Swiss Re says capital management will stabilise reinsurance pricing

Global reinsurance firm Swiss Re said that, in the face of pricing pressure from alternative capital, traditional reinsurers capital management activities will help to decrease sector capital and stabilise natural catastrophe and other reinsurance pricing.

Swiss Re released its 2014 annual report today and announced that it was stepping up its own capital management again. The reinsurer is aiming to return CHF 1 billion through a share buy-back programme and to increase its dividend by 10.4% to CHF 4.25 per share with an additional special dividend of CHF 3.00 per share, to return CHF 2.5 billion to shareholders through dividends.

The reinsurance industry remains flush with capital, as low levels of major losses have allowed traditional reinsurers to become capital-rich, while at the same time capital market and institutional investors such as pension funds continue to allocate capital to reinsurance risks and insurance-linked securities (ILS).

Swiss Re believes that capital management activities of traditional reinsurers will be enough to counter the pressure on reinsurance pricing, by removing excess capital from the market so reducing the weight of pressure on rates.

That’s a pretty bold statement as capital management activities among reinsurers have been ongoing for a couple of years now and the pressure on pricing, particularly natural catastrophe risks, has not eased at all as yet.

In fact some of the strongest signs of pricing pressure being alleviated are currently coming from the catastrophe bond market, an area that traditional reinsurers would like to blame for driving down rates across the catastrophe linked insurance world. But here investors are displaying signs of reaching pricing levels where they are not prepared to fall below and this market has little connection to reinsurer capital management.

Chairman of the Swiss Re board, Walter B. Kielholz, is adamant that alternative capital and ILS is no threat to the reinsurer.

In the report he writes about “alternative capital forcing its way into reinsurance and trying to substitute for traditional reinsurance.”

“I do not think that Swiss Re is particularly vulnerable to such market forces and that the market available to us remains as large as it ever was,” Kielholz explains.

The annual report notes that alternative capacity in reinsurance grew to around $60 billion, or 15% of the global property catastrophe market, by the end of 2014.

There is no denying that alternative capital and ILS has exacerbated the softening in the reinsurance market, particularly in property related lines of business. However the record levels of capital at traditional reinsurers and the need to deploy that has also been having an effect.

While the catastrophe bond market shows signs of nearing a floor on pricing, as we mentioned further up, there are other areas of the property catastrophe reinsurance market where prices are still declining.

In particular the upcoming Japanese renewals are being cited as likely to witness price declines of 10% to 15%, while there is an expectation that June and July renewals will also see further pricing declines. All the reinsurance markets are still dominated by traditional reinsurance capital, especially Japan, and highly competitive traditional reinsurers right now, so while reinsurers are returning capital they are also deploying it at increasingly low rates.

Swiss Re explains; “Because pricing has been softening and traditional capital has been growing rapidly, reinsurers have stepped up their capital management efforts by increasing dividend payments and intensifying share buy-back programmes.”

“This will decrease capital and is expected to help stabilise prices for natural catastrophe and other reinsurance covers.”

Will it? Are the level of capital returns to shareholders really enough to drain the market of sufficient capacity to establish a floor under pricing, or are we simply more likely to reach a floor as traditional reinsurers seek to do the same as catastrophe bond investors and stop going any lower?

Given the length of time that capital management has been increasing in the industry and the fact that pricing continues to decline, including in areas where ILS and collateralized markets penetration is much lower, it would seem to suggest that capital management at current levels is not having much of an effect on pricing yet.

Maybe Swiss Re knows something we don’t know, perhaps capital management efforts are set to increase dramatically over the coming months, reducing sector capital and helping to put a floor under pricing?

It seems more likely that a pricing floor will be established through discipline, by underwriters (traditional or alternative) who refuse to deploy their capacity at any cost in order to maintain premium inflows. Unless we see that kind of discipline, while losses remain low and capital continues to rise in the sector, a slow and steady price decline could take rates down to near technical levels.

At that point we may suddenly see the levels of capital management required to really stop the decline. As if you can’t make your cost-of-capital on underwriting anymore you have no choice left but to return it.

If prices do get down to that level though, reinsurers may have much more serious problems and choices about their future to worry about. Right now they remain squeezed from all sides and capital management alone does not seem to be easing the pressure.

It’s worth taking a moment to reflect on the profitability metrics that Swiss Re announced today. Economic Value Management (EVM) profit, the reinsurers own measure of profitability, is down -67% year on year. EVM income is down -18%. Premiums and fees down -2%. But at the same time economic net worth is up 3%, demonstrating how even in a challenging market value can still be created by large reinsurers.

Profit margin for new business for 2014 came in at 7.7%, down from 9.6% in 2013, so reflecting lower pricing and hence lower profits on business underwritten. Where this is most stark however is in P&C reinsurance where profit margin for new business in 2014 was 11.8% compared to 17.5% a year earlier.

Economic return on capital employed for new business across Swiss Re is down to 13.7% from 15.3%. In P&C reinsurance its 16.4% compared to 20.9%. In Corporate Solutions, where Swiss Re undertakes large complex, insurance related risk business, the figures are down too, with EVM profit down a huge -81% and the profit margin on new business only coming in at 2.9%, compared to 7.6% a year earlier.

We’re being selective clearly in what we cover here, the life and health business shows signs of increased profitability in 2014 for instance, but not by enough to make up these declines.

Investment losses are one cause for the decline in EVM, however the decline in profitability of new business must be concerning for Swiss Re, especially with the reinsurance market showing signs of further pricing declines and that pressure broadening into the commercial insurance markets.

Again, will capital management be enough to turn this tide? At the moment it really doesn’t seem likely without some major losses that really do drain capacity and capital from the space. And then we get back to the same question we’ve been asking for the last few years. If capital’s depleted who is going to replenish it and how will that affect the market dynamic? The traditional reinsurer shareholders or the capital markets and ILS investors?