What happens when the music stops (reserve releases run dry)?

The non-life reinsurance industry has been running on reserves in recent years. With large catastrophe losses notably absent and prior year reserve releases buoying results by 5% to 8%, perhaps the recent strong performance of reinsurers is a mirage?

Swiss Re dives into this issue in its recent economic outlook report and it’s one that ties in nicely with a lot of our recent coverage on the importance of expense management and efficiency within the reinsurance industry.

Swiss Re says in the report that while reinsurers have been reporting stirling results for the first three-quarters of 2014, these results do not reflect reality. The absence of large losses is just one factor which has skewed reinsurer results, perhaps masking the profitability of their underwriting, the other factor is reserves.

The reinsurance industry is expected, based on preliminary data, to report a combined ratio of around 90% for the full financial year in 2014, Swiss Re says. However, this number does not properly reflect the underlying underwriting profitability and performance, the reinsurer notes, due to the low-level of large natural catastrophe losses and the fact that the claims ratio has been reduced due to positive reserve releases.

These positive reserve releases from previous years of underwriting, are made up of redundant reserves no longer required to be held for prior year claims. As a result, these prior year reserves can be released and booked in a current year, where they lower the amount of claims incurred and positively impact underwriting performance, lower the combined ratio and boost net income.

The level of positive prior year reserve releases has been mooted to be as much as 7% or 8% of some reinsurers combined ratios for a while now. There is an expectation that these prior year reserve releases are going to run out, sooner rather than later. When they do, you can add that 7% or 8% back to the combined ratio to get a truer picture of underwriting profitability.

We first mentioned this issue in January 2013, so it has been a constant undercurrent of reinsurance market trends for the last two years. We wrote at the time; “It is more important than ever for reinsurers to focus on underwriting performance, capital management and adaptability in order to be profitable, as reserve releases continue to appear to be diminishing.”

Indeed, Swiss Re estimates that if you exclude the two major influences on reinsurer profitability, of low-cat losses and positive reserves, then the full-year combined ratio for the reinsurance industry in 2014 would look more like 98% and the average return on equity (RoE) more like 8%. That’s a significant difference to the 12% RoE that non-life reinsurance firms are expected to average.

When the reserve releases do dry up and if catastrophe loss experience becomes more typical or severe, while pricing remains lower than seen historically as the market remains softened compared to previous years, even post loss event, how would reinsurers make up that deficit? In fact, in a bad loss year, with no prior year reserves and pricing declines really biting, it’s very easy to see how the average combined ratio could suddenly leap over 100%.

Looking forwards, Swiss Re expects reinsurance pricing to remain under pressure and while the firm acknowledges that there will be premium growth opportunities in some emerging markets these opportunities may not be sufficient to make up any shortfall in the short-term.

Assuming average catastrophe losses, further softening of reinsurance rates, a less benign claims environment than seen in recent years and diminishing reserve releases, Swiss Re forecasts that the combined ratio in non-life reinsurance may actually be 100% in 2015.

Underwriting profitability is expected to be below the average of recent years and although there remains an expectation of some interest rate increases, this is not expected to be enough to boost investment returns significantly. As a result, Swiss Re forecasts an outlook for overall profitability of an RoE of 7% for 2015 and 2016.

So the outlook remains gloomy, with perhaps the hardest years to come for some reinsurance firms as the reserves dry up, combined ratios leap, return on equity declines and the music stops. The need to focus on expense ratio management and efficiency is clear. Reinsurers are going to have to do everything they can to squeeze out an extra percentage point of RoE to keep their shareholders happy.

The shift from positive reserves to no reserves could be quite sudden as well, we may see a single quarter to quarter jump of anything up to 10% in some reinsurer combined ratios if the transition is not well-managed. Finance teams are sure to be looking at how best to engineer a soft combined ratio landing, where it creeps up gradually, rather than one big, shareholder worrying, jump.

If that leap happens in a bad catastrophe year we could see some reinsurers report terrible performance. Or if a reinsurer that is multi-line also experienced severe worsening of reserves for longer-tailed lines such as casualty or life risks then the effect could be equally as stark, resulting in a very unprofitable year or years.

Hence percentage points on claims, expenses and the overall combined ratio are going to become increasingly important and receive increasing scrutiny. When the music stops we may well get a chance to really look at who is performing, who has the softened reinsurance rate environment hurt the most, who is navigating the structurally changed reinsurance market most effectively and, for those that have embraced third-party capital management, who is making that a profitable exercise and who has actually been cannibalising their own book.

When the music stops and reserves run dry we may also get an opportunity to see how the reinsurance market cycle has changed. If we do see a severe catastrophe loss at that time you can be sure that traditional reinsurers will be calling for payback and seeking to hike rates significantly, to both recoup losses but also to boost performance as it may be the best chance they will get.

Will that strategy work anymore? Will insurers want to “pay back” reinsurers for providing them with cover in previous years? Or will the ILS and capital market step in with increased capital inflows to soak up that business for a lower rate increase?

It’s impossible to predict how the market will react, given its current rate of development and change. All we can say for certain is that efficiency, flexibility and effectiveness are without a doubt going to be key to traditional reinsurers. Cost-of-capital is increasingly going to be a factor that traditional and non-traditional or ILS capacity providers are going to be competing on. Expenses will matter, a lot, as will size and scale, perhaps resulting in more M&A activity in reinsurance. Finally the asset side of the reinsurance business is likely to become an area of increasing focus, especially as it might be seen as a an area of profit that is growing in importance.

However these scenarios pan out, when the music stops things are going to get really interesting.