Cheaper ILS products to end golden era for property CAT margins: Numis

An analysts report from Numis Securities, which discusses softening property catastrophe reinsurance rates and the impact this is having on London market underwriters, suggests that the influence of capital market capacity and the availability of cheaper insurance-linked securities (ILS) products will end the golden era for property catastrophe margins.

Numis become the second analyst firm to effectively make the call that further softening is ahead and a soft market likely in 2014, due to the impact of lower-cost, third-party and capital market investor backed reinsurance capital and capacity. Nomura forecast a soft market in its recent reinsurance market analysis, and we don’t expect these to be the last discussions of the potential for a soft market in the coming weeks.

The report from Numis looks at how current market trends are affecting London market non-life insurance and reinsurance underwriters, such as Amlin, Beazley, Catlin, Hiscox, Lancashire and Novae. It suggests that the impact on property catastrophe lines from the influx of third-party capital and the ILS or catastrophe bond market will be negative for traditional players in the space who do not adapt to this new market dynamic.

The softening of rates in property catastrophe lines of business which has been seen at the June renewals is just the start, suggests the report by Numis analyst Nick Johnson. The report says that recent price softening signals the onset of a tougher environment for reinsurers.

Johnson says in the report that the June reinsurance renewals have seen price decreases of around -15% on average but as much as -30% on some Florida lines, partly due to a lack of Florida hurricane losses but mainly because of the influence of competition from insurance-linked securities (ILS). Johnson says that the influence of ILS on reinsurance prices looks set to continue, saying in the report; “We think the search for yield by investors will drive ongoing growth in the ILS space and put further pressure on property CAT rates and volumes in the traditional reinsurance sector into 2014.”

For the London market underwriters, this extra competition from ILS and third-party sourced reinsurance funds and vehicles will create a ‘material earnings headwind’ for some, particularly those with considerable property CAT focus within their businesses. The loss of volume to ILS and alternative reinsurance players is also likely to prove a challenge to traditional players, said Johnson in the report, but on the positive side reduced reinsurance prices will enable some outward cost savings.

Johnson notes the ability of underwriters to adapt to the ‘new normal’ of lower rates caused by an influx of third-party capital. Some will be able to offset the effects by deploying capital into other more profitable lines of business, others, such as Lancashire, Amlin and Hiscox, are developing their own fund management type businesses to focus on ILS and may bring shareholder benefits in time.

Traditional reinsurer price discipline has been slipping, according to the report, which it sees as a response to the increased competition from insurance-linked securities (ILS). This was in our view inevitable, as when the June renewals were approaching traditional reinsurers knew that they had to secure business for their books and drop their rates to ensure they acquired sufficient volume of risk. How traditional reinsurers react at the January 2014 renewals, the next key market juncture, will be a key test for the market.

ILS is becoming an increasingly accepted and mainstream asset class, according to Johnson in the report. This is helping to increase the pressure on rates, which Numis believes could get back towards pre-Katrina levels by 2015 unless we see an event, catastrophe or otherwise, that is large enough to turn the market again.

Numis expects ongoing continued growth in the catastrophe bond market, as ILS continues to gain acceptance among a broader group of institutional investors and its profile as a cost-effective risk transfer tool also grows. It expects this growth to continue up to and probably beyond the next major hurricane loss, which is certainly going to be a real barometer for the market.

On catastrophe bond spreads, Johnson said in the report that cat bond spreads could see further room to fall as more investors get accustomed to catastrophe risk and the investor landscape broadens further. The fact that investments in cat bonds have continually manage to offer positive returns no matter how severe the insured loss events each year have been is proving too much for some investors to resist, but there will be a time when this changes and that again will be a real test for the cat bond market.

Numis sees the lower cost of capital that ILS products have as a significant long-term challenge to traditional reinsurers, both in terms of pricing and also loss of volume to ILS products. Demand for reinsurance is likely to remain at current levels but ILS participation looks set to grow and this will see traditional reinsurers continue to lose market share.

Combining the factors of increased competition from ILS and third-party capital, reduced volumes of property catastrophe business due to this competition and the slight offsets of cheaper outward reinsurance rates and potential margin improvement on non-catastrophe lines, Numis expects an earnings per share EPS decrease of -7% on average across the London market underwriters it reviewed.

As if this outlook wasn’t pessimistic enough for some underwriters, Numis expects this trend to continue. The report suggests that rate reductions are likely to be repeated at the January 2014 renewals and even beyond that into 2014. With reinsurance rates having been near highs for seven years, Numis now expects sustained pressure on this segment of the market, which it says will end a golden era for property CAT margins.

The report goes into much more detail about the trends affecting the sector and the likely impact on these London market underwriters. It’s a report well worth reading and we suggest you contact Numis Securities if you want to read a full copy.

Of course things are changing rapidly in the sector and more traditional players are working out how best to either combat the threat of third-party capital and ILS or how to embrace it and launch their own ventures into managing external capital. Some will get this balance right and find the earnings headwind is not as strong but there will no doubt be some for who the headwind is likely to reach storm force.