Reinsurers need to offer more than just capacity, ILS can help: S&P

Aside from the very largest of global reinsurance firms, the rest of the pack need to understand that they need to do more than just provide reinsurance capacity, as that can be more simply and less expensively delivered through the capital markets, according to S&P.

Rating agency Standard & Poor’s provided its outlook on the global reinsurance sector this morning, maintaining it at stable for the moment as long as returns-on-capital do not drop below cost-of-capital for a sustained period.

But despite still being stable for now, S&P highlighted the declining profitability of the reinsurance segment and explained that we’re now at a stage where, for some reinsurers, there is an urgent need to find better ways to generate revenue than through capacity deployment alone.

It’s come to something when a reinsurer is being told by a rating agency that its core business model no longer cuts it, but that is where we are and after the disappointing response of the market cycle to the 2017 catastrophes it has become clearer than ever that change and an evolution in reinsurers’ strategies is more urgent than ever.

How the reinsurance industry should evolve its business model remains open to significant interpretation, with so many routes possible.

Achieving scale and diversity are two of the key traits reinsurers must seek out to become truly insulated from the majority of market forces, S&P’s new report makes clear.

But aside from that there are a multitude of ways reinsurers could go, as they look to protect their futures and create platforms that can deliver more than the just above cost-of-capital returns that the sector is averaging today.

The five largest reinsurers that S&P rates, Munich Re, Swiss Re, Berkshire Hathaway, Hannover Re and SCOR, are all relatively insulated already and have the scale and capital resources to spend time introducing new revenue streams.

Smaller reinsurers do not have that luxury and the need to change becomes more urgent the more commoditised your product offering becomes, it seems.

“We believe that the top five global reinsurers will likely continue defending their dominant market position given their strong relationships with cedents and access to business,” S&P explains.

Adding, “However, we believe the rest of the pack can also score some wins and narrow the gap by focusing on cedents’ needs.”

This focus on the customer is still something that some in the reinsurance sector appears to be struggling to come to terms with, despite the relationship focused nature of this business.

But there are routes that reinsurers can take to ensure they reduce the risks of being marginalised, but these all require a focus on more than just being a capacity provider.

S&P states that they can become, “more like risk partners,” adding that they need to get up to speed with “proposing innovative solutions rather than just providing reinsurance capacity.”

And the crux of that argument, of course, is that capacity alone, “can easily and less expensively be replicated through the capital markets,” the rating agency explained.

This neatly leads us onto the second part of the headline, that alternative capital and insurance-linked securities (ILS) can actually help her, providing the balance-sheet capacity that can augment reinsurers own, while they can earn underwriting and management fees as well.

Hence the growth in management of alternative capital, or alternative balance-sheets as these pools of capacity are becoming, at reinsurance firms, giving them greater flexibility and capital efficiency at a time when those traits are increasingly key.

While S&P said today that weak business conditions in reinsurance are partly down to “the influx of alternative capital” which serves to “challenge reinsurers’ business models,” it is also one of the levers they have to develop a business model for the future that can perhaps provide a new way to get paid for their expertise in originating, analysing, pricing, structuring and underwriting risk.

With capacity more easily and cheaply found via capital markets sources and ILS funds now reinsurers have to adapt or there will be little opportunity for them in certain short-tail lines and catastrophe risks, unless they have the globally diversified, scaled portfolios that allow them to deploy capacity more cheaply (like the top five).

The problem lies in the reinsurers underwriting and enterprise returns-on-capital no longer cutting it and hence S&P warns:

“Reinsurers are likely to barely cover their cost of capital in 2018 and 2019. This is entirely different from the situation witnessed in the aftermath of the 2005 and 2011 catastrophe losses, where excess returns were generated off the back of significant rate increases following the heavy catastrophe losses.

“If the industry’s return on capital declines sustainably below its costs, which causes market growth prospects to suffer, we could reassess our view of the sector.”

Of course S&P also highlights the moderating of prices due to alternative capital following the losses of 2017 and the rating agency expects that rates will only rise by low single digits at January 2019, in aggregate across the reinsurance sector.

That’s not going to be sufficient to enable reinsurers to generate significantly higher returns and with evidence that reserves may be dwindling and the fact that there could be more reserve hardening for some, after the 2017 losses, the outlook does not look particularly rosy in terms of business prospects.

That is unless reinsurers successfully adapt their business models of course, as there is every opportunity to become more profitable, while reducing expenses, and leveraging efficiency capital sources to augment capacity, right now.

It’s making the right strategic decisions that matters now and in some ways executive teams are becoming an important differentiator, as wrong decisions taken, or decisions taken too late, could mean longer in the doldrums and less chance of improving returns-on-capital in time to satisfy shareholders.

Reinsurers are “learning to live with” the challenges presented by alternative capital, S&P explains and it is this ability to leverage ILS and the capital markets for a profitable outcome, while not cannibalising core underwriting returns, that is key.

Finding ways to augment returns using another source of capital than your balance-sheet will enable reinsurers to ride out the cycle more profitably and reposition themselves, while their shareholder capital can be put to good work in developing additional revenue streams and income.

“The sector is actively looking at ways to adjust to the new normal of a heightened presence of alternative capital,” as a way to cope with excess capital in the industry, S&P says.

Get this adjustment right and find ways to offer more than just capacity, while leveraging the efficiencies of the capital market, and reinsurers could find they develop business models that sustain them through the new normal of a flatter pricing cycle and lower underwriting returns.

Also read:

New reinsurance normal wins out, optimism diminished: A.M. Best.