Stabilising prices a false hope for reinsurance profits: Fitch

The reduced profitability of global reinsurers will be a key risk for the industry in 2017 warns Fitch Ratings, suggesting that some companies could see their ratings impacted by profit deterioration. Fitch also warns that reports of stabilised prices are a false hope for increased reinsurance profits.

With the expectation that premiums in the global reinsurance industry will continue to fall and investment returns will remain minimal in light of low interest rates, Fitch expects reinsurers’ profits to reduce further in 2017.

A trend that is driving the rating agency’s negative outlook for the sector, explains Fitch, in a new outlook report on the global reinsurance industry released in time for the 2016 Monte Carlo Rendez-vous.

Importantly, Fitch explains that profit deterioration is a key rating sensitivity, and with the expectation that profits and investment returns will diminish further in the coming months, some could find themselves in a difficult situation not too far down the line.

“Fitch expects the majority of reinsurers to report lower profitability in 2017 compared to forecast 2016 results, driven by falling reinsurance prices and declining investment returns, especially on reinvested assets. This will make it more difficult for some companies to maintain underwriting and profitability credit metrics close to current levels,” said Fitch.

Profits are becoming increasingly difficult to achieve on both sides of the balance sheet, and as ample capacity, intense competition, and the benign loss experience combine with limited investment returns, reinsurers will likely find it harder and harder to achieve profitable returns.

The ratings agency states that should run-rate combined ratios move closer to 100%, or return on equity (ROE) fall below 10% then the rating outlook for the sector could change from stable to negative.

Currently, Fitch forecasts a run-rate combined ratio of 99.2% in 2017 and an ROE of 8%, reflecting the firm’s expectation that cat losses will rise to the long-run historical average. However, should there be an above normal level of cat losses, as seen in the first six months of 2016, then reinsurers will have even less room to manoeuvre and margins will decline further, and faster.

“An increase in 1H16 major losses led reinsurers to release prior-year reserves to supplement income. We believe the ability to generate a reserve surplus from earlier underwriting years will become ever more important and increasingly difficult,” said Fitch.

This notion has been underlined by a number of industry analysts and experts in recent times, which have warned that reserves could be running low for some in the industry and as a result the ability to mask true underwriting profits with reserve releases is dwindling.

“These tough market conditions could lead to rating pressure on smaller, less diversified firms that are reliant on business lines that have seen profit margins diminish. Thinning underwriting margins will also leave the industry as a whole more exposed to an uptick in major loss claims,” said Fitch.

In recent times there has been evidence of price stabilisation in certain business lines, but Fitch feels that any slowing of rate reductions witnessed at renewals so far in 2016, will have limited significance “in terms of improving the near-term profitability of reinsurers.”

“This is because the majority of classes that have exhibited stabilisation are those where cost of capital returns are close to or at breakeven. Classes likely to remain better margined continue to experience greater rate reductions, as reinsurers compete to retain or gain market share,” explains Fitch.

In an effort to avoid the most competitive business lines and improve returns, it’s expected that reinsurers will deploy more capital into sectors where returns are currently more attractive, which includes casualty. However, Fitch explains that this will eventually lead to pricing pressure in these sectors as competition ramps up, ultimately decreasing profits for more reinsurers across more business lines.

We’d also add that any move into new business lines will likely be followed by the insurance-linked securities (ILS) marketplace at some point in time, as ILS is increasingly looking to get closer to the original source of risk, and also avoid the competitive and lower priced business that the reinsurers are trying to moving away from.

In recent times the ratings agencies and other industry observers have highlighted the potential for further rate declines across the sector, and ultimately the expectation that profits will decline further for the reinsurance industry as a whole.

When the market does start to turn, which shows little sign of happening anytime soon, it will be interesting to see which companies were able to successfully manage the tough market conditions.

One consistent theme coming out of the general pre-Monte Carlo Rendez-vous thought-leadership deluge is that reinsurers need to evolve and fast, as simply standing still is not going to suffice.

That’s a message we’ve heard and been urging reinsurers to listen to for some time now, but clearly the urgency is rising and there is a growing expectation that we are going to see some more meaningful changes as the reinsurance business model evolves into something hybrid, or entirely new.

As the profitability of the global reinsurance industry comes under increasing pressure, the false-hope of stable pricing is not going to help reinsurers to navigate the structural changes facing the market.

Something more substantial will now be required for some of the small to mid-tier reinsurers to survive, we believe, which could suggest a wave of M&A as well as some dramatic strategic direction changes, as last gasp efforts to ward off unprofitability.

Read all of Artemis’ Monte Carlo Rendez-vous coverage here.