S&P warns on reinsurers protecting profits through reserve releases

In the current soft reinsurance market environment, some reinsurers have been relying on prudent reserving and timely releases of capital to protect or enhance their profits. But with major losses remaining absent from the market, dwindling reserves could come back to bite.

Rating agency Standard & Poor’s warns today that reinsurers who have either not been reserving prudently enough, or who have been releasing reserves to mask lower profit performance in the soft market, may be companies to watch for sudden dips in performance.

The competition levels in the property and casualty reinsurance market are fierce and have been so for some years now, S&P notes, adding that there is currently no sign of this trend reversing as excess capital and low losses remain a feature of the market.

Additionally the abundance of third-party and alternative reinsurance capital, largely from ILS funds and other institutional investors, is exacerbating the pressure on P&C reinsurance companies.

All of this pressure from capital, competition and the impact of low losses has resulted in a difficult market, where “margins have become tight enough to strain reinsurers’ ability to maintain their market positions while remaining profitable” S&P explains.

Lower investment returns have also been a factor, as reinsurers used to be able to leverage these to offset changes in technical underwriting result. But that tool has been drying up while the financial markets have been in flux, resulting in a trend towards alternative investments for some, but additional pressure for others.

Since the reinsurance market began to soften, which S&P sees as having begun in 2007, the rating agency notes that it has witnessed some companies supporting their combined ratios through the release of more of their prior year reserves.

Here prudence is vital, S&P notes. Those reinsurers who have prudently built and released reserves over the years stand a better chance of maintaining reserves and having more to release over a longer period of time, ultimately helping them to navigate the soft reinsurance market better.

Companies who have drawn on reserve releases too quickly, on the other hand, could find them dwindling, and may ultimately find that their reserves become insufficient to support profits, returns and combined ratios, resulting in a slow, but steady, climb towards and perhaps over 100%.

With rates and pricing still soft and no sign of reinsurers having any ability to significantly raise them, reinsurers rely on capital management to support profits and reserves play a role in that. However the disparity between the way reinsurance firms have been managing and releasing reserves makes it difficult to compare, underwriting results S&P notes.

The more conservative may choose to take longer to realise positive prior year development and to release their reserves, resulting in smoother performance, while those who release more quickly or aggressively may find performance volatility more common, the rating agency continues.

S&P says; “We consider that reinsurers with strong reserve margins will experience less volatility in their financial results and at the same time will be able to maintain their respective market positions. ”

But here’s the current situation that some reinsurance firms will face. A soft market, high competition, lower pricing, increasing levels of capital both traditional and alternative, capital having been returned to shareholders in recent years and then suddenly reserve releases start to run low.

We’ve written before that reinsurers returns on equity (ROE’s) have become supported by their reserve releases, with research from a number of sources saying that ROE’s would be more accurately quoted in mid-single digits, if reserve releases were taken out and catastrophe losses suddenly normalised. Broker Willis Re said an average of 5.9% is more realistic currently.

S&P notes that we’re coming up to the expected end of reserves for the loss heavy 2011/12 period, as catastrophe reinsurance losses tend to be settled in two to four years.

“The 2011 and 2012 catastrophe claims are currently maturing, which we think partially explains the increase of reserve releases in recent years,” S&P says.

But with major catastrophe losses conspicuously absent from the reinsurance market in the last few years, S&P adds; “We expect a reduction of reserve releases attributable to natural catastrophe events, because there have been relatively few catastrophe claims in 2013 and 2014.”

Additionally, longer-tailed business lines have not seen any major shocks in recent years, so again, similarly to catastrophe losses, reserves have not been building as quickly in the last few years as they had previously.

As a result of all of this, S&P notes there is some subjectivity in determining reserve adequacy. The impact of reserve releases on the combined ratio of the reinsurance market has begun to decline in recent years, after a few years of steady growth.

The dwindling contribution of reinsurance reserve releases to the market's combined ratio

This downward trend in reserve release contribution to the combined ratio will impact the performance of the reinsurance market. Here, those companies which have been most prudent will perform the best and we could see a divergence of combined ratios and ROE’s, to a degree.

Perhaps those reinsurance firms which are shorter-tailed and underwrite the most property catastrophe risk could be most exposed to this risk, as their reserves will be shorter and the last few years of very low catastrophe loss experience will not have enabled them to rebuild the reserves.

On top of much lower pricing from the last few years of underwriting, plus broader terms and conditions, ultimately leading to a greater degree of risk being taken on at a lower return, this additional reserve related risk will be closely watched by investors in reinsurers and is another area they will be testing their risk management skills on.

Protecting profits, returns and the combined ratio through reserving and releasing capital prudently is a strategy that has been part of the reinsurance landscape for many years. Managed well, it’s a valid way to smooth the performance of a reinsurance firm. Managed poorly, it could result in sudden volatility.

The issue currently is that we’re in a reinsurance market the likes of which have perhaps never been seen before. Any external shock, such as jump on loss experience, exacerbated by broader terms and lower priced underwriting, could be enough to show up anyone who has been less than prudent in reserve management, making S&P’s warning timely.

S&P concludes; “Based on our analysis, we anticipate that after the next big catastrophe event or liability shock, reinsurers that were prudent in how they handled reserves could see less volatility in their annual results. However, if they consume a significant proportion of their reserve surplus in protecting their reported profit, we would consider their financial risk profile had been eroded.”

This all comes down to effectively managing the reinsurance market cycle, as well as being equipped to deal with the structural change seen in the market. As we’ve written before, the key is to be ready and able to manage the fallout if or when the music stops.

Read other articles on this topic:

– Reinsurance price pressure to persist, ROE’s to struggle: A.M. Best.

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

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

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

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