Soft market aggregation build up a risk for reinsurers: Fitch

There is a risk that some reinsurance companies may have picked up “unintended aggregations” as they fight to retain business and compete their way through the soft market cycle, which presents a risk of certain firms facing larger than expected losses, according to Fitch Ratings.

Global reinsurance firms have been competing strongly, both with other traditional providers of reinsurance capital as well as with the alternative capital markets and insurance-linked securities (ILS) funds.

This, alongside the build up of record capital levels in the reinsurance market and the benign catastrophe loss environment, has resulted in a steady decline in pricing, as well as expansion of terms and conditions across property catastrophe lines in particular.

One of the unintended consequences of this soft market environment is that some reinsurers have been seeking to maintain a foothold in certain catastrophe markets, even when rates may not meet their return requirements and terms are broadened.

“Given the lack of large recent catastrophes and deterioration in market fundamentals, there is a greater chance that any individual reinsurer may have picked up unintended aggregations to retain shrinking business that will only manifest when a sizeable catastrophe event occurs,” Fitch Ratings explained in a report on global reinsurers first-half results.

Martyn Street, Senior Director at Fitch, went further saying that the next major or complex catastrophe could be “unfavourable” for some reinsurers.

Underwriting at or near cost-of-capital is a dangerous trend and one which in some markets continues, as reinsurers wield their global diversification in order to compete and retain business.

The risk is that broader terms and a more competitive edge result in poorer underwriting decisions being made, than you might see in a harder, less competitive market. This puts some reinsurers at risk of aggregations, when the next major catastrophe events occur, Fitch believes.

We’ve been highlighting this risk for a number of years now on Artemis, as it became clear that for some reinsurers underwriting is no longer strictly making their cost of capital anymore. As the softness persists the risk is rising with each renewal season we pass through, so it is encouraging that at recent renewals the discussion of a pricing floor has become louder and expectations for key January 2017 renewals are for more stability.

But there are markets where the diversification factor has been utilised to the limit, with rates on some property catastrophe accounts in Europe, Japan and other regions so low now that pricing is at expected loss levels, or even below.

Even the very largest reinsurance companies in the world now stand at risk of unintended aggregations appearing, should a very complex loss occur in one of these regions. Yes, diversification helps them to reduce prices, but it does not protect them against losses, and the magnitude of an event cannot be diversified away.

Another interesting point to add to this discussion is the reinsurer owned third-party reinsurance capital vehicle, ILS fund or sidecar.

Some reinsurers have openly stated that they utilise third-party capital when a risk no longer meets their own return requirements. Is there a risk of aggregations hitting third-party capital structures, but not a reinsurers own balance-sheet?

Perhaps. If that happened it could raise all sorts of questions about alignment of interests, whether multiple balance-sheets are the right way forwards, if risks are being placed based on return requirements of the capital and be detrimental to the reinsurer sponsored ILS vehicle idea as a whole.

Of course, not all reinsurance firms operate ILS and third-party capital vehicles in this way, with many having very strong alignment of interests. But there are some that openly discuss the passing of less desirable risks (based on their own portfolio requirements) to third-party investors.

This isn’t a problem if investors are aware and informed, but if they’re not it could come back to bite the reinsurer sponsors of such vehicles.

Aggregation risk is always an issue for reinsurers, but in a soft market it is heightened and amplified by the length of a soft cycle. ILS funds are not immune and some would also likely feel the aggregation effects of a major event hitting a soft market portfolio. This is an issue for everyone to be aware of.