Soft market, new capital, structural change, the threats to reinsurers: Fitch

The reinsurance market is moving beyond simply being soft into something “more structural”, as low pricing and competition from ILS and alternative capital continue to threaten the traditional reinsurance model, according to Fitch.

Speaking at a roadshow event held in London this morning, Martyn Street, a Senior Director at Fitch Ratings, said that the threat to traditional reinsurers remains and shows no signs of abating, as the sectors evolution is “moving beyond a soft market into something more structural.”

The soft market and reduction in pricing, which has begun to spread beyond just property catastrophe risks to broader swathes of the reinsurance market, remains the main threat. Alongside this the lack of investment returns are a threat, especially to some larger players with longer-tailed business to invest the assets from, Street explained.

However, with a soft market now in its third year, according to Street, the intense competition, sluggish demand from cedents, as well as the “enduring onslaught of alternative capital, are resulting in structural change which could mean the reinsurance market never looks quite the same again.

Street gave a typical overview of who is most at risk, highlighting the select group of smaller monoline reinsurers that have large property catastrophe books to manage. At the same time the largest and most diverse are increasingly becoming a “tier 1” of reinsurers and these are the most insulated from the structural changes and competition from ILS and alternative capital.

One interesting point Street focused on is reinsurers positive reserve releases, which he said have been more sustained than Fitch had expected a few years earlier. However, Street warned that given the recent low catastrophe loss years since 2012 reserves have not built up to the levels they would normally for these years, which could suggest a continued slowing of favourable reserve releases unless well-managed by reinsurers.

On return on equity, always a favourite topic for investors in the reinsurance space, Street explained that ROE’s have been on a steady decline in recent years and are expected to decline further in 2015. Fitch projects average ROE’s will near 11% in 2015, but Street noted that below 10% some companies will struggle.

Fitch believes that ROE’s of 10% mark the average whereby certain reinsurers will struggle to maintain their returns on capital. Street noted that should the average net income ROE for reinsurers decline below the 10% mark it could be a trigger for Fitch to turn its ratings outlook for reinsurance to negative. At the moment the ratings outlook is stable, while the sector outlook has been negative since the start of 2014.

Key issues facing reinsurers include the continued “deterioration of pricing adequacy and terms and conditions” Street explained. Also the search for yield that some reinsurers are now starting out on, given the continued low-yield investment environment which could introduce greater volatility on the asset side. Finally the “structural change” which Street said threatens to weaken the competitive position of traditional reinsurers, not helped by alternative capital which he said would have a “long-term influence on parts of the sector.”

Specifically on alternative reinsurance capital and insurance-linked securities (ILS), Street said that he expects this to increase and that the conventional thinking now is that the new capital is “mainly permanent.”

Fitch itself views the capital as largely permanent and Street explained that there is a belief that by the year 2018 alternative reinsurance capacity could contribute as much as 30% of global property catastrophe reinsurance limit, a level which would indicate a near-doubling from the current size of the ILS market.

Street explained that the decline in property catastrophe rates is likely to continue, albeit at a slower rate than seen in the last two years, perhaps with a levelling off around 2017 or 2018. This could result in a “permanent erosion of profit margins” for reinsurers, Street said.

Some of Street’s comments raise one question for us, if alternative capital and ILS is permanent and set to near double over the coming years, what does that mean for reinsurer ROE’s? If Fitch is set to turn negative on reinsurers ratings outlook if average ROE’s slip to below 10%, that point may not be far away?

While the asset side isn’t contributing much in this low-yield world, reinsurance pricing is declining and the softness expanding, commercial primary lines are slowing, casualty looks increasingly soft, but lower-cost ILS capital continues to take a share of the once most profitable catastrophe space, shouldn’t ROE decline accelerate over the coming years?

In order to change its ratings outlook on reinsurance to negative, Fitch says it will be looking for combined ratios to get nearer and stay closer to 100%, or ROE’s to be sustained at below 10%. Those scenarios may not be far off for some players in the reinsurance market.

However, some reinsurance players may find they can perform better in the next few years, as efforts to diversify, expand, scale, grow internationally and move into primary lines begin to pay-off. Could this result in a tiering of the rated reinsurer universe? Would it be fair to apply the same ratings outlook to a severely under-pressure monoline player and a ‘doing quite well’ globally diversified tier 1 reinsurer? Perhaps not. Fitch and the other ratings agencies could have a busy and interesting few years ahead.

Also read:

– Reinsurers face potentially permanent erosion of profit margins: Fitch.

– Select group of reinsurers have necessary scale, diversity, strength: Fitch.

– Insurance and reinsurance mergers and acquisitions to increase: Fitch.

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