Structural change, lower margins, a deeper reinsurance convergence

The global reinsurance industry is looking at a period of structural change and reduced margins, as the industry comes to terms with the new environment of excess capacity, both traditional and alternative, higher competition and lower rates.

So said analysts from ratings agency Fitch Ratings at its global reinsurance briefing event held this morning in London, an event where the rating agency commented on recent market trends and gave its outlook for the space over the next 12 to 18 months.

Fitch Ratings maintains a negative sector outlook for the reinsurance market, with a currently stable ratings outlook, as do the other major rating agencies. Fitch said it expects the negative sector outlook will remain for the foreseeable future as there is currently no sign of any factors changing the market or improving the outlook for the next year or two.

Fitch predicts a period of structural change for the reinsurance market, something it says has already begun in the highly competitive U.S. property catastrophe reinsurance segment. This is the single area of the reinsurance market most impacted by the influence of alternative capital, insurance-linked securities (ILS) and catastrophe bonds and as a result has seen the most rapid change.

This structural change, with pricing now driven by capacity and competition, as well as the appetite of different markets for different types of risks, is perhaps one of the most fundamental changes seen in the reinsurance market in years. Lower cost, or more efficient, capital from ILS specialists has taken a chunk of the U.S. catastrophe market, while traditional reinsurers have competed hard for market share resulting in growing price pressure.

This trend looks set to continue and could result in a tiered market, with different types of capital or capacity provider targeting different return hurdles on business underwritten. This could result in the market splitting, with the risk and return appetite of reinsurance capacity providers driving underwriting decisions, which might at least help cedents and perhaps calm down some of the extreme competition seen at recent renewals.

Fitch forecasts a small increase in premiums written among the reinsurers it rates in 2015. However, any increase in premiums written will likely be at reduced margins compared to 2013 and 2014, perhaps meaning a less profitable underwriting year is ahead.

Fitch also forecasts that property catastrophe reinsurance pricing could decline more steeply in Europe and Asia, than in the U.S., for 2015. This would not be that unexpected, given that U.S. rates have led the softening market down and rates in Europe and Asia have yet to catch up. Fitch said that reinsurers may divert capacity to other catastrophe markets now that U.S. rates are so low.

This is where a slow down in positive reserve releases could become a real issue for some reinsurers. Many have effectively been topping up earnings with favourable reserves in the last year, something other rating agencies have highlighted will not continue for ever. If that begins to slow down, at the same time as margins compress even further on renewal business, it could push some reinsurers into a corner where they are underwriting for a much lower return than in the previous year.

Looking ahead to the January renewals, where rates are expected to decline further although perhaps not as much as seen in June or last January, they could herald the start of a much lower margin year for reinsurers. Business underwritten at the January 2015 reinsurance renewal could be at lower rates than a year earlier. Reinsurers have bemoaned the returns on some business during 2014, but if contracts are signed at even lower rates the margins could be shaved further and earnings throughout 2015 become as a result lower.

This structural change being seen in the market and the continued impact and competition from alternative reinsurance capital and ILS will result in traditional reinsurers finding their positions weakened. If alternative capital stays in the reinsurance market we could see a true shake-out of competitive positions, potentially resulting in this split or tiered market (based on capital) we mention above.

The outlook is not exactly rosy for traditional reinsurers.

Continued heavy competition in key markets resulting in further reinsurance rate erosion will negatively affect reinsurer margins. Continued loosening of contract terms and conditions will also negatively affect margins as well as risk reinsurers being hit by outsized or unexpected losses. Continued expansion into new areas of the market, such as specialty and casualty risks will result in price erosion expanding and softening broadening, again with the result of negatively affecting reinsurer margins. Continued entry and uptake of alternative capital, as ILS, catastrophe bonds and capital market investors take a larger reinsurance market share, will also (you guessed it) negatively affect reinsurer margins.

Given the way the reinsurance market environment has played out in recent months we cannot see any of these trends stopping in the near future. All have an exacerbating effect on each other, resulting in greater competition, price erosion, broader diversification, additional margin dilution and often making more opportunities for alternative capital to step in.

All of these trends continuing will soften the reinsurance market cycle, shorten any hard markets, reduce the amount of time reinsurers have to earn back their losses and potentially turn the market we know today on its head.

As a result the structural change that many now believe has begun to impact the reinsurance market may be a long way from over. Quite where the reinsurance market ends up a few years down the line is very hard to predict. But it is increasingly looking like we will see a more capital-source agnostic reinsurance market, with the lines between capacity providers becoming increasingly blurred.

We’ve seen or are still seeing, depending on your view, a convergence of capital. This structural change now being witnessed could result in a much deeper convergence as new business models and innovative products, sometimes developed by ILS or new forms of capital and sometimes by traditional firms, look set to disrupt and then become adopted within the broader reinsurance market.

It’s going to make for an interesting few years ahead.

Read our other stories on Fitch’s recent reinsurance market reports:

– Alternative reinsurance capital to fuel M&A deal-making: Fitch.

– Global reinsurance profits down, outlook still negative: Fitch.

– Asian insurers look to diversify risk capital, cat bonds one option: Fitch.