reinsurer valuations too high, even at lower cost of equity: Deutsche Bank.

– Stand-alone reinsurance model may be unsustainable: Goldman Sachs.

– Managing the cycle & risks key, but reinsurance ROE’s set to decline: A.M. Best.

– What happens when the music stops (reserve releases run dry)?