Top reinsurers capital redundancy drops below ‘AAA’ level: S&P

Despite the constant reports of overcapitalisation in reinsurance, S&P reports that the top 20 reinsurance firms in the world have lost their capital redundancy at the ‘AAA’ confidence level for the first time since the financial crisis back in 2008.

It’s an interesting fact, given the excess levels of capital in the space, but S&P notes that despite the dip at the ‘AAA’ confidence level, it sees capital adequacy of reinsurers as remaining strong in 2017, being redundant by 7% at the ‘AA’ confidence level.

Capital adequacy, by S&P’s measure of the top-20 global reinsurers’ aggregate total adjusted capital (TAC), began to decline at all confidence levels in 2015 through 2016, due to asset-liability management (ALM) practices, longevity risk capital charges, share buybacks and special dividends, and to a lesser extent, mergers and acquisitions (M&A) activity in 2016, the rating agency explained.

But it was the hurricanes and other catastrophe losses of 2017 that sent TAC into negative or deficient territory for the ‘AAA’ confidence level, exacerbating the decline, along with the impact of M&A transactions among the major Bermudians.

Reinsurance firms have slowed share buybacks and been more carefully holding capital since the losses of 2017, S&P notes, as they rebuild their capital strength.

Interestingly though, the property catastrophe reinsurance specialists have fared better, despite the losses, continuing to enjoy a 14% redundancy at the ‘AAA’ confidence level in 2017, despite the fact most faced a capital event because of the losses.

Still, S&P explains that despite all this, “The global reinsurers’ robust capitalization has provided a rock of stability in an otherwise tumultuous environment,” adding that it “continues to view the reinsurance sector’s capital adequacy favorably and as a strength,” and that alongside sophisticated enterprise risk management, the capital stength underpins S&P’s stable outlook on the global reinsurance sector and on the majority of the reinsurers it rates.

The top-20 reinsurers could regain their ‘AAA’ confidence level capitalisation if catastrophe losses turn out to be average for the full-year 2018, S&P notes, as their capital buffers would be largely rebuilt by that time.

Further explaining what this means for reinsurers, S&P said, “A 1-in-10-year aggregate loss experience, which we estimate to be about $21 billion, would exceed the annual natural catastrophe budget and hit the top-20 global reinsurers’ earnings, but would not become a capital event for them as a cohort. On the other hand, were 1-in-50-year aggregate catastrophe loss events to occur, the top-20 global reinsurers would suffer losses of about $36 billion, which would exceed their annual catastrophe budget and the forecasted earnings for 2018 and would become a capital event.”

There is a lot going on in terms of how S&P calculates the capitalisation levels of the major reinsurers, but it’s clear that no matter how dreary the outlook for renewals etc may be, these companies remain capitalised well-enough to continue to operate at the softer-for-longer pricing levels we see today.

In fact, it continues to be seen that globally diverse reinsurers are the ones driving pricing in diversifying peril regions, which can serve to lock out the majority of third-party capital providers in certain markets.

Europe, Asia, Latin America and Australian renewals all see this trend, of major global reinsurers writing regional catastrophe programs at pricing close to or at expected loss, something the major ILS players cannot as easily do, given their lesser diversification and minimum return commitments. Hence it is taking much longer for ILS to penetrate some of these markets as deeply as Florida and the U.S.

This isn’t the case in peak zone United States though, where capital charges are heavier for the reinsurers and ILS funds can therefore compete on a more level playing field.

But of course, these reinsurers do have newer levers at their disposal in the more competitive regions as well, with alternative capital, ILS and third-party backed structures all offering a way for them to utilise efficient capital in areas of their underwriting where the capital charges may have been heavier for their own equity balance-sheets.

This is an interesting area that has not been clearly analysed as yet. What is the impact of all this third-party capital on reinsurers own capitalisation levels and adequacy? How does it assist them in shifting capital heavy risks onto third-party backed balance-sheets, still earning fee income for their underwriting but avoiding the capital charges that peak catastrophe risks can come with?

S&P notes the trend towards greater use of quota shares, as one way that reinsurers have been reducing the costs of their protection, while sharing in the performance (and losses) of their portfolios.

That adds capital efficiency, but so too does the use of their own third-party capital vehicles, or their private ILS arrangements with major investors and with ILS capacity in use by major reinsurers now such a significant sum it is clearly assisting them in maintaining their capital levels and adequacy.

Reserves are also an interesting area of capitalisation and here S&P highlights that after the events of 2017, some of the reinsurers have been releasing fewer reserves, suggesting that redundancy is lower than it was.

Some too have been bolstering reserves for the 2017 loss events, which could result in greater releases down the line, or equally could mean that others have to harden reserves in the future.

Hence there is a lot of uncertainty still over the full capital impact for the major reinsurers from the losses of 2017 and how that will continue to play out.

Importantly, S&P says, “We believe the sector needs to preserve and solidify its capital strength so that it can weather any potential threats from any unexpected rise in inflation, inadequate reinsurance pricing, unfavorable reserve developments, major market correction, and unforeseen “black swan” events.”

We believe that reinsurance firms are now doing this using third-party capital, at least to a degree.

The role third-party capital plays in helping reinsurers to manage their own capital base, optimising its adequacy through the shifting of capital-heavy risks onto managed balance-sheets and vehicles is providing a performance lever that reinsurers did not benefit from (as much) in the past.

With reinsurance firms also clearly using third-party capital for growth, it’s apparent that the business model of the traditional reinsurer may now be considered to be becoming reliant on access to sources of alternative or third-party capital.

It’s going to be interesting to see how that trend continues and just how integral ILS and third-party capital can become in a reinsurers overall capital model.